Depending On What Congress Does Between Now and Aug. 2, Scenarios Range from Modest Slowdown in the Recovery to Dire Economic Consequences
With Washington facing a showdown in less than two months for reaching a deal on the government’s debt ceiling, many observers are weighing the potential impact on the commercial real estate recovery depending on various scenarios the Congress may pursue in dealing with this matter.
On May 16, the U.S. government smashed through the $14.29 trillion statutory limit that the government could borrow to finance obligations such as Medicare, Social Security, military salaries and interest on the national debt. The Treasury Department is using what Secretary Timothy Geithner called “extraordinary measures” to keep the government afloat until Aug. 2, at which point the nation will exhaust its borrowing authority and default on its debt obligations.
On April 18, Standard & Poor’s downgraded its outlook on U.S. debt from stable to negative, meaning that if fiscal deterioration is not reversed, the nation’s current stellar AAA rating will be downgraded. Soon after the House of Representatives last week rejected a measure to raise the ceiling, prolonging a budget standoff between Democrats and Republicans, Moody’s Investors Service also warned that the U.S. government’s top credit rating could be in jeopardy.
If there’s no progress on increasing the statutory debt limit in coming weeks, Moody’s expects to place the U.S.’s rating under review for possible downgrade due to the “very small but rising risk of a short-lived default,” the rating firm said.
Although Moody’s fully expected political wrangling prior to an increase in the statutory debt limit, the degree of entrenchment into conflicting positions has exceeded expectations, the firm said. “The heightened polarization over the debt limit has increased the odds of a short-lived default.”
“The real question commercial real estate should be asking is how large the budget cuts will need to be to get Republicans to buy into raising the debt ceiling, and what impact those budget cuts will have on GDP. Commercial real estate demand is correlated with GDP,” observed Chris Macke, senior real estate strategist for CoStar Group.
“If the government cuts spending, somebody has to make up the difference, or the economy will shrink. That means commercial real estate needs corporate America to increase its hiring and investment levels.”
A white paper addressing the topic issued by Cassidy Turley posited the potential CRE impact from three debt ceiling outcomes, ranging from the U.S. defaulting on its debt (deemed least likely) to raising the debt ceiling with drastic short- and long-term cuts to government spending (also not very likely) to the most likely scenario: The U.S. raises the debt ceiling and makes smaller short-term cuts combined with larger cuts and reforms to Social Security and Medicare/Medicaid in the long term.
“The safe bet is that Congress and the Administration will come to terms and raise the debt limit as they’ve done 70 times in the past 60 years,” said Cassidy Turley Chief Economist Kevin Thorpe, co-author of the white paper. “If it breaks that way, the economic recovery and by extension, the real estate recovery should continue.”
In fact, if lawmakers raise the debt limit and frame their decision in the right way, “it could send a signal that the federal government will be more fiscally responsible going forward. All of a sudden, all this uncertainty could be replaced by certainty and the market could actually take off,” Thorpe said.
The details on the larger cuts are likely to be worked out starting in the fall, with the short-term budget resolution enacted on April 15 resulting in $38.5 billion in cuts from 2010 levels, about a 1-2% reduction in total federal outlays. Longer term, the goal is to reduce the annual deficit from the current fiscal-year figure of nearly 11% of GDP to 2-3% by mid-decade, with further reductions following that.
Assuming a 2% short-term reduction, then the decline in government spending would shave off approximately 0.4 percentage points from real GDP growth in 2012, lowering Cassidy Turley’s forecasted growth rate for the U.S. economy of 4% in 2012 to 3.6%.
Granted, even modest cuts in federal spending will have a tangible impact on real estate, particularly markets closely tied to the federal government such as Washington, D.C., and markets in the Midwest and Southern California.
“It’s reasonable to assume that the days of massive federal hiring in D.C. are over; we’re already seeing signs of that,” Thorpe said. “But I see very little from the budget proposals of both sides that suggest significant cuts in the areas of information technology and cyber-security, regulatory oversight — many of the areas that drive demand for real estate in the greater D.C. region. But we don’t know the specifics yet.”
Moody’s said the nation’s credit rating would be maintained if the debt limit is raised and default avoided. However, the future rating outlook will depend on the results of deficit reduction talks.
What effect would it have on commercial real estate investment if debate drags on through most of the summer until near or close to the Aug. 2 drop deadline?
“Our assumption is that an agreement will be reached with modest near-term cuts to spending on a scale that will not significantly slow the economy or CRE recovery,” said CoStar Real Estate Strategist Kevin White. “If an agreement isn’t reached by early August, the Treasury will probably find other creative ways to push off default.”
Waiting until the 11th hour to raise the ceiling does inject a level of uncertainty into the marketplace, Thorpe acknowledges.
“For commercial real estate, this is a big deal. That’s two months from now and it does have people in wait-and-see mode in terms of investment decisions.
“You have to ask, where would CRE be today if the debt ceiling was already raised? I think the market would be in a stronger position.”
Under the worst-case scenario, most believe that a U.S. default on its debt would be devastating for the country, the economic recovery and commercial real estate. The Treasury Department would have no choice but to deeply slash spending, which would sharply reduce short-term economic growth. More importantly, a default could permanently damage the country’s credit and ability to borrow.
“It would wreak havoc on the property markets in the form of massive layoffs, surging interest rates, spiking vacancy across all product types including trophy assets — in other words, results much like those from the recent financial crisis, only worse,” Cassidy Turley said.
If Congress raises the ceiling but approves deep spending cuts such as the House’s aggressive proposal to cut nearly $6 trillion over the next decade while also cutting taxes, it could also deeply hurt the recovery, the Cassidy Turley white paper said. Under the House plan, total federal outlays would shrink by $89 billion in fiscal year 2012 compared to those in fiscal year 2011. Some analysts have estimated that the U.S. would create 900,000 fewer jobs in 2012 under the House plan.
Cassidy Turley emphasized that stronger up-front fiscal discipline has both short and long term benefits. Decreased spending would result in less bond issuance, causing investors to bid up the price of the existing bonds, likely pushing interest rates lower.
However, nearly 1 million fewer jobs would result in a “significant reduction in potential demand for [commercial real estate] space,” Cassidy Turley said. Net demand for office space would decrease by an estimated 38 million square feet in 2012, Cassidy Turley estimates.
“By our estimates, [the deep cuts scenario] would slow the vacancy and rent recovery for all CRE sectors by one year,” the white paper said.