Author: Warren K. Hoppke, SRPA - Principal of http://www.appraiservalues.com specializes in Los Angeles commercial and industrial real estate. He provides full real estate appraisal services throughout Southern California, including mortgage lender reports and detailed forensic appraisal reporting requirements for court testimony.
As Wall Street reels from major losses many cash starved Wall Street firms, financial institutions, and some insurance companies are scrambling for capital to shore up struggling balance sheets. Liquidation of real estate assets will be one of the first places firms will look for cash.
Prices are on the decline and many firms will soon be in the market hocking their commercial real estate in trade for cash. To top it off, unemployment has doubled over the past year and continues its upward spiral.
This double whammy will result in investors placing upward pressure on capitalization rates as vulture funds hover around looking for fire sales on commercial real estate. Unfortunately, one feeds on the other and as Wall Street layoffs start commercial office and industrial markets will be hit.
For example GE has been selling off its commercial real estate and many other cash strapped corporations and financial institutions will follow. Credit has contracted by almost 400 billion dollars. As credit contracts it has a multiplier effect. The multiplier effect can be 3 to 4 times the amount of the contraction. As Leman Bros. goes under approximately $150 billion of bonds will default.
As reported by AFX News Limited, besides banks and other financial institutions pension funds have been among the top investors in mortgage backed securities (MBS) and collateralized debt obligations (CDO). After years of channeling money into MBS and CDO portfolios of mortgages bundled and sold as debt securities the total size of pension fund securitizations are massive. Thomas Martin, president of the Homeowners Consumer Center estimates pension funds will take a 1 trillion dollar hit from devalued securities.
The nations largest public pension fund the California Public Employees Retirement System (CalPers) could take a hit as large as their $2 Billion dollar residential mortgage portfolio.
Has the Great World Wide Depression started ?
The first phase started in the residential market from the bottom up as prices rose faster than incomes could support creating a drop in demand. As demand dropped off due to affordability issues builders were in denial and continued to build because their astute real estate advisors said demand was stronger than ever because of high population growth. After their buyers got into a home they quickly found out they could not afford to make the fully amortized payment. As a result, builders started to realize that affordability was the dominate player in the demand for residential real estate and not just new household formations and population growth.
Technically, prices should deflate until they reach equilibrium in line with median income levels. Since markets tend to overcorrect either on the upside or the downside the real estate market will most likely overcorrect before comes back to equilibrium. With the entrance of a government mortgage bailout a monkey wrench will be throw into the mix. The markets will now stabilize at higher levels than equilibrium thus creating a long flat period of very weak demand for real estate. This could last for the next decade until incomes catch up with prices and consumers have a chance to save for down payments.
The 2nd phase is the unemployment created by the down turn in real estate. The recession that started in the 1990’s started with the rise in unemployment creating a drop in demand for housing which then infected commercial real estate. Now,with Wall Street and financial firms collapsing and major corporations starting to layoff, the 2nd phase has started. This is the double whammy that we did not have in the 1990’s and that’s why this will be many times worse the 1990 downturn.
As employment unwinds it will set the stage for another round of price declines. As people lose there jobs they will not be able to make their house payments which will force more and more people into foreclosure. This will create additional downward pressure in the housing market. Additionally, the retail, office, and industrial markets will experience a drop in demand as businesses cut back. This will result in increasing vacancy levels and declining rents as layoffs and faltering businesses continue the downward cycle.
Expect to see commercial real estate price declines throughout 2009 and 2010 as cap rates rise due to increasing vacancies, declining rents, and increasing investor risk premiums. We should never forget there are business cycles and real estate is by its very nature cyclical.
Again, to answer the question will cap rates increase one need only look at the equation:
Cap Rate = Risk free Rate + Risk Premium + Capital expenditures - minus expected appreciation.
We now have two of the four variables on the rise.
Author: Warren K. Hoppke, SRPA - Principal of http://www.appraiservalues.com specializes in Los Angeles commercial and industrial real estate. He provides full real estate appraisal services throughout Southern California, including mortgage lender reports and detailed forensic appraisal reporting requirements for court testimony.
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