Recovery coming

As the drama that has become commercial real estate finance continues to unfold, Florida Real Estate Journal sought out the perspective of Hugh Kelly, currently the principal of Hugh Kelly–Real Estate Economics, an independent consulting firm specializing in analysis, interpretation and application of economic variables for real estate decision-making.

Kelly is also a clinical associate professor of real estate at NYU Schack Institute of Real Estate and former chief economist with Landauer Real Estate Counselors.

Following are Kelly’s thoughts on the credit markets, federal intervention and general economic recovery.

FREJ: To date, what is your opinion of federal efforts to unfreeze the credit markets? What initiatives hold promise, and what might be better left undone or done differently?

Kelly: This is a really complicated opening question! There are so many “facilities” that the Fed and the Treasury have initiated - the big “TARP”, the liquidity facilities targeted to term auctions, the commercial paper markets, TALF (1.0 and 2.0) - that it is tempting to pick them apart as winners and losers. It does seem clear at this point that the commercial paper program has helped bring private debt back to the corporate short-term market. Foreign banks made use of the central bank liquidity swaps to cover their dollar exposures, and now no longer seem to need that capacity nearly as much. These were successful but temporary tools, as Bernanke intended them to be.

Likewise, it seems like the massive AIG bailout did what it was supposed to do - keep counterparty claims on AIG’s misbegotten credit default swaps from sinking the whole system. But rather than praising, or damning, the programs one at a time, I think the key point is that a nuanced, targeted, complex program was needed - and the whole effort of devising and implementing a multipronged program beyond the traditional interest rate management and FOMC trading techniques was necessary and has helped us (I hope) avoid the risk of a Japanese-style “lost decade.”

What are your thoughts on the Public-Private Investment Partnership specifically? Will it help the capital situation? At what cost/risk?

I have very mixed reactions to this program, as I understand it. The idea of placing the leverage of the federal government against the “toxic assets” that were, in an Orwellian move, renamed “legacy assets” and “legacy securities” is, in principal, a decent idea. That is, in a market where there is no credit available and where price discovery is an essential step to unfreezing the market, it makes sense to me to make Uncle Sam the lender of last resort - provided he is a REAL lender, that is, he is expecting to be paid back!

I’m not crazy with the way that the P-PIP allows the banks to “game” this leverage into balance sheet improvement by allowing a nominal loss in their “partnership equity” to effectively transfer a larger loss to the FDIC as guarantor of the debt. But it seems like someone at the Treasury has figured that out and is trying to iron out the wrinkles.

This is all an indication of how complicated this is, and how important it is to take some time in implementation. I know people are in a rush to “solve the problem,” but I’m sympathetic with the administration’s repeated admonition to Congress and others that the crisis developed by systemic weakening over a period of decades, and the resolution will not come overnight.

Is all of this intervention really necessary, or could the free market have been left alone to work this out over time?

Of course, the whole reason the government got involved was that the “free market” was not only not “working it out” but - by being as paralyzed as the proverbial deer in the headlights - the private financial system was about to cause a systemic financial and economic collapse of cataclysmic proportions. So, yes, at the time (last fall) and even now, the intervention of the government was necessary.

I’d go further - to have done nothing would have been a dereliction of duty both on the part of Bernanke and on the part of Hank Paulson (and now Tim Geither). An impeachable dereliction, I would maintain. For these guys have the primary responsibility under the law to see to the safety and soundness of our system.

Ironically, had it been left to the “free market” alone, there might have been no “free market” left to save in very short order. It should be recalled that it was ideology that led the Versailles Treaty framers to impose such war reparations on Germany - under the moral hazard argument that its actions must bear consequences - that (as Keynes predicted in 1918) it was inevitable that inflation would topple its economy and a dictator would step into the rubble.

Had our system been allowed to collapse last September - December, we would have ourselves been looking for a “strongman” to fix it at any cost. As far as the market’s ability over time to remedy the situation, Keynes had another famous adage: “In the long run, we are all dead.” Or alternatively, “The markets can remain irrational longer than you can stay solvent.”

Some have said the volume of commercial real estate loans coming due for refinancing over the next three years presents a genuine crisis, given the lack of liquidity in the capital markets. How do you see the situation?

This is a big issue, but one that wouldn’t be so big except for the larger credit situation. First of all, how big? My understanding is that there are some $300 billion of commercial mortgages maturing this year, about the same next year, but more than $350 billion in 2011 and more than $400 billion in 2012. So let’s say (round numbers) $1.4 trillion.

Ordinarily, commercial banks, pension funds, insurance companies, and the CMBS market could digest this without undue difficulty. But, because lending is now so hard and so expensive, the process of deleveraging is reducing the putative value of the properties securing the debt, making even well-occupied buildings that are paying their loans “toxic” and unable to be refinanced at par. So this is a real issue that will (a) spur many high-profile defaults and (b) further weaken the capital markets for real estate.

At the same time, it will put a volume of distressed properties (already estimated at $72 billion and rising) out for sale and enable “cash-is-king” buyers to reap a windfall later in the coming decade. This may be part of the creative destruction of capitalism, as Shumpeter told us long ago, but it seems wasteful to me.

I’m skeptical, too, of claims that commercial real estate has its own bubble price that requires massive correction. Given the run-up in construction costs that we’ve seen in steel, copper, concrete and other building materials, I’m not sure that the pricing of assets in the mid-2000s wasn’t pretty closely aligned to replacement cost. If that’s the case, then that’s where the pricing will return, once the economy resumes growth.

What is the likelihood that we will see widespread foreclosures on commercial properties as a result of these fiscal challenges?

Right now, absent a freeze on lenders (not going to happen), the likelihood is 100% for all practical purposes. Real Capital Analytics has already identified nearly 4,000 troubled commercial assets. If only a quarter of them go into default, the domino effect will be unstoppable. My only issue with your question is that you term this a “fiscal” challenge. To me, “fiscal” means “government budget.” The challenge isn’t fiscal in that sense, it is operational. How can borrowers and lenders go through a workout process that has the objective of “timely payment of interest and ultimate repayment of principal?” That is what I’d aim for if I was the banking regulator for commercial real estate.

What are your thoughts on when a general economic recovery might take place and what it might look like?

I think that the consensus forecast of the Blue Chip Economists survey has it about right: measurable GDP growth by the final quarter of 2009 and real GDP expansion of 3% or so by the end of 2010. Certainly most of the economic data emerging in the past four weeks or so have had more upside than downside surprises. If the stock equities markets generally lead economic recoveries by six months, then the surge in the S&P and Dow since March 9 means the timing of a fall 2009 recovery is pretty much on track.

Like the recoveries of the early 1990s and early 2000s, though, this is likely to be a “jobless recovery” in that it will take at least three years of growth to replace the roughly 6.5 million jobs that will ultimately represent the employment decline from the late 2007 peak. In that sense, it will not feel like a recovery until about 2012.

But, in terms of the wealth effect (increases in stock portfolios including 401(k)s, and home values), I expect next year to be very good. And I believe that consumer confidence will be a good indicator of that.