Strengthening Economy Bodes Well for Real Estate

With the latest indications showing that the economy has clearly recovered from the mild recession that began back in 2001 - although there is the possibility, however slight, that the momentum could be delayed if there is any other shock to the system, considering that the U.S. is engaged in an ongoing war against terrorism - commercial properties are likely to perform better going forward. This means that mortgage delinquencies are likely to go down, too. Among the positive indications, the economy posted a whooping 7.2% growth in annualized gross domestic product for the third quarter. And employment levels, which had remained low well after the recovery began, prompting market watchers to dub this a "jobless recovery," are finally on the rise.

Delinquencies are lagging indicators though, and it is likely that it's going to get worse before it gets better. A downturn in delinquencies is likely to come about after they have hit their peak sometime next year. Standard & Poor's, for one, is expecting that commercial mortgage delinquencies will trend up to 2% next year, from 1.79% for the third quarter (on a $200 billion CMBS base). And Fitch Ratings is seeing property sectors in various geographic areas being impacted by operating income declines and expects that "the softer markets will continue to see upticks in delinquent loans."

At the end of the second quarter, the delinquency rate on S&P-rated CMBS was 1.69%. In dollar terms, the rating agency reports that CMBS delinquencies totaled $3.59 billion at the end of the third quarter, a 45% rise from the end of 2002 (in 2002, delinquencies increased 15% from 2001 levels). While all the major property types have contributed to the rise, office and multifamily properties have been at the forefront. In terms of amounts delinquent through the end of September 2003, the office sector saw a 178% rise, the multifamily sector a 70% rise, retail properties 30%, lodging properties 22% and health care properties 11%. While office loans had the greatest "net delinquency amount increase in the third quarter," the sector trailed retail loans that "became delinquent," according to Roy Chun, a managing director in S&P's structured finance surveillance group. "New retail delinquencies, which totaled $232.2 million of principal balance, represented a 33% increase over the amount delinquent at the beginning of the quarter. Retail was also active in he amount of loans that were resolved either by becoming current, through payoffs, or liquidations," Mr. Chun noted. Lodging was the only property type to see a decline in the amount delinquent for the third quarter, with more loans being resolved than became current.

Fitch Ratings is also seeing a decline in hotel delinquencies for the third quarter, compared to the second quarter. Hotel

delinquencies declined by $192 million, a 15% decrease, which reflects a "third-quarter improvement in hotel loan performance due to the summer travel season," according to Mary O'Rourke, a Fitch senior director. However, "the question is whether hotel loans can sustain the improved performance during the fourth quarter and into next year as the volatility of hotel loans is still a great concern." The removal of just four loans from Fitch's 60-day delinquent list contributed to half of the decline in hotel sector delinquencies.

As for the other property sectors, the rating agency saw retail loan delinquencies increase $175 million, a 24% rise, in the third quarter. Office loan delinquencies increased by $101 million, a 27% rise. Fitch also reports a 12% increase in industrial loan delinquencies, about a 7% increase in health care delinquencies and a 5% rise in multifamily delinquencies. The rating agency is anticipating increased office and industrial loan delinquencies for at least the next three quarters, and a slowdown in retail delinquencies. Fitch's loan delinquency index registered 1.61% for the third quarter, "essentially unchanged" from the second quarter reading, Ms. O'Rourke said. However, it is 34 basis points higher that the reading for the third quarter of 2002. "The improved performance of hotel loans has masked to a large extent the declining performance of loans in other sectors," she believes.

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