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Government Intervention, Bank Stress Tests Aim to Restore Confidence -- Will Measures
Be Enough?
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Government stimulus and financial market intervention — already
at unprecedented levels — have become even more aggressive in the wake of a steeper
recession and escalating credit market woes. Government loan facilities
established last year are being modified, and new programs have been proposed to
help jumpstart stalled credit markets. The first round of funding for the Troubled
Assets Relief Program (TARP) was originally intended to buy toxic assets from financial
institutions, but the capital was instead used primarily to purchase equity shares
of major banks. Therefore, toxic assets, which include difficult-to-price mortgage-backed
securities, have remained on the balance sheets of financial institutions. Uncertainty
and the potential for significant write-offs associated with these assets have subsequently
hindered banks’ ability and willingness to originate new loans.
With toxic assets still a crucial hurdle to be cleared before the financial system
can function effectively, the government has become more focused on the issue. In
addition to the stimulus package, new programs aimed at restarting the market for
these assets have been proposed. While these measures are expected to positively
impact capital markets, it likely will require at least six months for credit flows
to improve measurably.
Steps to increase transparency in the financial system are also under way, which
appears to be alleviating some of the uncertainty in the marketplace. Based on the
results of stress tests performed on 19 of the largest financial institutions in
the nation, 10 major banks have been ordered to raise a total of $75 billion in
capital to protect against worst-case losses. While the results of the tests were
better than many had feared, they could work against credit markets in the near
term by encouraging banks to continue hoarding cash to protect against potential
losses. On a positive note, the increased transparency in the marketplace has been
generally well-received by investors, with financial stocks trading at higher levels
than a few months ago.
Government stimulus and initiatives alone will not overcome the impact of the private
sector pullback on the economy, but the multitude of programs should promote improvement
in the flow of capital. This spark, in turn, will help generate economic activity,
bringing the recession to a close by the end of this year. Risks to the economy
and financial sector are still present, as the housing market has yet to reach bottom,
and the potential exists for additional unwinding of complex financial instruments.
Commercial real estate fundamentals typically lag the economy six to nine months.
As a result, deep job losses in recent months are forecast to translate into rising
commercial property vacancy through year end, with rollbacks in rents likely to
continue through the better part of 2010. Commercial real estate fundamentals and
the investment climate ultimately will benefit from improving capital flows and
the economic recovery, especially since the sector was generally not overbuilt heading
into the downturn.
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Quick Reference Glossary
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ABS
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Asset-Backed Securities – Loans such as commercial real estate and credit card debt
are sold on the secondary market, pooled and rated. The pools are securitized and
divided into shares, which are sold to investors. As borrowers make payments on
the original loans, investors who purchased the ABS receive dividends.
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TARP
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Troubled Assets Relief Program – TARP was initially planned to purchase toxic mortgage-related
assets from financial institutions; however, the majority of the first installment
of $350 billion was instead used to recapitalize banks through equity purchases.
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TALF
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Term Asset-Backed Loan Facility – The Federal Reserve will make up to $1 trillion
of loans under TALF in an effort to restart the market for newly issued asset-backed
securities. The Fed recently announced new TALF loans will be available in June
with five-year terms to finance purchases of CMBS.
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Legacy Assets
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Assets on the balance sheets of financial institutions, including CMBS, RMBS and
other ABS, that have become difficult to value or sell.
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PPIP
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Public Private Investment Program – PPIP is aimed at removing existing real estate-related
loans and securities from the balance sheets of financial institutions. The program
should encourage private investment in these assets by providing government equity
co-investment and affordable public financing.
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Legacy Loans Program
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Legacy Loans Program – Combines FDIC guarantee of debt financing with equity capital
from the private sector and Treasury to support the purchase of troubled loans from
insured depository institutions.
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Legacy Securities Program
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Legacy Securities Program – Combines financing from the Federal Reserve and TALF
with equity capital from the private sector and the Treasury to address troubled
securities, which include CMBS.
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KEY FINANCIAL SECTOR DEVELOPMENTS
- The $787 billion economic stimulus package passed in January is designed to create
or prevent the loss of 3.5 million jobs over the next two years. The components
of the package with the greatest potential for immediate impact include $288 billion
in tax cuts, an $8,000 tax credit for first-time homebuyers, $144 billion to assist
state and local governments, and $111 billion to be spent on infrastructure improvements
and science.
- Stabilizing the banking system and restoring function to credit markets are also
top priorities for the U.S. government, as evidenced by the proposed Public-Private
Investment Program (PPIP). The program is designed to address the toxic assets clogging
balance sheets and hampering the formation of new credit. Recently released details
of the plan have been generally well-received by financial markets; however, implementation
will take time, and some trial and error likely will be required.
- The expanded Term Asset-Backed Loan Facility (TALF) is a critical piece of the solution,
as it provides low-interest loans for purchasing newly issued, AAA-rated asset-backed
securities (ABS). The ABS are mostly backed by student, consumer and small-business
loans. Commercial mortgage-backed securities (CMBS) were recently added to the program,
however, and the Fed has increased the term on TALF loans for purchases of CMBS
to five years.
- The Legacy Assets Program is expected to assist PPIP in purchasing previously highly
rated assets, including non-agency residential mortgage-backed securities (RMBS)
and CMBS, from financial institutions. PPIP aims to remove $1 trillion of toxic
“legacy” assets from the balance sheets of financial institutions. If successful,
the program will provide a price discovery tool for these troubled assets, the first
domino in clearing the balance sheets and eventually resetting credit markets.
- Recent relaxing of mark-to-market accounting rules by the Financial Accounting Standards
Board allows banks greater flexibility in calculating the value of difficult-to-price
assets. Under mark-to-market accounting, financial institutions had to value assets
based on current market prices, which reflected significant discounting due to distress.
The modified rules should greatly reduce write-offs, which, ironically, may diminish
the motivation for institutions to become aggressive in moving toxic assets off
their balance sheets through PPIP.
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ECONOMIC AND COMMERCIAL REAL ESTATE OUTLOOK
- The economy is expected to remain weak through the third quarter of 2009 with the
recession concluding by year end, partly as a result of improved credit flow and
the stimulus package. Growth should resume in 2010, but, unlike the majority of
past cycles, the rate of recovery is likely to be moderate due to high levels of
debt.
- Commercial property fundamentals will continue to soften in reaction to steep job
losses. Given the typical six- to nine-month lag to economic trends, property fundamentals
are expected to begin improving by mid-2010, with apartments and industrial properties
leading the way.
- Commercial real estate transaction volume continued to decline through the first
quarter of 2009. Activity was down 70 percent from one year earlier due to the disconnect
between buyers’ and sellers’ expectations and continued tightening of capital markets.
Commercial property sales should pick up by the third quarter of 2009 as the pricing
gap begins to narrow. A growing inventory of distressed properties, spurred by rising
vacancies tied to job losses and maturing debt, as well as more reasonable pricing
expectations in general, will move more buyers off the sidelines.
- Increased levels of available inventory, overall price pressures and low interest
rates are creating some of the best acquisition opportunities in 20 years. Cap rates
are likely to move higher over the next year, reverting to longer-term averages.
The degree of price correction, however, will remain highly influenced by asset
quality and location.
- There are still unknowns surrounding government programs to finance and handle the
disposition of distressed mortgage-related assets, due in part to the complex loan
structures and the high level of securitization that fueled the market in recent
years. As a result, a government-sponsored clearinghouse for distressed commercial
assets is not likely to emerge, at least in the short term; distressed assets will
continue to be handled by individual lenders and agencies.
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ECONOMIC OVERVIEW
From Moderate Recession to Global Financial Crisis
Resilience in the first part of the economic downturn, which was marked by below-trend
job losses through August 2008, ultimately gave way to the most severe GDP declines
in recent history. The deepening of the recession was due in large part to the freezing
of interbank lending and the commercial paper market in the fall of 2008. These
events created a chokehold on credit for numerous U.S. businesses and have resulted
in extreme job cuts. Homeowners, who have already lost considerable wealth through
the downturn, have grown increasingly uncertain about their employment prospects.
As a result, consumption, which accounts for nearly 70 percent of U.S. economic
activity, has shown significant weakness.
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The current recession, which officially began in December 2007, is already one of
the longest and deepest in recent memory. The past two recessions each lasted just
eight months, and only two of the 10 recessions since the Great Depression lasted
a full year. Since the start of the downturn, 5.7 million Americans have lost their
jobs, with unemployment currently at 8.9 percent and rising.
Despite the generally grim economic news, there are a few encouraging signs that
suggest the worst may be behind us. In recent months, job losses have remained at
elevated levels but have slowed, homes sales have ticked up in many markets, and
mortgage applications have increased. The rate on a 30-year mortgage is hovering
near its lowest point since the early 1970s, and home price declines in recent years
have brought them closer in line with incomes. As a result of greater affordability
and government programs aimed at stimulating demand and preventing foreclosures,
many potential homebuyers who have been waiting on the sidelines finally are beginning
to purchase houses.
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Dragged into the Fray – A Double Hit for Commercial Real Estate
The commercial real estate market reflected the resilience of the economy during
the first phase of the recession, with vacancies rising at a relatively steady pace
through the third quarter of 2008. The primary exception was the retail sector,
which had already entered a serious downturn due to weakness in the consumer segment
and some overbuilding. The wave of job losses since the fall of 2008, however, has
taken its toll on commercial properties, causing vacancy to spike across core property
types.
The financing climate, which tightened dramatically in the summer of 2007, became
even more challenging as the credit crunch escalated to a full-blown global financial
crisis last fall. Commercial property sales volume, down by 40 percent to 60 percent
through the first three quarters of 2008, has come to a near halt over the past
six months, dropping as much as 80 percent to 90 percent from the peak. Smaller
transactions make up the lion’s share of deals in today’s environment, compared
to the large portfolio sales that became increasingly prevalent in 2006 and early
2007.
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The collapse of the CMBS market, which accounted for nearly half of new commercial
mortgages at the market’s peak, along with a shortage of capital from commercial
banks, life insurers and private equity markets, define the current financing environment.
In addition, a significant price expectations gap between buyers and sellers has
contributed to the sharp decrease in commercial property sales.
Deteriorating property fundamentals and constraints on debt capital are resulting
in price corrections and rising cap rates. The trend gained momentum in the first
quarter as more sellers came to terms with market realities. It should be noted
that the degree of correction is highly varied depending on property quality and
local market strength.
The risks facing commercial real estate are deepening. An estimated $218 billion
of commercial mortgages will mature this year, and an additional $270 billion is
expected to come due between 2010 and 2011. Commercial delinquency rates have been
near historical lows throughout the downturn; however, as a lagging indicator, they
are now beginning to reflect the impact of the recession on commercial real estate.
The CMBS delinquency rate as of the fourth quarter of 2008 was 1.2 percent, which
is only 50 basis points below the peak reached during the last cyclical downturn
in the early 2000s; first quarter estimates reflect further increases in the rate.
Delinquencies among banks are at the highest level on record since 1996 and could
reach $53 billion according to the recently completed stress tests. Although this
is a significant number, it makes up 8.5 percent of the 19 banks’ total failure
risk. Life insurance companies and Fannie Mae/Freddie Mac are faring best, as their
focus remained on lowerleverage loans and safer, quality assets during the most
recent boom.
With property values down and loan-to-value (LTV) requirements at significantly
lower levels than a few years ago, many owners will be unable to refinance without
contributing substantial amounts of equity. As a result, delinquency rates are expected
to continue rising, reaching 4 percent to 5 percent by the end of this year and
potentially exceeding levels recorded in the early 1990s by 2010. Since underwriting
standards loosened dramatically from 2006 to early 2007, loans originated during
this time are at the greatest risk.
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Deepening of Recession Spurs More Aggressive Intervention
We are currently in the midst of unprecedented levels of governmental spending and
market intervention. Recent and new measures are focused on stabilizing the banking
industry and real estate markets by improving credit flows and ultimately sparking
an economic recovery.
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Measures Aimed at Increasing Economic Activity
After the onset of the credit crunch in the second half of 2007, the Fed began to
aggressively cut interest rates and pump liquidity into the system. In early 2008,
the Economic Stimulus Act was passed, which included $100 billion in stimulus checks
for U.S. households. The checks provided nothing more than a short-term boost to
consumer spending; the economy was already headed for a major downturn, led by debt-constrained
consumers and rapidly declining business spending as companies opted to preserve
cash. As stimulus checks were being mailed, the financial situation was darkening.
Bear Sterns was acquired by JPMorgan, while Fannie Mae and Freddie Mac were placed
under government conservatorship; Merrill Lynch was sold to Bank of America; and
Lehman Brothers went bankrupt. This sequence of banking industry events set the
stage for the freezing of interbank lending and the commercial paper market in the
fall of 2008.
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Almost immediately after the new administration took office, the American Recovery
and Reinvestment Act (ARRA) was passed. The much-debated bill provides $787 billion
in stimulus, including $288 billion of tax breaks to consumers and businesses, and
is intended to generate demand via consumption. Funds also have been allocated to
assist state and local governments and toward infrastructure and science. Additional
stimulus funds will be spent to promote job creation in health care, education and
training, and energy-related projects.
Combined with the other stimulus programs, the ARRA will reduce the time needed
for the economy to stabilize, as 74 percent of the money will be spent during the
next 18 months. The program is intended to create or save more than 3.5 million
jobs. These programs alone will not reverse the negative employment trend; however,
they should provide a foundation to limit further deterioration and set the stage
for growth in 2010. The economy is not expected to snap back following the recession,
with forecasts calling for modest job creation of 1.25 percent in 2010 and 1.9 percent
growth in GDP.
Commercial real estate tends to lag the overall economy by approximately six to
nine months. Market fundamentals are therefore forecast to begin recovering by late
2010 or early 2011, led by apartments and industrial properties, both of which react
almost immediately to job creation and improved consumption. In the near term, vacancies
for apartments and office properties are expected to reach or exceed levels recorded
during the recession early this decade, with retail approaching highs last seen
in the early 1990s. On a positive note, construction was significantly lower heading
into the current recession than the last two downturns. As a result, property fundamentals
are likely to improve faster than in previous cycles.
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Government Programs Designed to Thaw Credit Markets
Regardless of the dollar amount of government stimulus or the depth of tax cuts,
function first needs to return to the credit markets in order for the economy to
stabilize. Businesses are struggling, as many forms of credit remain tight, ranging
from lines of credit to acquisition loans and even inventory financing. U.S. households
have seen home equity lines of credit pulled and credit card limits cut. The recently
released bank stress test results were not as grim as many had feared but could
hamper lending in the near term to protect against potential losses, which, in the
“more adverse” scenario, could reach nearly $600 billion in 2009 and 2010.
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Government intervention to stabilize the banking sector and thaw credit markets
has been vast and far-reaching. In addition to reducing the fed funds rate to essentially
zero, the Federal Reserve has expanded access to credit through its Discount Window
and created multiple new credit facilities that allow for a broader range of collateral.
Furthermore, the Fed opened the door for securities dealers to borrow directly from
the central bank. Specific facilities also have been created to pump liquidity into
various segments of the financial sector. To start, the Fed established the Term
Action Facility (TAF) in December 2007, offering depository institutions an opportunity
to obtain credit through a bidding process. Additional programs were rolled out
to address economic dominos as they fell, including AIG, money market funds and
the commercial paper market, which came to a near standstill last fall. Furthermore,
the Fed approved currency swap agreements with several foreign central banks to
help quell concerns regarding dollar liquidity in global markets. Additional support
for credit markets came in late 2008 when the Fed announced plans to purchase $600
billion in debt backed by housing-related government-sponsored entities, including
Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Banks. As a result of
government intervention, residential mortgage rates have slipped to the lowest level
in decades.
In addition to Federal Reserve support, the government has enacted significant programs
focused on unlocking credit markets. The first was TARP, which was passed in October
2008 and was initially intended to purchase toxic assets from troubled financial
institutions. The government instead used nearly all of the first $350 billion installment
to recapitalize banks through preferred equity investments. While the exact impact
of these investments is difficult to quantify, they clearly helped to firm up the
balance sheets of numerous institutions and likely kept several banks afloat.
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The next $100 billion of TARP funds has been earmarked for the TALF program. Under TALF, the Federal Reserve receives credit protection of $100 billion from TARP by the Treasury Department. The Fed will use this allocation to partner with private investors in the leveraged acquisition of up to $1 trillion of newly originated AAA-rated ABS. The debt underlying the ABS includes recently issued consumer and small-business loans, student loans, and residential or commercial mortgages. Under this program, the Federal Reserve lends to investors at low interest rates to encourage purchases of these collateralizations. This program has been in place since November 2008, and there is evidence that it is working; spreads on highly rated ABS have narrowed significantly from peak levels. With ready buyers for this type of paper, banks ultimately should have incentive to make new loans and earn the associated fees.
One of the major issues with the original TALF and modified TARP programs is that they did not assist banks in ridding balance sheets of toxic securities and loans that no longer have marketable value. With these legacy assets still on the books, it has remained difficult for banks to engage in any meaningful level of lending. The government has therefore circled back to the issue of these assets and recently began releasing details on the PPIP. The program is intended to entice private investors to purchase toxic assets with the help of co-investment from the Treasury and nonrecourse loans backed by the FDIC. If successful, PPIP should serve as a price discovery tool for these assets, which is critical to restarting transaction volume. While the government is in the process of finalizing plans to make PPIP operational, market sentiment has been positive so far. Additionally, TALF will be expanded with a Legacy Securities Program to help fund PPIP purchases of previously AAA-rated ABS, including non-agency RMBS and CMBS.
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Framework for the PPIP:
- Banks will identify loans to sell to the PPIP.
- An auction process managed by the FDIC will take bids from private investors for these assets.
- The FDIC will offer nonrecourse loans for up to 85 percent of the winning bid price under the Legacy Loans Program.
- The Treasury and private investors would split the equity requirement 50/50 and share profits in the same proportion.
- Private investors would be responsible for managing the loans, and, due to favorable financing terms and government participation, they would have minimal downside risk.
- Also, investors should be able to purchase AAA-rated ABS with loans available through the Legacy Securities Program.
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If successful, the government’s approach will help restore function to the financial system by:
- Ridding banks’ balance sheets of toxic assets, which should restore liquidity and lend strength to the financial health of many banks
- Creating a market clearing price for securities, allowing additional assets to be priced effectively
- Increasing capital that banks are able to raise and subsequently use to originate loans
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Impact on Commercial Real Estate Market
While the PPIP should help unclog the balance sheets of banks, the $789 billion of outstanding CMBS loans still face significant risk of defaults and delinquencies. PPIP, combined with other measures, should help the macroeconomic picture, however, by improving the flow of capital. Once credit flows improve, a greater number of commercial property owners will be able to refinance maturing debt, which is critical to the health of the market over the next several years. Due to decreases in property values and lower LTV requirements, though, along with the sheer size of some loans originated in recent years, many owners will still face challenges, and values will be pressured.
Creating a market for newly originated CMBS through the TALF program could help restart the securitization market, ultimately providing additional financing options for commercial real estate investors. It will require more than just this first push to get the CMBS market running again, however, as investor confidence in the product must be restored. This will likely necessitate greater regulation, minimum participation by the originator and more stringent risk-assessment guidelines, all of which will require time.
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Other regulatory changes designed to assist the credit markets have been enacted recently or may be in store. These include relaxing mark-to-market accounting rules, a change announced in early April. Mark-to-market standards forced institutions to value assets based on the current market, which is largely illiquid for the bulk of the assets clogging balance sheets. The modification should reduce bank writedowns almost immediately, increasing lending capacity and equity market stability. In addition, the proposed restoration of the “uptick rule,” which forces short sellers of stocks to wait for an uptick in price before selling the stock short, could also promote stabilization of equity markets. This may, in turn, make it easier for banks to raise new equity and help restore normal function to credit markets. Ironically, it also reduces the pressure to sell underperforming assets in the short term.
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Commercial Real Estate Investment Conditions
Distressed property sales will increase over the next 24 months; however, the handling of these assets is likely to remain quite different than in the early 1990s. During that period, loans were held on balance sheets of commercial banks and savings & loans. The government stepped in by taking over failed institutions and creating a clearinghouse in the form of the Resolution Trust Corp. (RTC) to dispose of assets. In this cycle, securitization of commercial mortgages has complicated the issues. At the end of 2008, 21 percent, or $789 billion, of outstanding commercial mortgages had been pooled and sold to investors as CMBS. Unwinding these loans is far more complex than it was during the RTC days. General Growth Properties’ (GGP) recent bankruptcy filing exemplifies the complexity of the situation and the potential for growing distress amid a wave of maturing commercial mortgage debt. While GGP gained reprieves from individual lenders on bank debt it defaulted on, the company was unsuccessful in working with the many smaller creditors that own CMBS backed by its debt. In addition, financial institutions have been generally focused on preventing or delaying foreclosures in order to minimize further losses.
So far, true distress in the market has been limited largely to busted developments and lower-quality assets. Although a growing number of higher-quality properties are being brought to market at more reasonable prices, the share that is truly distressed is minimal, as owners and lenders remain focused on preserving value. Nevertheless, attractive investment opportunities are rising as prices adjust based on quality and location, and more assets are being brought to the market. Across major property types, cap rates have already increased from a low of 6.4 percent in 2007 to 7.3 percent as of the first quarter of 2009. Many owners who were planning to ride out the downturn are likely to re-evaluate their strategies in the near term due to maturing debt, deteriorating NOIs or the need to raise capital to support other properties. This will result in more realistic pricing and significant acquisition opportunities, including some high-quality assets that come to market as REITs and institutions focus on improving liquidity.
Although risks to the economy and financial system still exist, today’s commercial real estate investment opportunities should be viewed with a long-term perspective. The U.S. economy is expected to bottom in 2009, setting the stage for a recovery cycle to begin in 2010, with commercial real estate following the trend. Even with modest job growth compared to past economic recovery periods, property fundamentals will stabilize, ultimately bringing a substantial volume of capital off the sidelines.
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