Industry Wonders How War Might Affect Real Estate

Commercial mortgage delinquencies have held up very well in the current economic downturn, but everyone is now watching on the outcome of a war with Iraq to see what might happen in the future. The possibility of war now appears more likely, and a long drawn-out war is likely to have a negative impact on commercial mortgage delinquencies going forward.

Stuart Gabriel, director of the Lusk Center for Real Estate at the University of Southern California, believes that if a U.S.-led invasion of Iraq turns into a protracted conflict, consumer confidence could plunge and stock prices could fall, which could cause the U.S. economy to go back into recession and send commercial property markets into a deeper slump.

Mr. Gabriel notes, "History could repeat itself. Further weakening in economic activity would exacerbate the slump in the nation's commercial property markets." At the start of the Gulf War in the early '90s, he recalls, consumer confidence plunged, sending the economy into a prolonged recession.

In the worst-case scenario of a long drawn-out war, demand for office space - which has already been weakened by the loss of 2.4 million jobs nationally over the last two years, according to Mr. Gabriel - would fall further, causing rents to soften further.

In this scenario, consumer confidence and spending would also fall, causing retail sales to slow and reducing demand for retail space. Businesses would spend less on plant and equipment, resulting in a decreased demand for industrial space. And the hotel market, which is finally beginning to recover from the 9/11 slump, according to Mr. Gabriel, could fall back into a decline.

In a more optimistic scenario, "The cloud of uncertainty over the U.S. economy could be removed if the U.S avoids war or carries out a quick invasion with minimal loss of life and minimal damage to Iraq's oil fields," Mr. Gabriel believes. In this case, consumer spending and business confidence would both pick up. Standard & Poor's also expects that if the economy continues to improve this year, real estate fundamentals will also begin to recover. The rating agency expects delinquency rates on the commercial mortgages linked to the S&P-rated CMBS deals to be in the 1.5%- 1.7% range this year, with a caveat relating to economic uncertainty.

S&P reports, in its CMBS quarterly review report for the fourth quarter of 2002, "Fundamentals in the real estate market, which declined in 2002, will see a modest recovery in 2003. This expectation is based on a critical assumption that, barring a war in Iraq or other shocks to the market, the economy will grow between 2.5% and 3.5%, with a mild 2% to 2.5% inflation rate and a modest 50 to 100 basis point increase in interest rates in 2003. There are extraneous factors that could significantly affect real estate property markets that cannot be predicted or controlled. However, the expectation is that if the economy continues to improve this year, real estate fundamentals will also begin to recover."

The rating agency expects apartment and retail properties to show stronger improvement than office and hotel properties if the economy improves this year. And metropolitan areas on the East and West Coasts are also expected to perform better than those in the southern United States. At the end of 2002, the delinquency rate on Standard & Poor's- rated CMBS transactions was at 1.51%. This low level of delinquency continues to "mystify its observers, as the underlying collateral appears to be ignoring the signals of the economy and the property markets." However, the apparent contradiction is likely to end this year, the rating agency believes. "Borrower perceptions of the economy and property markets appear to be changing and could influence payment decisions.

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