By Chris Shaw
A major contributor to the global financial crisis was the downturn in US housing prices as this not only brought the sub-prime issue to the fore but the fall in house prices has subsequently impacted on household wealth and this has translated into lower consumer spending levels.
In the view of Standard Chartered there remain significant risks with respect to US real estate, with possibly the next shoe to drop being the commercial property sector as prices here are currently falling faster than house prices. While losses won't match those in the housing sector Standard Chartered analysts point out they will still be large and will drag down private commercial construction activity levels for some time.
Such an outcome would be a drag on economic growth, Standard Chartered estimating it would likely be significant enough to offset any expected pick-up in residential investment. It will also have an impact on lending by smaller regional banks, which will also flow through to the overall economy.
The analysts point out the peak in commercial real estate prices was back in October of 2007, which was about 16 months after residential real estate prices topped out. Since then prices in the sector are officially down 24% according to Federal Reserve figures but as Standard Chartered notes many analysts see the real fall as being of greater magnitude. For example, the Moody's/Real commercial property price index shows prices down 35% from their peak, which includes a 7.6% fall in May alone.
In contrast, the NCREIF returns index shows prices are down just 15% but as Standard Chartered points out when rents are taken into account prices on this measure are down by around 25%. The decline has been quite sharp, likely a result of rapidly tightening credit markets.
The other factor of note in the group's view is the decline this time has come with underlying consumer price inflation much lower than in the downturns of the 1990s, meaning there is not the same cushion for nominal real estate prices as has previously been the case.
Another issue Standard Chartered highlights is most commercial real estate is owned on a leveraged basis, meaning equity losses by investors have been much larger than the falls in prices. This supports its view the sector is likely to act as a drag on overall economic growth.
Looking ahead, Standard Chartered sees further price falls given vacancy rates are rising, rents are falling, distress in the sector is leading to both foreclosures and forced sales and tighter controls are limiting the availability of financing.
Construction levels in the sector support this outlook as the group notes while construction activity made a positive contribution to GDP up until the September quarter of last year, it has since fallen sharply, taking a little more than 2.0% from GDP in the March quarter this year.
With the current financing issues few new projects are expected to commence over the next year to help put some positive momentum back in the sector, so Standard Chartered sees scope for construction spending to fall below 2003 levels. Even allowing for this, it sees vacancy rates staying high for some time and expects it will be several years before construction activity levels genuinely pick up again.
Over-building was not the same problem in the commercial sector as it was in residential housing, but as the group points out the fall off in demand means there is currently excess supply and this additional capacity is likely to remain until demand recovers.
On the group's numbers it would require GDP growth of around 6% for both of the next two years for this gap to close by 2011, an outcome the analysts regard highly unlikely. If GDP growth averaged 4% it would take four years, meaning no quick fix for the sector's problems.
In terms of the sector's financial losses, Standard Chartered estimates the US commercial real estate market is around one-third the size of the residential market, meaning it is valued at around US$6.7 trillion. Assuming overall price falls of about 50% this implies as much as US$3.3 trillion in lost asset value. The analysts estimate this will be around half the equity market losses and around one-third the size of losses in the US housing market.
For lenders to the sector estimates of potential losses vary, ranging from US$250 billion to closer to US$400 billion. Either way the losses will be far smaller in the commercial sector than in the residential sector, meaning while the commercial sector will be a drag, the real issue for the US economy remains how far house prices eventually decline before a bottom is reached.