Lending advice
Rough Waters Ahead
by Mark Levine
Happy birthday to the mortgage crisis! The credit crunch celebrated its first birthday in July. Will it live to reach its second birthday? We hope not, but nobody really knows for sure.
Will the markets be completely calm before the end of another 12 months? That does not appear to be the case. Are we still heading in the wrong direction and facing several years of negative trends in the real-estate industry? That certainly does not appear likely either. But what does seem evident is that we will be facing some choppy waters throughout the rest of the year. That does not necessarily imply a definitively bad market, but it does mean that we should brace ourselves for significant ups and downs before we can start heading in the right direction again.
In other words, the only thing that we know for sure is that we will not be sure about the state of our industry throughout the next year. The problem is not that things are falling apart. That was the story over the past 12 months due to the rapid downturn in residential housing, the failure of the CMBS market and the collapse of some major financial institutions. Hopefully, we are beginning to move beyond those monumental issues. In reality, there will likely be some more collapses, but various market and government mechanisms will continue to absorb those shocks.
There are two major items in our near future, though, which guarantee uncertainty throughout the rest of the year. The first is interest rates. From a lender’s perspective, it has been very difficult to watch Treasury and mortgage rates fluctuate by 50 basis points in the period of a week. I can only imagine the heartache of watching the same movements from the perspective of a borrower, especially borrowers with floating rate debt or those who are otherwise financially impacted by movements in the Treasury rates.
Unfortunately, this volatility will last thanks to the very mixed signals that continue to come from economic data reports. I do not envy Ben Bernanke, or the other Federal Reserve Bank policy makers, who appear to be schizophrenic due to no fault of their own. On the one hand, our economy might still not be clear of entering a technical recession. On the other hand, inflation seems to be getting more significant every day.
Throughout the early stages of the credit crisis, consumers stayed optimistic and helped to keep the economy growing thanks to fearless spending habits. Watch for that to change, though. Jobs continue to be cut, especially in many high-paying sectors, such as investment banking, real estate and aerospace. The effects of these cuts will trickle down to many other sectors, such as housing-related services and tourism, as discretionary income continues to shrink. Retail will also likely feel the effect, and this area, which has helped to support the economy, will probably continue to weaken. Watch for low expectations and consumer sentiment as we move toward the holiday season.
As mentioned above, there is also this ugly thing called inflation. If you watch or read the news, or even do the grocery shopping, you likely know that the prices of most agricultural goods and farm-related costs have gone through the roof this year. And if you simply have a heartbeat, you know that prices of gasoline and other fuels have gone past the roof and reached the sky this year. There are certainly various efforts to control these price increases, such as changing individual consumption habits and creating alternative fuels. However, the bigger supply-demand dynamics will not change in the near term, and therefore this inflationary pressure from fuel costs will continue to weigh on our economic system.
Mixed messages will most likely continue to prevail. As a result, the Federal Reserve will attempt to keep a delicate balance, and therefore probably will not make any dramatic moves this year. However, it will continue to be very vocal about actively responding to both economic weakness and inflation, and this dialogue by itself will create market volatility. In the long run, interest rates are certainly expected to increase from today’s historic lows. But expect a slow climb instead of sudden movements similar to the ones we experienced on the way down last year and early in 2008.
The other major event that will guarantee market uncertainty is the upcoming presidential election. I will certainly not opine on which candidate would be better for our ailing real-estate industry; however, I do surmise that any clear path towards one direction or the other will speed up the recovery process. In general, political uncertainty breeds market uncertainty, and therefore our economy will have a difficult time getting back on track until a winner begins to emerge. When that picture becomes a bit clearer, I believe that market stability will begin to replace the dizzying volatility that has characterized 2008.
Both major presidential candidates are making an overriding effort to stress the notion of change. Within a few months, that change will be upon us, and increased stability should begin to replace our current state of volatility. With a newfound sense of direction and certainty comes a greater sense of confidence in the economy. With greater confidence comes increased spending and perhaps even an end in sight for the housing crisis. Even if we are still facing slow economic times—or even an actual recession—at that point, I believe that the skies will begin to get brighter right after the election season.
There is currently pressure on interest rates coming from both directions. The downward pressure on rates could lessen when we start to realize this overall improvement in consumer sentiment and economic growth. However, because the inflationary—or upward—pressure on rates is somewhat independent from consumer behavior or even the domestic economy, there is a good chance that it will not wane at the same juncture. Therefore, when we are left with pressure in just one direction and there is nothing to counter that pressure, things should move in that direction. For lenders and borrowers, that upward direction of interest rates is not necessarily what we want to see.
In sum, there are actually two things about which we can be certain right now. The first is where we stand in today’s market. We currently have relatively low interest rates; readily available debt, particularly for apartment investors; and strong real-estate fundamentals for commercial property in our local markets. Things could be much worse. The second thing that we know, as mentioned earlier, is that the road ahead will be fairly rocky before it smoothes out. For investors who are nervous about the state of the market, it likely will not get any easier in the near future.
For investors interested in transacting business over the next year, now is probably a very good time to do it. With the benefit of hindsight, today will likely look like a great opportunity when viewed from several months in the future.
The second year of this troubled real-estate market will be a challenging one, but hopefully it will also be the last one. Nobody wants this credit crisis to run into its “terrible twos.”
The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Mark Levine is a vice president in the San Francisco office of ARCS Commercial Mortgage. He can be reached at 415-981-9700 or Mark_Levine@arcscommercial.com. Copyright © 2008 SF Apartment Magazine. All rights reserved.