by Rebecca Rockey, Economist, Head of Americas Forecasting, and Rob Miller, Director, Americas Forecasting & Capital Markets Research
Financial and Economic Markets Feel the Impact
Is there nothing more appropriate to get you ready for the holiday season than an uplifting reminder that this month marks the 10-year anniversary since the last recession, often thought of as the other side of the coin of the Great Financial Crisis? However you want to think about it, the 2007-2009 recession was the worst downturn to hit the U.S. economy, not just in the Post-WWII era, but since the Great Depression, giving birth to the title ‘The Great Recession.’
Despite extensive debate about what—and who—caused the greatest global financial meltdown in more than 70 years, one thing is for sure: a subprime mortgage lending bubble burst and stresses on the financial system were rising precipitously by 2007. Volatility, while escalating throughout the year in 2007, skyrocketed after the collapse of Lehman Brothers in September 2008, further pressuring credit default swap prices on banks—the cost of downside protection—which spiked at 500 to 600 basis points (bps). (CDS prices are just now registering levels observed in July 2007; most bank CDS prices are less than 50 bps.)
Runs on the shadow banking system outside of the typical regulatory purview were alarming to those developing policy responses. What was not anticipated at the time was just how much of the contagion would affect the real economy. Recall that most of what became the trauma to the real economy had started to emerge in the financial sector as early as mid-2006, when the national mortgage default rate began its ascent. According to the National Association of Realtors, year-over-year growth in national home prices became negative in December 2005. Between the end of 2005 and 2007, financial losses began to impact the economic outlook. In its October 2007 meeting, the Federal Open Market Committee downgraded its projection for GDP growth in 2008. Its new, more pessimistic forecast called for growth to moderate to 1.8% instead of the original 2.5% that had been estimated. At the same time, the FOMC predicted growth to return to a range of 2.3% to 2.7% in 2009. In reality, GDP clocked in at -0.3% in 2007 on an annual basis and at -2.8% in 2009. In response, the U.S. government enacted an unprecedented effort to contain the crisis and prevent its effects from spreading further.
Table 1: Summary of Policy Response by U.S. Government
|Fiscal Policy||· Emergency Economic Stabilization Act of 2008 created the Troubled Asset Relief Program (TARP) and authorized a bailout of up to $700 billion
· American Recovery and Reinvestment Act of 2009 passed, including tax cuts and spending increases that were estimated to cost $787 billion at the time
|Monetary Policy||· FOMC lowered the overnight rate on bank reserves to near-zero (0.125%)
· Federal Reserve invoked use of rarely used emergency 13(3) clause, allowing for the bailout of non-banks (i.e., AIG)
· Multiple credit facilities used domestically and internationally to stabilize financial markets
|Other Policy||· FDIC increased limit of deposit insurance to $250,000 from $100,000 and engaged in resolution of IndyMac
· Over 150 federal credit programs provided $344 billion in fiscal stimulus in 2010 alone
|Government Sponsored Enterprises||· Fannie Mae and Freddie Mac were put into conservatorship
· $185 billion in capital injections from Treasury and Federal Reserve
· Implicit guarantee became explicit
· GSEs, including FHA and VA, guaranteed 90% of mortgages in the secondary market in 2009
Commercial Real Estate Leasing Before, During, and After
Although commercial property market performance generally lags the broader economy during expansions by a year or more in some cases, the downturn in 2007-2009 initiated a slowdown in commercial real estate (CRE) that began with the recession’s start date. Vacancy rates had reached their tightest levels of the cycle in the third quarter of 2007—office vacancy was 12.7% while industrial vacancy bottomed out at 7.7%. Shopping centers reached their nadir in vacancy at the same time, just below 8%. Then the rise began.
All three sectors peaked at their highest levels of vacancy in the first quarter of 2010, one quarter after the recession’s trough had passed, reaching 17.4% in the office property markets, 10.8% in the industrial market and 10.1% in the retail market. Deceleration that began in 2007 led an outright decline by 2009 in asking prices for vacant space with peak to trough asking rents falling by 8%, 16%, and 6% in the national office, industrial, and retail markets, respectively. Year-over-year rent decreases persisted for almost three years.
Slowly but surely, leasing activity picked up after the worst had passed, and those tenants were getting a deal. Between their low point in 2010 and today, asking rents have risen from $26.80 (office), $4.64 (industrial), and $16.63 (retail), by 24%, 25%, and 19%, respectively, all achieving record highs. The absorption rate of office space found its pre-crisis home around 195 square feet (sf) per worker. (The rate actually rose during the recession as employment declines outpaced firms’ ability to offload space.) Since demand turned positive in the second quarter of 2010, the national office market has tallied 380 million square feet (msf) of net absorption, the industrial market 1,450 msf, and shopping centers 300 msf. For the industrial sector, this had led to record-setting runs in leasing and new lows for vacancy. It has also meant that the swift rise in eCommerce has disrupted commercial markets, including warehouse and distribution networks, to a significant degree. More than ever, consumerism’s connection to industrial markets will intensify.
On the retail side, shifts in preferences alongside decades of overbuilt markets—the U.S. has five times that amount of retail sf per person than the UK and Europe, for example—has led to corrections in particular types of retail assets. Most notably, lower-class or ill-located malls have not performed well this cycle. However, experientially driven retailers in walkable environments have fared better than most give them credit for.
Capital Markets See New Era
A decade of near-zero interest rates and low inflation—which translated to low 10-year yields—has allowed for a tremendous appreciation in property values. These low interest rates, not only in the U.S. but globally as well, have depressed yields across income-oriented asset classes, making real estate more appealing on a risk-adjusted basis—particularly to cross-border investors. Cross-border investors perceived the U.S. as a safe(r) haven amidst global financial turmoil. Cross-border investment volume increased rapidly between 2009 and 2015, when it surpassed its 2007 peak, and has remained at elevated levels through the third quarter of 2017 despite a recent pullback by China. Much of this deceleration is due to a reorienting of capital flows towards Asia and Europe where economic momentum is picking up, but also a lack of trophy product for sale in the U.S. gateway markets. Despite these recent shifts in investment flows, dry powder targeting North American commercial properties has never been higher. As of mid-December, this figure stood at $153 billion, or nearly double the amount observed in 2007 and 2008 ($84 billion in each year). Indeed, although interest in Europe and Asia will persist as economic performance improves there, a larger share of global fundraising continues to target North America.
In terms of pricing, apartment and CBD office assets take the front running spots, having gained 30% and 60% from their pre-crisis peak prices as of October. In fact, the only sector that has not yet fully recovered is suburban office, where pricing is 3% below its prior peak. Pricing in the major gateway markets stands at 39% above its prior peak compared to 12% for the rest of the country. Capital values remain a driver of total unlevered returns. Ending a 15-year streak, total NCREIF returns for all property types fell by 6.5% and 16.8% in 2008 and 2009. Buoyed by income returns, which have never posted a negative annual rate, even during recessions, NCREIF total returns posted double-digit figures for six years straight, from 2010-2015, before softening to 8.0% in 2016. Moving forward, less upside for values will put pressure on headline returns.
For more, read the full report, “The Great Recession – Ten Year Retrospective.”
 CDS are quoted in basis points and reflect the price to insure $10,000 of bank debt against default for five years.
 National price index for existing homes.
 Examples include the (domestic) Term Auction Facility (TALF) and the foreign exchange currency swap lines established with the European Central Bank, among others. There was extraordinary pressure on U.S. dollar interbank funding during the crisis.
Becky joined Cushman & Wakefield in January 2014 as the U.S. Economist. Before joining Cushman & Wakefield, she worked as a consultant at a finance and economics consulting firm in the DC area, primarily working on loss forecasts for a national housing finance company’s single-family, fixed income portfolio. Prior to that, she was a junior economist at the Congressional Budget Office in the Financial Analysis Division.
Rob is a Director of Research, focusing primarily on National Capital Markets. He rejoined Cushman & Wakefield in 2013 bringing over fifteen years’ of economic and real estate market analysis, consulting and institutional investment research experience across all major commercial property sectors and all major U.S. markets.