S&P Downgrade’s Impact On Commercial Real Estate

Aug 10, 2011 No Comments by

While S&P’s debt rating downgrade for the U.S. may not have come as a total surprise to investors, it’s important to understand the specific rationale the ratings firm cited for the downgrade, and perhaps more importantly, to understand what was not part of the reason for the downgrade.

The title of the downgrade statement issued by S&P is very revealing: “United States of America Long-Term Rating Lowered To ‘AA+’ On Political Risks and Rising Debt Burden” (emphasis added). It’s clear from reading S&P’s statement that the U.S. debt wasn’t downgraded because, unlike certain other countries, it doesn’t have the ability or capacity to pay its debt obligations today. Despite all the hand-wringing over the debt ceiling, the U.S. does have the financial resources to meet its obligations.

Rather, in the ratings agency’s view, the greater risk is that the U.S. political leadership may lack the ability to agree to pay its debt obligations today, as well as make the tough and necessary decisions to reduce long term debt levels. That is why S&P primarily focused on the process (or lack thereof) used to increase the debt ceiling.

While the issue of whether the downgrade was warranted or not is open to debate, it is telling that S&P focused on the political process. A borrower’s ability to service its debt and their ability to agree to service their debt are two different things. In the five C’s of lending this falls under the “C” that stands for character — will you do whatever it takes to meet your financial obligations.

The U.S. reputation for reliability has been impaired. As a result, any continued rhetoric and brinkmanship that gives credence to the view that either party might be willing to allow a default will have the same effect as a real estate partnership that does the same. Borrowers will pay a higher interest rate because of the perception of higher risk, and if it continues long enough, they will have increasing difficulty borrowing money.

With this heightened concern, why hasn’t the rate on U.S. Treasuries skyrocketed? While economists point to a number of reasons, including favorable expectations regarding inflation near term, the U.S. also can thank the European Union to a large degree. The recurring fears of sovereign debt default by various EU member countries is making the U.S., even with its current dysfunctional political situation, look better by comparison.

While the U.S. may have difficulty in taking the steps to agree to pay our debt, it continues to have the capacity to do so. Conversely, there are very real concerns regarding the ability of various EU member countries’ to repay their debt.

Impact On Commercial Real Estate

The impact of the downgrade on commercial real estate will likely be multi-faceted. As some analysts have pointed out, the downgrade may prompt a re-evaluation of sovereign risk by investors. This may spur greater interest in high quality real estate and the presumed durability of their cash flows providing an attractive option for wealth preservation and current income.

There will also be implications for commercial real estate financing. If Treasury yields continue to decline, the starting point for the cost of real estate capital will be lower, which should bolster the market.

However, if bank stocks continue to retreat their ability to lend will be reduced. This depends on how much of their recent retreat was due to lowered growth expectations as opposed to the market’s overall reaction to the S & P downgrade.

Also, those with means for tapping capital will continue to have an advantage in a turbulent market. Despite the hit many REIT values took this week in the wake of the downgrade, equity analyst Sandler O’Neill believes many REITs are well positioned to remain active buyers and sellers. This will be especially true for those with an investment grade rating, providing access to both the corporate and mortgage markets.

The larger impact for commercial real estate could be felt on the demand side, at least in the near term. The shock to the system will likely only increase hesitancy to invest and hire workers among companies and consumers already hesitant to spend.

There likely will be a negative impact on consumer and business spending, at least in the interim. This could translate into reduced economic activity and as a result reduced commercial real estate demand.

This all could change based on many factors, including as S&P correctly pointed out, the ability of Republicans and Democrats to work together to govern effectively. That is why they call it the study of political economy.

Source: CoStar

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