Friday, October 17, 2008
Oversupply drives ‘90s cycle, but it’s easy credit this cycle - Merrill Lynch
"Many investors believe that term CRE losses this cycle unlikely will match those in the early ‘90s, due to the relative lack of oversupply. However, easy availability of credit and loose underwriting standards likely will drive this CRE cycle, which could pose as much risk to credit quality as oversupply. Material oversupply drove the early ‘90s CRE cycle, and it is unlikely that supply will run as high in this cycle on average – although select products and regions could post similar supply/demand imbalances, which we discuss later in this report. A tax law adopted in ‘81 (Economic Recovery Tax Act) drove several changes to the tax code that contributed to the oversupply issues: 1) lowered the income and capital gains tax rates; 2) decreased depreciation schedules; and 3) permitted 175% declining balance depreciation instead of straight-line. These changes encouraged CRE investment, as it increased after-tax returns in the early years. However, the regulators rescinded key real estate-related portions of this tax law in ‘86, which led to the bursting of the CRE bubble. In this cycle, easy credit and weak underwriting standards have prevailed, and we are concerned that this trend could be as detrimental to CRE credit quality as oversupply. First, weak underwriting has driven over supply in select products and markets. Second, easy credit drove artificial price inflation. When this bubble deflates, it could leave developers with little to no equity in their properties. This trend, in turn, might render it difficult to refinance these mortgages, particularly if debt service is also compromised.