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Economic Data Offers Cause for Cautious Optimism: Home Sales Rise, While Job Losses Down from Peak
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Recession Drivers Shift. U.S. GDP contracted at an annualized rate of 5.7 percent in the first quarter of 2009, following a 6.3 percent decline in the previous quarter. Despite dramatic decreases in both quarters, the components of change varied significantly. Weakness during the fourth quarter was driven by a pullback in consumer spending, while contraction in the first quarter was due largely to drastic cutbacks in business spending and inventory reductions. During the first quarter, consumer expenditures made a positive contribution to GDP for the first time since mid-2008, and consumer confidence began to improve. Retail sales slipped in March and April before rising minimally in May, however, as consumers remained cautious, driving the savings rate to its highest level since 1995.
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Job Losses Still Above-Trend but Decelerating.
The freezing of the commercial paper market and interbank lending last fall resulted in extreme cutbacks across employment sectors. In May, employment declined by 345,000 jobs amid continued economic weakness, though losses were down more than 45 percent from the previous six-month average. Since the start of the downturn, 6 million jobs have been lost nationwide, the greatest contraction in history, and the unemployment rate has skyrocketed from 4.9 percent to 9.4 percent, the highest level since 1983. Unemployment is expected to rise past 10 percent by early 2010, even after job losses subside, due to individuals who suspended job searches during the downturn re-entering the labor pool.
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Home Sales Activity Rising, but Prices Yet to Bottom. Rising foreclosure activity has led to dramatic declines in home prices, which, combined with low mortgage rates and an $8,000 tax credit for first-time homebuyers, have sparked a wave of home sales in many major markets. While sales activity appears to be moving along a floor, prices are forecast to slip further through 2009 as bank-owned properties continue to flood the market.
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Government Measures Improve Confidence, Help Settle Financial Markets — No Quick Fix. Government intervention since the onset of the credit crunch has reached unprecedented levels. Several credit facilities have been established since the fall of 2007 to address troubled segments of the financial system, including money market funds, the commercial paper market and asset-backed securities. A more systemic approach has been proposed to clear toxic loans and securities from banks’ balance sheets through public-private partnerships. While these programs could provide a much-needed price discovery tool and free up capital for new lending, implementation will require time and likely some trial and error.
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Stress Tests Uncover Potential Problems Ahead of the Curve; Markets Respond Favorably. The economic downturn may be rooted in the housing and mortgage markets, but uncertainty and fear played critical roles in the escalation of a credit crunch to a full-blown financial crisis. To provide more transparency in the financial system, the government recently performed stress tests on the 19 largest U.S. banks. Although 10 banks were ordered to raise a combined $75 billion to protect against potential losses, the results were not as grim as many feared. Markets have reacted somewhat positively, with financial stocks posting gains immediately following the release of the results. Furthermore, major banks have already raised a substantial portion of the government’s capital requirements through stock sales.
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Fed Focuses on Unlocking Commercial Mortgage-Backed Securities (CMBS) Market; Potential S&P Downgrades May Hamper Effectiveness.In early May, the Fed announced it would offer five-year loans through its Term Asset-Backed Loan Facility (TALF) for the purchase of highly rated, newly issued CMBS starting this summer. The government followed a few weeks later by adding highly rated legacy CMBS to the program. The program’s expansion was initially well-received, with spreads for AAA-rated CMBS narrowing more than 100 basis points. Furthermore, a few major banks have announced plans to originate new, fixed-rate commercial mortgages that will be securitized and eligible for TALF financing. CMBS spreads have ticked up again, and near-term volatility is likely, however, as Standard & Poor’s recently proposed modifications to its ratings methodologies. The changes could lead to mass downgrades, particularly for 2005 to 2007 vintages, which were subject to the most lax underwriting. The latest developments may prompt some retooling of the CMBS component of TALF, since a large share of legacy CMBS may not qualify for the program.
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Forecast:
Indicators Offer Cause for Guarded Optimism.Business and consumer confidence have increased in recent months due to more optimistic expectations for the second half of 2009, while initial jobless claims are still elevated but down from the peak. Some near-term spikes in new unemployment claims may occur due to recent bankruptcy filings by GM and Chrysler, but overall employment should begin to level in the third quarter. Assuming home prices bottom by early 2010 and credit markets continue to ease, employment should expand by 1.0 percent to 1.25 percent in 2010.
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Moderate Economic Growth in 2010.The housing market was the first domino to fall and has weighed heavily on the economy, subtracting an average of 95 basis points from GDP every quarter since 2006. Therefore, even a bottoming of the housing market bodes well for overall GDP, which is forecast to increase by 2.0 percent to 2.5 percent in 2010.
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Commercial Property Distress to Rise Amid Wave of Maturing Debt.Even if programs aimed at restarting the securitization market are successful and constraints on debt capital ease, the combination of deteriorating property fundamentals, declining values and tighter underwriting will make it impossible for many owners to refinance maturing loans without considerable equity contributions. During the first quarter of 2009, the distressed component of the marketplace increased by more than 50 percent, and with nearly $365 billion in commercial mortgage debt due to mature in 2009 and 2010, distress will undoubtedly rise further. On a positive note, there is a tremendous amount of equity awaiting placement in the commercial real estate market. REITs have raised more than $7 billion year to date, for example, positioning them to acquire well-priced assets that may come to market in the near term.
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Apartment Vacancy Rising as Steep Job Losses
Stall Renter Household Formation
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Apartment Demand Weakening.
Vacancy increased to 7.2 percent in early 2009, matching the peak level recorded during the last cyclical downturn. At the end of the first quarter, vacancy was up 60 basis points from year-end 2008 and 120 basis points from one year earlier, as net absorption posted its largest decrease since early 2002, excluding conversion-related declines in 2006. Extreme job losses and rapidly rising unemployment are hampering household formation, forcing many renters to double up or even move back with family. In addition, deeply discounted home prices due to foreclosure sales and an $8,000 tax credit for first-time homebuyers are encouraging some current renters to purchase houses.
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New Supply Contributing to Weakness.
At an annualized rate, first quarter apartment completions were 45 percent below the long-term average, but new supply was down only modestly when compared to last year. In addition, a flood of shadow-rental stock continues to plague many markets. Fortunately, apartment starts have dropped 50 percent from peak levels, while the number of units in the final planning stages has declined more than 60 percent since the first quarter of 2008, and multi-family permits have retreated 50 percent over the past 12 months, all trends that suggest a drop-off in construction starting next year. Furthermore, many development projects are likely to stall as softer fundamentals make it difficult to justify construction.
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Apartment Property Sales Continue to Slide.
During the first quarter of 2009, sales dollar volume was down 55 percent from the previous quarter and 90 percent from a peak in the fourth quarter of 2006. The number of transactions declined to a lesser degree over the same period, as smaller deals accounted for a greater share of overall activity. Financing properties over $15 million has become a considerable challenge, as most lenders are wary of originating large loans and increasing their single-asset risk exposure. A handful of large property sales have closed recently, though prices for many of these assets reflect significant discounts when compared to the market’s peak. In early May, for example, the first multi-family REIT acquisition of the year was completed by AvalonBay. The property, located in Bellevue, Wash., traded for slightly more than $33 million, which is 45 percent below the estimated replacement cost.
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Lending Still Tight, but Apartments Faring Better than Other Core Property Sectors. Year over year, total commercial mortgage originations were down 70 percent as of first quarter; however, the apartment sector recorded a less severe decline due to lending by Fannie Mae and Freddie Mac. Like other lenders, the two government sponsored-enterprises (GSEs) have reduced originations of new multi-family loans over the past year, but by only 26 percent.
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Risk Premiums More Pronounced Based on Quality and Location. Apartment cap rates continue to rise, with the current average at 6.7 percent, up from a record low of 5.6 percent in 2006. The degree of change in prices and cap rates varies widely by property quality and location. Cap rates for properties in primary markets have increased by an average of 80 basis points from their most recent low point, while cap rates among assets in tertiary markets are up approximately 150 basis points. Further upward correction is anticipated as fundamentals continue to weaken and distress rises amid a wave of maturing debt. From 2009 to 2012, more than $300 billion of multi-family loans are expected to mature, including $36 billion in CMBS mortgages. Based on current estimates, more than 70 percent of the multi-family CMBS loans reaching maturity during this time may not qualify for refinancing. This will likely result in strong acquisition opportunities for well-capitalized investors who are ready to move quickly as properties are brought to market.
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Forecast:
Further Weakening in Fundamentals Expected. Apartment vacancy is forecast to approach 8 percent this year, the highest level on record since at least 1980. Effective rents are expected to lose 4.5 percent to 5.0 percent in 2009, with rents in some markets forecast to fall at double-digit rates. Apartment owners are finding it necessary to compete aggressively to retain and attract renters, resulting in concessions rising to more than 7 percent of asking rents by year end, compared to approximately 5 percent at year-end 2008. Market rents began to slip in late 2008 and are forecast to decrease by 1.2 percent in 2009, the largest decline on record.
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Benefits of Development Pullback, Economic Recovery to Emerge in 2011. New supply is forecast at 80,000 units this year, down from 107,300 units in 2008. Based on the diminishing development pipeline, completions are expected to slow in the second half of 2009 and drop dramatically in 2010, setting the stage for a relatively swift recovery once housing finds its bottom and the economy turns the corner.
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Freddie Mac’s Securitization Model a Step in Right Direction. Freddie Mac is in the process of securitizing approximately $1 billion of multi-family loans originated in 2008. The sale of the highly rated securities will mark the first full-scale securitization for the GSE and the first CMBS issuance since the market stalled last June. Compared to the original securitization model, whereby all risk was passed through to investors who purchase the CMBS, Freddie Mac will guarantee the senior bond classes. If its inaugural issue is a success, Freddie Mac could move forward with another securitization of multi-family debt this fall. By shifting a significant amount of debt off its balance sheets, Freddie Mac will be able to free up capital for new multi-family lending.
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Apartment Market Vital Signs
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1Q 2007 to 1Q 2009 Change in Apartment Vacancy
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Top 10 Markets by Change in Vacancy
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| Metro | 1Q 2009 |
YOY Chg (bps) |
| West Palm Beach | 7.7% | -30 |
| Louisville | 7.1% | 10 |
| Indianapolis | 8.2% | 10 |
| San Francisco | 4.2% | 10 |
| Cincinnati | 7.3% | 20 |
| Washington DC | 5.8% | 40 |
| Milwaukee | 4.3% | 50 |
| Minneapolis | 4.7% | 50 |
| Boston | 6.4% | 50 |
| San Diego | 4.6% | 70 |
| US Metro Average | 7.2% |
120 |
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Bottom 10 Markets by Change in Vacancy
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| Metro | 4Q 2008 |
YOY Chg (bps) |
| Tampa-St Petersburg | 9.3% | 190 |
| Orlando | 9.9% | 190 |
| Charlotte | 8.5% | 200 |
| San Jose | 5.6% | 210 |
| Austin | 9.2% | 230 |
| Phoenix | 11.3% | 230 |
| Jacksonville | 12.7% | 240 |
| Oakland-East Bay | 6.9% | 250 |
| San Antonio | 9.8% | 250 |
| Tucson | 11.7% | 350 |
| US Metro Average | 7.2% |
120 |
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Download the June 2009 Apartment Outlook Here