Real Estate Investments in 2002

The U.S. real estate market enters 2002 in relatively good condition, considering the fact that the country is in an economic recession. While vacancy rates have risen in most markets and rents on new leases have declined, the market is not faced with significant over-building nor serious liquidity problems, as was the case ten years ago.

However, the economic recession has brought about a major divergence within the U.S. real estate market. On the one hand, quality properties leased to credit tenants on long-term leases are in great demand by investors. There is very little risk involved in such properties, and many investors are buying them to obtain the relatively high current yields that they provide.

On the other hand, there is relatively little demand for properties that have any near-term leasing risk. Prices for such properties have fallen between 10% and 20%, and investors are making fairly pessimistic assumptions as to re-leasing prospects.

With most economists predicting that the economy will emerge from recession during the second half of the year, the real estate market should begin to recover at about the same time.

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Market Conditions:

The U.S. economy officially fell into recession during the second quarter of 2001. Current forecasts indicate that this recession will continue at least through the first quarter of 2002. The real estate market is, of course, affected by this recession and, with few exceptions, higher vacancy rates are being experienced in most categories of real estate throughout the country. In addition, there has been an across the board softening of rental rates as corporations reduce their requirements for office, industrial and retail space. However, basic conditions in the U.S. real estate market are significantly better than they have been in previous real estate recessions. Typically, as an economic recession begins, the real estate market is suffering from significant over-building, and the combination of over-building and a recession causes severe financial problems for the industry. Fortunately, the lessons of the last recession had been well learned, and bankers and other real estate lenders had restricted construction loans to properties that were substantially pre-leased. Therefore, with fairly reasonable levels of financing on most properties and with only moderate increases in vacancy rates, there should be few “distress” properties over-hanging the market during 2002. Occupancy rates are declining currently because of a decline in demand, rather than an increase in supply. As demand picks up later in 2002, we expect that vacancy rates will once again begin to fall back to previous levels.

Mortgage Interest Rates:

The U.S. Federal Reserve Board lowered interest rates eleven times during 2001, bringing rates down to the lowest levels in forty years. Since interest rates for fixed rate mortgages are set as a spread over comparable maturity U.S. Treasury bonds, the Fed’s action in reducing rates this dramatically has had a direct effect on the mortgage market. Today interest rates on fixed rate mortgages are currently at about the 6 1/2% level, or about 200 basis points over the rate on five-year maturity U.S. Treasury bonds. In addition, many lenders have been willing to provide financing on an interest-only basis, at least for a period of up to five years. As a result, the spread between mortgage interest rates and capitalization rates on new real estate investments is now wider than is has been in the past twenty-five years, making leveraged real estate purchases quite attractive.

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