Where Are We in the U.S. Commercial Real Estate Market Cycle?

By Sean Pattap, Fitch Ratings

Over time, commercial real estate fundamentals will be driven by location, the strength of the financing markets, credit spreads, underwriting standards, asset pricing and retail consumer spending.

U.S. commercial real estate fundamentals are recovering. That said, leverage remains high compared to pre-recessionary, real estate boom levels. Over time, commercial real estate fundamentals will be driven by location, the strength of the financing markets, credit spreads, underwriting standards, asset pricing and retail consumer spending.

Jobs are a primary driver in the outlook for commercial real estate. As unemployment rises, not surprisingly, net operating income tends to fall. Consequently, an improving jobs picture may result in a significant slowing of the downturn in aggregate net operating income this year.

While the improving job outlook will help stabilize fundamentals and increase transaction volumes, unforeseen events, as Libya and Japan illustrate, may negate any positive momentum an improving job outlook may generate.

Additionally, regional economic downturns, a lack of liquidity for commercial properties, widening credit spreads, a broad weakening of underwriting standards, and weak retail consumer spending may also offset the extent to which job gains bolsters the commercial real estate market.

With respect to U.S. equity REITs, Fitch carries a Stable Outlook for the sector based primarily on continued strong capital markets access, continued de-risking of issuers’ balance sheets and strategies, expectations of relatively unchanged coverage metrics, and a strengthening asset sales environment.

The stable outlook also reflects the strong liquidity position for many REITs. Many issuers have accessed the capital markets to repay or refinance near-term indebtedness, combined with a sector-wide reduction in projected development expenditures.

Offsetting these positive elements are continued negative property-level fundamentals across most asset classes. While multifamily sector fundamentals should improve as 2011 progresses, net operating income declines may still occur. The same challenge will apply to suburban office, industrial, and retail properties.