Debt Ceiling Debate and U.S. Credit Downgrade Intensifies Uncertainty; Risk to Economy Heightened

August 12, 2011

  • Down-to-the-wire debt ceiling debate and the subsequent downgrade of U.S. debt intensified uncertainty and fear among businesses and consumers, leading to heightened caution and the rising potential of an economic stall. Negative forces, including the spike in energy prices, supply-chain disruptions in Japan, sovereign debt issues abroad, and a housing double-dip had already sapped much of the vitality from the economy, but the self-inflicted negative psychology emanating from Capitol Hill exacerbated these broader factors. Despite this, risks of a downturn have been mitigated by several factors.
  • The financial system is much stronger than in 2008-09, with better-capitalized banks and fewer unknowns. While institutions with systemic or implied backing of the U.S. government, such as Fannie Mae and Freddie Mac, face downgrades, the potential of a broad-based financial collapse remains slim. In addition, corporate profits are nearly 11 percent higher than previous peaks, and companies have amassed more than $1.9 trillion in cash and equivalents. With companies operating lean, chances of another round of mass layoffs are unlikely. As important, there are no longer any employment bubbles set to burst, as was the case with construction and financial services in 2007 and 2008. Therefore, hiring stagnation appears a more likely scenario than massive job cuts.
  • The downgrade of U.S. debt and looming possibility of a default in Europe have placed indirect pressure on interest rates, with the yield on the 10-year Treasury now in the low-2 percent range. Since S&P’s announcement, stocks have been on a wild ride, driving capital into U.S. Treasuries and reaffirming U.S. debt as a safe haven investment. While the downgrade ultimately may result in higher borrowing costs, investors will continue to flock to U.S. Treasuries in the near term, holding interest rates close to historic lows.

             Impact on Commercial Real Estate

  • Extremely low interest rates, stabilized fundamentals, and volatility elsewhere point to rising capital flows into commercial real estate, albeit on a selective basis. As disappointing as job growth has been during this recovery, the 1.8 million private-sector positions added over the past 12 months were enough to end occupancy and rent declines across all property types. Unless the U.S. enters a dramatic downward spiral that leads to fear-based, not fundamentals-based, job cuts, property operations should remain relatively stable in most sectors.
  • Commercial real estate investors’ flight to quality, which began to wane in recent months as yields compressed to extreme lows, will once gain intensify. More Class A, primary-market buyers will emerge now that the cap rate-to-interest rate spread has widened. Class B assets in strong metros and top-tier properties in healthy secondary markets stand to win as well. On the other hand, lower-quality assets and tertiary markets may see their prospects dim amid renewed risk aversion. Lenders’ spreads have already pushed out 30 basis points to 50 basis points in response to recent events and more caution may follow, but credit generally will remain available for commercial real estate deals.

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The information contained herein was obtained from sources deemed reliable. Every effort was made to obtain complete and accurate information; however, no representation, warranty or guarantee to the accuracy, express or implied, is made.

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