Precision Needed in Fed Comments

Words are powerful and no one understands that more than Fed Chairman Ben Bernanke. Among those who follow the actions of the Federal Reserve, many believe that the Fed will hold rates steady at its meeting this week. All eyes will be scrutinizing the phrasing of the statement in order to uncover clues to any future rate increases. This type of semantic analyses can impact the confidence of the market over the short term.

Core Strength in CRE

The consumer price index increased 0.6% in May, the Labor Department noted last Friday. Excluding food and energy, it advanced a modest 0.2%. Wall Street economists had expected a 0.5% rise in the headline and 0.2% core increase.

The surprising strength of the retail market, which came in twice as high as economists predicted, reinforces the ongoing shift of financial market and policymaker attention toward inflation risks and away from the risk of an imminent downturn in the economy, a move I wrote about in last week’s blog.

The strong report helped to boost the dollar, which rallied against both the euro and yen. The U.S. Dollar Index, which tracks the currency’s value against a basket of six foreign denominations, recently rose 0.9%, or 0.66 point, at 73.90.

As a whole, these reports indicate a U.S. economy that is, at best, tentative. Our core economy continues to post modest gains, which is good news for business and industry and has enabled CRE to remain fundamentally strong.

Real estate fundamentals remain solid with vacancy rates near the set points and with workman-like rent growth. CRE delinquency rates – at 0.5% – remain at near-historic lows and reflect generally healthy occupancy and income growth. The unknown continues to be the uncertainty in the economy, which is creating some deterioration in selected markets across the country. Clearly there has been deceleration in the first quarter of 2008, which has resulted in negative net absorption – not seen since the last downturn.

Overall vacancies edged up slightly to 14.3% in the first quarter from a cyclical low of 13.6% at the end of last year. With an uncertain economy, business turned cautious more quickly. Companies planning relocation or expansion have tabled their plans temporarily. Others are watching and waiting to see if there is more downward pressure on rental rates. Companies, if they are able, are waiting on the sidelines.

One factor that differentiates 2008 from the previous downturn in the national office market is that there are fewer construction projects online across a majority of markets. Private nonresidential-construction spending in April was at a seasonally adjusted annual rate of $388 billion, up 1.6% from March 2008 and up 15.4% from April 2007. Most of this construction was earmarked in the lodging sector. This time the industry is not saddled with too much inventory; it is weighted down with an anchor of poorly managed and priced debt. Fortunately, this is a situation that can be cured more rapidly.

Regionally, the commercial office market remains solid, and in many cases is still growing, albeit more slowly. In Houston for example, the nation’s fifth largest office market with 183.05 msf of total office space, overall occupancy stood at 88.2% — 91.1% in the CBD—and Class A space was 92.4% leased.

In Dallas, the area’s office leasing market began strong in the first quarter of 2008 with 834,200 square feet of positive net absorption, which primarily was driven by the Class B sector. Overall vacancy rates remain stable, signaling that current availability is meeting demand. For the first quarter of 2008, rental rate growth inched up slightly from the fourth quarter of 2007.

At 412 million sf of office space, New York City still is seeing modest rent growth of about 8.8%. In the Midwest, Chicago posted a modest positive absorption of 70,000 sf in the CBD during the first quarter. Total vacancies in the CBD were at 13.3%.

Although there is core stability in the industry, transactions must be completed in order to generate solid growth. Clearly, the CMBS market, which may be the driving force behind the recent boom years in the real estate capital markets, has completely changed in the last nine months. The widening of spreads, combined with a low tolerance for risk, has resulted in an industry that has seen virtually no activity for those who rely on securitized mortgage products.

As a result, U.S., banks — constrained now because of weak balance sheets — will have to start lending again. The good news is that with their borrowing costs relatively low, banks can repair the damage relatively quickly. Over the remainder of 2008, cash buyers including institutional funds and foreign buyers, may be expected to increase their market share among all purchasers. And as often is the case, the market will trim and prune itself and the result will be a stronger industry.

Right Time to Focus on Inflation

In the last two weeks we saw mixed May economic releases, from an expanding non-manufacturing sector and improving chain store sales, to continued declines in payrolls and a surge in the unemployment rate. Together, they added up to a soft but still growing U.S. economy. The Fed has been very effective through its aggressive monetary policies to sustain economic growth and minimize harm from collapse of the sub-prime mortgage market. The Fed’s powerful doses of rate cuts that started last September along with the government’s $170 billion stimulus package, including rebates for people and tax breaks for business, have stalled a potential recession expectation and should bring about better economic conditions in the second half of this year.

Cautious Optimism in Office Market

The GDP grew 1.2 % in the first quarter of 2008. Year-over-year inflation edged lower in April to 3.9 %. In April, core inflation – a more stable indicator because it factors out large monthly swings in food and energy prices – moved lower to 2.3 %. Stable core inflation may be the saving grace bolstering the sluggish U.S. economy, which has limited price increases outside the volatile food and energy sectors.

Unemployment edged down slightly to 5.0 % in April but the employment report did provide some optimism, revealing a manageable 20,000 job loss, a sign that the economy may face a shallow rather than severe recession. Some of the optimism stems from a sharp turnaround in the professional and business services sector. This sector is the largest component of the office-using segment.

Last week’s slight pullback on oil prices and better-than-expected GDP figures created positive momentum for real estate stocks, which were up 2.8% as they rallied with the NASDAQ (up 2.6%) and were ahead of the S&P 500 (1.7%) and S&P Utilities Index (1.5%).

Although the financial sector continues to drag down the broader markets, the office sector is maintaining some positive momentum. Last week, it marginally outperformed the WRESI, which gained 2.8 % during the past week. Year to date, the WRESI is up 9.4 %. For the week, office stocks moved up 2.9 %. SL Green Realty led the group by edging up 5.2 %.

For the quarter, office vacancies rose a less-than-expected 20 bps to 12.8 % nationally. Uncertainty in the economy has caused some tenants to delay large lease commitments and expansions. With that said, asking rents increased some 1.7 % in the first quarter. This occurred despite rising vacancies in certain challenged markets including South Florida, Orange County and Riverside-San Bernardino, Calif. Markets that experienced the most notable increases in rent growth included Boston, New York, Houston, and Dallas. Effective rents remain flat due to use of concessions. On a positive note however, sublease space is rising more slowly during this period, which is having less of an effect on office rents.

There continues to be bright spots on the horizon for the office sector. The national default rate on commercial mortgages is a slim 0.4%. Economists generally are in agreement that this downturn will be unlike previous events and most predict a shallow slowdown with a recovery beginning in the second half of 2008. During April, $4.9 billion of office investment transactions occurred, which was an increase from February, but still well below comparative levels in 2007.

Despite changes in the capital and debt markets, not all buyers are constrained by the debt markets or are waiting on the sidelines for prices to fall. Although many institutional investors have slowed their rate of investing, they actually have increased their share of all office acquisitions to 23% because so many other buyers are out of the market. It is anticipated that institutional buyers will help drive the recovery with offshore investors accounting for 12% of all recent office acquisitions.

We think the divergence with the debt markets reflects the reduction of hedges that were put in place earlier this year. As more banks sell off their commercial mortgages, the amount they need to hedge is reduced as well. This means that banks would be able to sell credit default swaps, buy REIT equities or purchase the CMBX index. What’s more, fund flows remain positive with $31 million flowing into domestic real estate funds and another $73 million into the global funds.

When the economy and credit markets have stabilized, we continue to believe that the Federal Reserve may shift gears and begin raising interest rates to combat inflation.