U.S. Real Estate - The 2005 Outlook

January 2005 will mark the start of President George W. Bush's second term in office, and the fiscal and monetary conditions that will prevail going forward will be in sharp contrast to the policies that were implemented at the start of the President's first term. At that time, the U.S. economy was in recession and the President immediately abandoned the fiscal restraints that had been in place under President Clinton and quickly moved the Federal Government into the biggest budget deficit in history. At the same time, the Federal Reserve Board, under Chairman Alan Greenspan, adopted an extraordinarily aggressive monetary policy, pushing interest rates to their lowest level since World War II. As a result of this massive fiscal and monetary stimulus, the U.S. economy began its recovery in late 2002 and is now considered to be on a sustained growth path.

With the economy growing again, and the Presidential election in the past, an effort will almost certainly be made to try to reduce the massive budget deficit. Some limits on new government spending have been suggested, but continued expenditures on the Iraq war, combined with the large tax cuts put in place by the President, make it unlikely that the budget deficit will shrink to any meaningful extent. As to monetary policy, however, it is clear that the Federal Reserve Board is committed to regular increases in the fed funds rate. This rate was gradually raised from 1% to 2% during 2004, and it seems likely that it will be increased to 3% or above during the next 12 months.

From the viewpoint of the real estate market, the fundamentals of the market will benefit as the economy continues to improve. However, rising interest rates will put upward pressure on mortgage rates and on capitalization rates and, accordingly, downward pressure on real estate yields and on real estate prices..

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Interest Rates:

The very low level of U.S. interest rates has almost certainly been the single most important factor affecting the real estate market in the United States for the past several years. The basic fundamentals of the real estate market were relatively poor during almost the entire span of President Bush's first term. After the high tech/ telecommunications bubble burst, a tremendous number of the small, start-up companies that had helped fuel the boom of the 1990's collapsed, and office vacancy rates rose around the country. There had been some overbuilding in all sections of the real estate market during the 1990's and, as the recession continued, weakness spread throughout the real estate industry affecting retail, industrial and apartment properties as well.

However, the low level of interest rates allowed investors to obtain very attractive mortgages, which, in turn, produced relatively high cash-on-cash yields. As a result, the demand for properties leased to credit quality tenants on long-term leases escalated dramatically. Cash-on-cash yields of 9% to 10% were easily obtained - yields that were almost twice what was available in the bond market and nine to ten times what was available in the money markets - and these yields attracted many new investors to the real estate market. This flood of money looking for secure yields caused some distortion in the market, as capitalization rates on properties on long-term leases to credit quality tenants fell from the 8% to 9% range down to the 6% to 7% range or even lower. However, as interest rates in the mortgage market move back up in 2005, capitalization rates in this part of the market can also be expected to move back up and some of the excesses that we have seen in the market should begin to disappear.

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