Commercial Real Estate Blog

The Royal Bank of Scotland’s (RBS) chief credit strategist Bob Janjuah has issued a report to its clients to be prepared for a global credit and equity crash. Bob Janjuah forewarned against last year’s looming credit crisis. According to his report, the next three months will be nasty.

The report includes warnings that the S&P could fall by more than 300 points to 1050 by September. In debt markets, they are forecasting that both the high grade and low grade iTraxx indexes could soar. This index is a European index designed to allow people to trade the “Riskiness” of European debt, with the US having a seperate set of similar indexes as well.

What is key in the report has to do with inflation, the fed pumping money into the market, and what needs to be done about it. All the money being pumped into the market by the Fed is causing headline inflation to increase. Unfortunately we find ourselves in economic conditions which don’t easily allow the raising of interest rates. The economy, both domestic, international, and emerging markets will then be faced with further tightening of credit causing global growth to cool significantly.

The impact on commercial real estate could be significant; you would have the cost and availability conditions of debt to continue to deteriorate, coupled with the fact that risk premiums will have increased in other asset classes. This would suggest a similar jump in expectations for commercial real estate, which translates into higher cap rates and tighter, more conservative underwriting from institutions. Things are trending in that direction, and RBS’s report could suggest that we’re aways away from any reverse.

The manager of the world’s largest bond fond, the Pimco Total Return Fund, says that the methodology the United States uses for calculating its inflation rates results in an understatement by roughly 100 basis points. This results in real GDP growth and real bond yields to be off by a similar amount.

If the calculation was done in conformance with how much of the rest of the world calculates its inflation rate, then not only would bond investors seek higher returns, but property investors would also require a higher return or cap rate when looking at real property investments. A 100 basis point difference in the cap rate represents a significant difference in price and that is where the risk would lie for property owners.

His concern or comments seem to lead back to the diminishing pricing power the U.S. has in the global global market; if investors beging to require higher returns to offset inflation, then there will be few options but to comply.

As always, there is a catch to the theory. Bill Gross is a smart guy and all, but to assume that there has been a mispricing of debt in the markets for decades is, at best, a stretch.

Whether Bill Gross is right or not though, I’m sure anybody who has bought milk or pumped gas lately would argue that inflation is in fact running higher than purported.

The Fed’s recent actions to help stabilize economic conditions are not impressing foreigner’s holding US debt instruments. The inflationary actions of the Fed have resulted in foreign buyers of US debt to essentially boycott government auctions for treasuries.

Over the past eight weeks, the share of foreign buyers participating in these auctions was somewhere around 25%. In last week’s auction, they represented only 5.8%.

Additional steps the Fed has taken or will take this week include bailing out Bear Stearns by essentially financing a JPMorgan takeover of Bear Stearns. The emergency overnight rate for bank’s was cut by 25 basis points, and in the Fed’s next meeting, they might cut interest rates by as much as seventy five basis points.

Unfortunately though, the Fed can only control short term rates. What the Fed cannot do is control long term rates and that is what will affect commercial real estate going forward. The current economic conditions, compounded by inflationary pressures and increasing long term rates does not bode well for holders of such real estate. What we see is people continuing to be bullish in certain market sectors, but it is hard to see how they envision that some sectors, such as Silicon Valley, will escape unscathed.

Time will tell who is right, but with a weakening dollar and thereby increasing commodity prices (for those priced in US Dollars), the effect will be felt in Silicon Valley. We are seeing some Venture Capitalists increasingly wary of their ability to raise any more money in this market and have become increasingly conservative in placing investments.

This has already and will continue to have an impact on the Silicon Valley Market.

The 50-basis point decrease in interest rates by the Federal Reserve should provide a short-term catalyst for REIT shares to move higher and commercial real estate activity to resume.

The rate decrease makes the dividend paying shares of REITs more attractive for the time being.

The risk is that it will take some time for the short-term rates to affect long-term rates, and the risk remains that during this time we could see a further slowdown in the economy, more troubled housing numbers, and a reverse in commercial real estate leasing activity.