The recent New West Era of Arizona’s fast-growth economy from 2004 through 2007 is now expansion-cycle history. Having faced the Great Recession and what Alan Greenspan called a “once-in-a-century credit tsunami,” we now plan to resume positive economic growth in 2010.
Since late 2008, Arizona has lost more than 200,000 jobs. Commercial real estate (CRE) loan delinquencies are programmed to accelerate, with some distressed loan exposures exceeding 200 percent of total equity for smaller financial institutions. Given the scale of pending defaults, key decision-maker questions revolve around ideas such as “Who is too big to fail?” and “Who will benefit and who will pay in loan restructuring?”
Since rents and property values rapidly declined last year, banks’ loan delinquencies have been widely reported. Borrower defaults are increasing due to the inability to make timely debt service payments on existing notes. Rent concessions abound, and some recent short-term leases have been negotiated as break-even deals that just cover operating expenses, a preferred choice over the cost of holding vacant space. Many existing tenants are attempting to renegotiate contract rents as record high vacancy rates are underreported, especially in cases where leases are intact but the tenant is in default. The credit freeze has taken a toll on loan refinancing, especially when funding loans of more than $1 million with lower loan-to-value constraints. Costar Analytics recently reported commercial property price declines from 15 percent to 35 percent since 2007 peaks.
Negative commercial space absorption has given back the early gains of a few years ago, as new construction deliveries wind down and building permit activity is off dramatically in Arizona. Commercial space demand is driven by jobs, and employment is expected to be weak through the middle of this year. Positive business growth and a boost in hiring are essential for large-scale investment in the built environment. Considering employment as a lagging economic indicator and consumer spending as a prime driver in economic activity, commercial real estate vacancy rates are problematic.
Since March 2009, Bloomberg reported a five-fold increase in Phoenix-area loan delinquencies backed by office, industrial, retail and apartments. Recently, Deutsche Bank projected price declines from 35 percent to 45 percent as necessary to maintain return-on-investment requirements in a declining rent environment. Over the next 24-plus months, delinquency rates are expected to exceed the results posted in the savings-and-loan bailout days of the early 1990s.
Non-performance is two-fold: initially as term default risk where debt repayment cannot be met, and later as maturity default risk where the loan cannot be repaid or refinanced due to value declines and higher borrower down-payment requirements. Perhaps two-thirds of loans do not qualify to refinance at maturity, mostly recent (2004-2007) originations.
The fall 2009 Greater Phoenix Real Estate Consensus Forecast, a quarterly consensus on general economic indicators and key construction measures from economists, real estate analysts and executives, shows only “marginally better” commercial real estate market results expected through 2011. With office vacancy so high, it is likely there will be no new office building construction for the next five years. Retail sales are tied to rooftops. While housing markets are expected to improve through 2011, improvement in single-family residential activity is expected to be slow by historic standards. Industrial demand will be end-user driven and also likely to be slower than historical trends.
Economist Elliott D. Pollack, CEO of Elliott D. Pollack and Company in Scottsdale and co-editor of the Greater Phoenix Blue Chip Economic Forecast, states, “Now is the time for banks to raise capital in order for them to workout their loans.”
He says many banks believe the best way to handle the loan workout is to deal with the current borrowers. The difference between now and the 1989-1992 real estate crisis is bank regulators are not currently forcing banks to immediately liquidate loans. Given the events of late 2008, regulators are reluctant to force financial institution closures and seem to be more willing to let institutions work out their problem loans. The idea is to rebuild confidence in America’s financial system.
In positive terms, the Mortgage Bankers Association forecast calls for Real Gross Domestic Product growth in 2010, the first GDP gain in two years. Clearly, widespread hope exists for a rebound in local commercial real estate prices. In the near term, investors are closely monitoring federal government bank policies that privatize profits, nationalize losses and buffer the banks against failure.
Fundamentally, real estate market performance will follow the time pattern when Arizona’s primary economic activity rebounds with measurable employment gains. Without recognizable fundamentals focused at the property level, end-user demand is missing, and commercial real estate performance is likely to remain speculative through 2011 and beyond.