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Experts See Realty Markets Remaining Weak in Near Term

Findings from two studies indicate that the weakness in the commercial real estate sector is likely to continue for some time to come.

The Federal Deposit Insurance Corp. reports that bank commercial real estate portfolios are performing well now, but they are likely to weaken going forward due to rising vacancy rates and falling rents in commercial real estate markets.

The federal regulatory authority believes however that "even with this anticipated turn in the cycle, banks are not likely to experience the problems of the last downturn of the late 1980s and early 1990s."

The FDIC continues to monitor the trend of declining demand for office space and falling rentals in many regions of the country. According to FDIC chief economist Richard Brown, "The good news is, despite declining fundamentals in most commercial property types, bank loans secured by commercial real estate and construction projects continue to perform well on the whole. Loan losses in this line of business remain near their cyclical lows even as the vacancy rate approaches the peak of the previous real estate cycle."

The factors that the FDIC cites as having helped hold up the performance of commercial real estate portfolios include historically low interest rates, more conservative underwriting practices, and greater financial market involvement in the industry. These factors "offer significant reassurance that the present downturn will not lead to credit problems on nearly the same scale as we saw during the last downturn," the FDIC believes. Even then, they expect that "bank commercial real estate loan losses will rise in coming quarters from their current low levels as more borrowers experience problems servicing their debt."

Another commercial real estate market report from Wachovia Securities anticipates a "delayed recovery" in the sector. According to Wachovia CMBS analysts Brian Lancaster, Davis Cable and Kathy Mixon, "the clouds overhanging the property markets have become slightly grayer and more widespread" since their last report. Property revenue levels have declined for all sectors except retail, they report. Among the "gloomiest" areas are Northern California, Denver, Indianapolis, Atlanta and several Texas metros. The apartment sector is facing oversupply and is expected to be slow to respond to recovery because of continuing strong home ownership trends, lagging job growth and increased multifamily building activity. However, capital flows to the apartment sector are slowing.

The retail sector continues to attract capital and is the most stable sector, according to Wachovia. Retail properties and hotel properties are expected to benefit the quickest from an economic recovery. Although they believe that the hotel sector has touched bottom and expect that hotel revenue will recover later this year and going into 2004, they still caution that "event risk" exists. The office and industrial sectors, which are expected to continue to suffer from extensive overcapacity, are expected to hit bottom only late in 2004 or in early 2005. In the office sector especially, the recovery is likely to take especially longer because of slow and late job growth and the current "suburban overhang." However, there is a silver lining to the story. Southern California and Southern Florida continue to do well, along with parts of Greater Washington, D.C., and Baltimore.

Although loan delinquencies remain low in the commercial mortgage-backed securities sector, except in the hotel sector, Wachovia expects them to go up. While they expect CMBS delinquencies and defaults to increase further in the coming months, even up to double their current levels, they believe that "low interest rates and continued capital flows to the sector will be stabilizing factors, limiting loan deterioration." Another positive is that CMBS collateral is concentrated in property types and metro areas that they expect will outperform the overall market.

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