Depressed Real Estate Market in Need of Prozac

The real estate market continues its depressing plunge. Banks face a "systemic margin call" of $325 billion from losses in the U.S. Mortgage market according to recent JP Morgan Chase & Co. report. This sum would quadruple if it includes Alt-A prime, construction loan, or equity costs. But it only considers the subprime loan losses.

The report concludes that the value of subprime home or properties owned by subprime borrowers will fall 30% in the next few years. Already, they've dropped by 14% since 2006 and the miserable market won't stop anytime soon.

For investors and some commercial real estate developers, this means banks and lenders won't likely provide a loan. The slowing of the national economy already hurts companies that stand on thin ice, yet worries don't end there. Some in the market believe that the nation's credit crises will hit overextended commercial markets.

The Wall Street Journal provides some good news:

Even optimistic commercial-property developers are stacking sandbags to hold back a financial deluge in the market for office towers, hotels, shopping malls and other commercial real estate.

The consolation is that it looks like commercial property in the U.S. faces a once-every-25-year flood, not the once-a-century inundation facing the nation's housing market.

The article reports that the commercial property slump won't be as bad as originally thought. Moody's gives the U.S. office sector an average score of 52 out of 100. Anything above 50 signifies that market conditions are looking up. However, the office sector depends on the location. Thanks to overbuilding in Phoenix's suburbs, the area has a score of zero.

The article describes the effects on cash flow.

While office landlords haven't dropped their asking rents, many have started offering more concessions like interior construction work and months of free rent so their so-called "effective" rents are lower. According to Reis, effective rents were flat or falling in 16 markets in the fourth quarter of 2007, compared with seven markets in the third quarter.

The problem is that while most properties' cash flows are holding up, their values are falling primarily because financing is so much more costly. That's particularly scary for owners (and their lenders) who borrowed aggressively during the easy-money years of 2005 to 2007 and need to refinance soon. Many won't be able to borrow nearly as much or get the same terms, putting them at risk of default.

In spite these gloomy reports -- and more will surely come -- we need to understand the big trends:

Fact: The U.S. still represents over 25% of the world's GDP (economy).

Fact: In the last 30 years, the U.S. lost 50% of its manufacturing activity. We can argue whether that is good or bad for the U.S. (it clearly helps the rest of the world develop their own economies and participate in the world scene).

Fact: The U.S. is moving more and more towards service businesses and retaining manufacturing of only the most specialized goods.

Fact: Throughout history, there always was -- and will be -- troughs and valleys.

Fact: Our economy is VERY strong (based on GDP per capita, cost of money, inflation, and interest rates).

Don't despair. After all, "In the last few years, the press was able to predict forty of the last two recessions."

In a future post, I will share a handful of ideas of how our smart clients -- manufacturers and service providers -- take advantage of "the slow down in the economy."