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Market Commentary

Commercial Real Estate: More Trouble Ahead
February 26, 2010, David Kotok, Chairman & Chief Investment Officer

“Between 2010 and 2014, about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are at present “underwater” – that is, the borrower owes more than the underlying property is currently worth. Commercial property values have fallen more than 40 percent since the beginning of 2007. Increased vacancy rates, which now range from eight percent for multifamily housing to 18 percent for office buildings, and falling rents, which have declined 40 percent for office space and 33 percent for retail space, have exerted a powerful downward pressure on the value of commercial properties.

“The largest commercial real estate loan losses are projected for 2011 and beyond; losses at banks alone could range as high as $200-$300 billion. The stress tests conducted last year for 19 major financial institutions examined their capital reserves only through the end of 2010. Even more significantly, small and mid-sized banks were never subjected to any exercise comparable to the stress tests, despite the fact that small and mid-sized banks are proportionately even more exposed than their larger counterparts to commercial real estate loan losses.”

We have extracted these two paragraphs from the executive summary of the February 10, 2010, Congressional Oversight Panel’s Special Report entitled “Commercial Real Estate Losses and the Risk to Financial Stability.” This 190-page document is packed with vital and detailed information. Find it at: http://cop.senate.gov/documents/cop-021110-report.pdf .

The issue of CRE is on everyone’s mind. And, unlike residential housing, there is no political will in Washington to subsidize a mall developer or office landlord. That is a good thing. In the longer run the CRE adjustment will be faster and less costly to the American taxpayer than the protracted demise of the Fannie and Freddie.

At Cumberland, we expect the forthcoming losses on CRE debt to be large and continuing. Essentially the United States is re-pricing its commercial real estate sector with debt-driven deflationary forces.

CRE is another of the several reasons the Federal Reserve will remain committed to its very low interest-rate policy for an “extended period.” In the case of CRE, the Fed does not have the policy of subsidy and support in place that it has for the federal housing finance agencies.

Large-scale federal attempts at subsidy for CRE have failed miserably. That is what we would expect when the government tries to create a mechanism to avoid the reality of taking a loss. The most notorious of those attempts is the PPIP. That monstrosity was designed and released with great fanfare by the Treasury Secretary. Notice how little you hear about it now. Had it advanced, there would have been a $1.1 trillion program with a massive transfer of subsidy from taxpayers to special finance interests.

The Senate report doesn’t mince words about PPIP. It also clearly establishes that PPIP is not likely to have much impact. The section on PPIP starts on page 127. In the spirit of American history it could be nicknamed Geithner’s Folly. The only thing wrong with that metaphor is that Secretary Seward’s purchase of Alaska turned out to be a dramatic success for the US while Secretary Geithner’s PPIP stands no chance of a positive outcome.

Let’s sum this up. Big losses are going to be reported on CRE. Banks have another round of pain ahead of them. The stress test on the 19 large institutions only runs through 2010. It is clear that the nation has not reach a stabilized level with its commercial real estate. It is likely that another round of painful adjustments lies ahead.

We conclude that the falling price level in CRE is a deflationary force in America and will continue to be so for several more years. Debt tied to it is in trouble. Banks will take more losses and bank capital will be tested again. This impact on banks can only be determined on a case-by-case issue.

Meanwhile, this is another reason why the Federal Reserve will continue its very low interest-rate policy for an “extended period.” We believe that means all of this year and most if not all of next year. Our forecast is that the short-term interest rate in the US will be between zero and 1 percent during that period. Add to that the conditions in the rest of the world, and one can make that projection of low interest rates for nearly all of the major economies. Exit strategies may eventually come, but not for an “extended period.”

We look forward to seeing some readers at the Philly Fed conference on March 3. See www.interdependence.org for details. Also, we are scheduled to discuss our market outlook on CNBC’s Power Lunch on Monday, March 1 shortly after the noontime opening. Good weekend wishes to all from the Cumberland Advisors’ Sarasota office.

David Kotok, Chairman & Chief Investment Officer
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