By Karl Plath

Is the U.S. economy in a recession or on the verge of recession? Or is it just a slowdown?

Dr. Michael Miller, an economist at DePaul University in Chicago, believes it is only a temporary slowdown.

But, he acknowledges, “Never, in looking at the economy, has there been as much uncertainty as there is today.”

Miller, speaking at the annual Commercial Real Estate Forecast Conference sponsored by the Illinois Real Estate Journal on January 22, said economists have widely varied outlooks on the economy. Some believe the country is in a slowdown that will correct itself over the next two quarters. Others believe America is on the "precipice" of a recession the likes of which has not been seen since the 1970s.

“The data support a slowdown,” Miller said in speaking against recession. “GDP (gross domestic product) is growing; you cannot have a recession when GDP is growing. Retail sales over the past
year have grown okay. They’ve been slow, slower than the past four years, but there is growth. You cannot have a recession when GDP and retail sales are growing."

Miller has noted that employment has been growing despite not meeting targets. Even vehicle sales, although slow, have remained stable. "Normally, during a recession, you will see people fleeing in terms of buying vehicles," Miller said.

Other bright spots in Chicago include solid commercial real estate, although recent lending activity reports point to a slowdown over the next couple of quarters. And exports, fueled by the weak U.S. dollar, have been especially strong. Manufacturing activity, although slow, "is not crashing."

"It’s not to say there isn’t a crisis," Miller added. “There is credit crunch; lenders don’t want to lend and borrowers don’t want to borrow. When you get that kind of situation there is a setup for a disaster in the economy.”

And that, he pointed out, is where the Federal Reserve’s monetary policy can make the biggest difference. Miller pointed out that the Fed’s interest rate cut of 75 basis points, which occurred the same morning he was speaking, could begin to spark more credit activity.

"The one thing the Fed has done is they have begun to reestablish faith in the financial system,” Miller said. “As soon as lending picks up there’s a good chance that things will turn around.”

Some of the alarm over the economy may be due to the fact that the U.S. has not had a significant recession since the early 1980s and a slowdown may be viewed as more serious than it is.

“If we get that credit back and flowing, that will be the key.”

Industrial Market Leads Commercial Real Estate Outlook

The industrial market in Chicago—fueled largely by demand for “big box“ warehouse space—has been the strongest in the area, according to real estate professionals speaking at the “Big Picture” session of the conference.

Gerald Pientka of First Industrial Realty Trust said that the demand has accelerated over the past several years with the proliferation of offshore manufacturing and the need to effectively distribute goods to local retailers and smaller distributors.

"The number of imports coming into the United States has really driven the big-box warehouse," Pientka said. “That is going to continue o be strong and will drive industrial real estate for many
years to come."

Although acknowledging a probable slowdown during the first half of 2008, he said he expects demand to resume during the second half because of the need to effectively and economically receive and distribute goods.

Chicago is especially strong in the market, Pientka said, because it is the largest inland port in the U.S. and the fifth largest in the world.

Class A industrial property, especially, will do “exceedingly well” over the next year. Although he expects absorption of industrial space in 2008 to be about half of the brisk clip of 2007, Pientka said he expects it to resume on pace by the end of the year.

Demand for office space, particularly in the downtown area, also remains solid, according to Steve Stratton of The Staubach Company.

“There is 6.5 million square feet under construction now or through 2011,” Stratton said. “Of that, only 1 million square feet is unencumbered, and half of that is after 2010. That’s a key statistic.”

Demand remains strong for quality properties that are built with plenty of technological flexibility, he said. “There is firm balance in the downtown market.”

Drew Nieman of The John Buck Company also noted continued leasing activity and demand for
more office space in newer buildings, although he said caution among lenders might make it difficult to finance a large project.

"The office market is one of the keys that hold everything together."

Greg Moyer of Marcus & Millichap said the rental market also remains on solid footing in the Chicago area. He said demand has been fueled by job creation, which leads to new households, and the fact that current economic conditions are prompting many potential new homebuyers to rent instead of buy.

He added that although some investors may be skittish about investing in real estate, alternative investments are far riskier.

"The real estate market and the economic drivers behind it are fairly stable and should be able to weather a recession,” Moyer said.

"The availability of debt is crucial. Investors will continue to have confidence in commercial real estate. Are we in a recession? Yes. At the end of the day it’s a correction and commercial real estate will win. It’s going to be a bumpy year, but investors are still out there looking to buy real estate.”

Although a source of some of the gloomiest economic news of late, the retail market is also holding its own. Despite news that Wal-Mart was scaling back its national expansion plans, David Bossy of MidAmerica Development said that is not evident in the Chicago area.

"I have a pipeline of 20 to 30 Wal-Marts over a five-year period,” Bossy said. “I see them being very aggressive in the marketplace.” Other large retailers, who have a long-term view of expansion, are also maintaining demand. The problems, he added, lies with smaller retailers who are being squeezed out of the market by the big players.”

Stratton added that the major retailers are “proceeding on a normal course.”

Lawyers Urge Speed and Predictability in Government Dealings

Lawyers speaking at the conference said among the key legal challenges facing developers are complicated regulations, unpredictability and long delays they face when dealing with government
entities.

Richard Klawiter of DLA Piper citied as an example the municipal planning process and the length of time it takes to receive approval for a development project as well as the sometimes- adversarial relationships between developers and planners.

"We need to professionalize the planning process,” Klawiter said. “Public planners are not compensated particularly well and there is high attrition—a brain drain in some cases. It’s important that the planner and developer get on the same page early on so there’s no skepticism on the part of the municipality that the developer is trying to scam the system and no skepticism on the part of the developer that the city is being obstructionist.”

Phillip Gordon of Perkins Coie added that planners need to have some flexibility in considering a project, especially as it moves through the development phases.

“There has to be a recognition that there is an extraordinary dynamism to the development process,” Gordon said, noting that changes in initial plans are almost inevitable.

Likewise, Brian Kozminski of Levenfeld Pearlstein added there must be greater speed and predictability to the inspection process and construction progresses.

Preservation or adaptive use of existing structures is another area plagued by delays and a myriad of regulations, especially in financial incentives, the lawyers said.

“There are plenty of incentives available,” Kozminski said, citing tax credits and tax deductions among them. “There are creative ways to bridge that gap and make a project work.”

The problem, added Gordon, is that the process can be very complicated and time consuming.

“Part of the process is the uncertainty of where you will end up,” Gordon said. “We need to shorten the timetable—process with sufficient predictability and speed.”

The regulations involving tax incentives, he noted, are very complex and often intertwined with other rules.”

Klawiter said planners and community activists also need to recognize that preservation is not always the best approach, although it should be encouraged. Readapting an existing building has a lesser environmental impact on an area than a project built from the ground up.

Turning to the credit crunch facing developers, Janet Johnson of Schiff Hardin said the problem
was brought on by fierce competition among lenders.

“Financing over the last five or 10 years was so competitive that people were reducing their cap rates and accepting loan-to-value ratios that were sky high,” Johnson said. “There has to be a correction before the market will come back.”

She added, however, that institutions such as pension funds tend to be countercyclical and will continue to invest in commercial real estate with strong fundamentals.

Lenders See Plenty of Capital Available

Lenders speaking at the debt market outlook session painted a much rosier picture on real estate financing prospects in the Chicago area. But they cautioned that lenders are going to be more conservative, demand greater equity participation and stick closely to their overall lending guidelines. Still, all five speakers expected strong performance in the commercial real estate financing market.

“The commercial real estate markets are strong,” said Aron Levine of Bank of America. “The office side, the retail, industrial— all those real estate fundamentals are strong. All of the banks that have strong balance sheets are going to be looking at growth this year.”

Cheri Grossman of Wrightwood Capital said her firm, which focuses on commercial real estate financing, is also expecting 2008 to be a growth year.

“It might be a bit slower (at first), but we think it’s a great time and a great opportunity,” Grossman said. “We think the fundamentals are there in real estate. The important thing for us is to have strong portfolio. It’s a good time for us with less competitors and probably smarter lending.”

Added David Pfeiffer of Harris Bank: “With good deals that have consistent underwriting dynamics, there is money available. But you are seeing a pullback, maybe less capital out there. It’s a little more conservative, it has a more structure. It’s returning to a more normal market from such a hotly competitive market (in 2007).”

Ken Kadleck of First Midwest Bank said he expects banks to substantially increase their portfolios of fixed-rate (commercial) real estate loans that are kept on balance sheet (as opposed to being sold to the secondary markets).

“Because real estate fundamentals are strong, there’s capital out there for deals,” Kadleck said. “But we’re going to be more disciplined and more conservative and less leveraged.” Paul Doyle of Anglo Irish Bank said even condominium projects— a market that has softened substantially— can be financed. “With the right borrower and the right structure the deals can be done— but with more caution.”

Levine said developers should expect lower loan-to-value ratios and be prepared to demonstrate
adequate cash flow based on current conditions. As an example, he said lenders likely will not accept “trend-rent” figures but will base their decisions on current rent levels in assessing cash flow.

Pfeiffer said, “As long as there’s identified cash flow, whether it is in office or storage, multifamily, retail, we’re going to be fine.”

He said the current real estate downturn contrasts sharply with the severe downturn in the early 1990s.

“In the early 90s the real estate downturn was more broad based,” Pfeiffer said. “It was both residential and commercial real estate. We have not seen the deterioration in real estate on the fixed income side as we have seen on the residential (currently). Now I think the residential side is in much worse shape than it was in the early 90s.”

“There’s just going to be a return to balance versus investors getting out of the market,” Levine concluded. “There’s a huge amount of capital that’s willing and able to go into real estate. The question now is ‘What’s the right price?”

Reprinted with permission from the March 2008 Supplement to Illinois Real Estate Journal.