Stress Testing the REIT Market The real estate industry is significantly better positioned to weather a recession today than in prior periods. by Jonathan Litt

As real estate debt securitization matured from its infancy in the early 1990s, lenders felt increased freedom to initiate real estate loans since they could use the market for collateralized securities to remove the new debt from their balance sheets. One implication of this financial innovation is that the capital markets now play a much more immediate role in influencing the debt flows into real estate by determining the spreads in the CMBS market.

The fact that in recent months both the equity market for REITs and the CMBS market have stumbled has important implications for the pace of new construction in the next couple of years. On the equity side, new issuance has virtually shut down as a result of the sharp decline in REIT stock prices this year. These capital constraints are causing real changes in the way REIT managements evaluate new investment opportunities, with many firms beginning to see merits in simply "keeping their powder dry" and conserving capital until market conditions change.

A similar capital crunch on the debt side began to emerge recently, as evidenced by sharply increasing spreads in the CMBS market. Spreads over 10-year Treasurys for AA-rated securities exploded during August to 140 basis points from 100 basis points at the end of July. The volume of new issues has been affected, with only seven issues worth $6.7 billion coming to market in July and August vs. 22 issues at $18.0 billion over the prior two-month period.

Although commercial banks have resumed strong real estate lending in the past couple of years, total real estate lending by commercial banks fell from $38.7 billion in the first four months of 1998 to only $9.2 billion from May through August. Although it is too soon to tell whether this decline will be sustained, the warnings issued by Fed Chairman Alan Greenspan in June to banks regarding their level of real estate exposure suggests that regulators are not prepared to permit banks to take part in overbuilding as they have in the past.

If we assume a recession scenario, then the anticipatory nature of capital markets is helping to lessen its impact. If instead the economy continues to grow, albeit at a moderate 1% to 2% rate over the next 24 months, then the current capital crunch should result in even lower vacancy rates, leading to greater pressure on rents, especially in the office sector, where vacancy is already at historical lows.

The implications of a recession for REITs is that rent growth will likely slow and occupancies may decline on their existing portfolio. However, we do not believe net operating income will decline in the scenario outlined above.

Office, retail, and industrial companies typically have leases of five years or greater, which means that less than 20% of their leases come up for renewal each year. Furthermore, most companies find that 50% or more of their tenants renew. The long-term nature of the underlying leases, and hence revenues, for these companies reduces the impact of short-term slowdowns in the U.S. economy.

Multifamily leases are typically for six months to one year, and hotel guests rent space by the night. As a result, these two property categories are more susceptible to short-term slowdowns in the economy. However, based on our recession scenario, we do not believe net operating income will decline, but rather that the rate of increase will slow.

Companies actively engaged in speculative development face the greatest risk in the event of an economic slowdown, as weak demand makes it difficult to lease-up new properties. As demand slows, new construction typically becomes the greatest contributor to increasing vacancy rates, not the existing supply of space.