streetwise by bob knakal nyc

Streetwise Blogs 2009

Published February 4, 2009 

When you listen to most New York politicians speaking about the current economic crisis the City is facing, you always hear a reference to the fact that, although spending and services need to be cut, conditions will not revert back to the way things were in the 1970’s.  I think there is one exception and that is that during the 1970’s the welfare system in New York was out of control. The expectation of entitlement was at an all-time high and if the package of bills endorsed by the Assembly gets adopted by the Senate, we could have a 1970’s level of entitlement expectation within our housing system. Forget about “Rent Control” or “Rent Stabilization”, given the pending legislation, why not just call it “Rent Welfare”.

It is not surprising to me that there is a groundswell of momentum to promote a more pro-tenant environment among elected officials. For most politicians, getting re-elected is their main goal and taking an anti-tenant position is political suicide. In private they will tell you that the system is overly protective of tenants but simply cannot take this position publicly. MIT and The Wharton School have completed studies demonstrating that the elimination of rent regulation would result in lower average rents citywide.

Some of the proposed changes include eliminating high rent vacancy decontrol, raising the bar on income decontrol from the current $2,000 to anywhere from $2,700 to $5,000 and the means test level of income from $175,000 to about $240,000 with an indexing provision, eliminating the present method of implementation of preferential rents, reducing the vacancy bonus from 20% to 10% and reducing the increment that can be added to the monthly rent resulting from renovations to an individual unit. Another potential change which would have a profound effect on the system is the proposed repeal of the Urstadt Law which would place oversight of rent regulation in the hands of the city as opposed to the state. This would likely result in the City Council, which is extraordinarily pro-tenant, taking over, which would probably vaporize the Rent Guidelines Board and determine rent increases themselves.

Owner advocates have said that, should the present bills become law, we could see a wave of foreclosures which would not be good for the landlords or the tenants and that fundamentally changing the rules in the middle of the game is not fair. While foreclosures may indeed increase, this will have a relatively short term impact on the housing stock. Sure, the services in the buildings are likely to decrease during the foreclosure process but, ultimately, the lender will resell the property at a lower market value, a new owner will take over and the property’s operation will get back on track.  

The longer term impact is that the proposed changes will lower property values thus eroding the real estate tax base, which is needed now, more than ever, to address record level budget deficits. The incentive to upgrade apartments would be greatly diminished causing what is already an aging housing stock to rapidly deteriorate. Vacancy decontrol created tremendous incentive for owners to invest heavily in improving the quality of the housing stock.

There is a great need for affordable housing in New York but for the public sector to ask the private sector to provide it in this fashion is not the solution. Incentives for the creation of new affordable housing units is an easy fix but is politically unpopular. Giving tenants effective ownership of their buildings through a far reaching entitlement program is not a good thing for the city. Let’s hope, in this way, we do not return to the 1970’s.

Published February 11, 2009

Perhaps the most difficult property type to determine value for today is vacant land or low rise properties which one would think have the highest and best use as a development site. The difficulty stems from a lack of transactions upon which to form an opinion.

Does land have value today? Sure, it does, but calculating that value is not an easy task.  Interestingly, during the most challenging years in the recession of the early 1990’s, land actually had no value. Zero. Nada! During most of 1990 and 1991, there were development sites, which had been foreclosed on by banks, which were on the market for $20 per buildable square foot and there were no takers. This was shortly after the development market hit a peak in 1987 through 1989 when the best sites in Manhattan (Metropolitan Tower, Cityspire, and the Blockfront on Second Avenue between 64th and 65th Street) hit a record of $125 per buildable square foot. Massey Knakal sold a site, which I believe was one of the first development sites coming out of that zero-land-value period, at 408 East 79th Street to RFR Holdings for about $30 per buildable square foot. I vividly remember the seller being thrilled to have achieved such a high price.

Today, land has value but the disconnect between buyers and sellers is significant. During this past cycle, land values routinely hit $400 or $500 per buildable square foot. The most prime sites reached approximately $700 and The Drake hotel site at 56th and Park achieved a price in excess of $1,000.

Since the peak of this most recent cycle and as the economy has deteriorated, the availability of financing for development projects has all but evaporated. Accessing debt for hotel or office construction is very challenging today and the properties with the best chance of obtaining financing are residential rental developments. We are working with several developers who are looking to purchase sites for residential rental construction, however, the common opinion is that in order to make a residential rental project work, a price of $150 to $200 is the maximum that can be paid for the land. Given that sellers could have obtained two or three times this amount 18 months ago, they are not presently willing to “hit the bid”.

Many developers who are interested in taking advantage of current market conditions are waiting on the sidelines for the failed projects of novice developers to hit the market via lenders who will likely take back many of these properties.

One thing to keep in mind is that there are always exceptions to the rule.  A hospital recently purchased a site at 1133 York Avenue for just under $300 per buildable square foot and they will probably sit on this site for a while before ultimately building a new facility for their own use. Users will always have needs and sites that are extraordinarily well located or have some strategic values are likely to achieve premium pricing.

This segment of the market is where I see the most opportunity today as not only do you need capital to take advantage of the opportunities but you need development expertise as well. As transactions start to occur, the question of what land value is will be much easier to answer.

Published February 18, 2009

I was reading a weekly publication today and I saw the results of a poll asking if respondents considered our present economy a “depression”. Surprisingly, nearly two-thirds of New Yorkers feel that we are either definitely in a depression or maybe in a depression very soon. And it is no wonder that people feel this way as many of the politicians we have listened to lately (from the very top on down) have been using language which is nothing short of fearmongering. Phrases such as, “an economic abyss from which we may never recover”, “catastrophic economic conditions”, “a coming economic apocalypse”, “a complete economic meltdown” and “without this stimulus package, another depression will befall us”.  Of course, the game of politics operates this way and swaying congressional votes is assisted with such grand statements.

What these politicians seem not to realize is that this rhetoric is, in fact, harmful to consumer confidence and consumer spending.  People are starting to believe these proclamations as evidenced by the referenced poll. These statements may make for good political theatre, but they do not accurately reflect the current state of our economy.

Please do not misinterpret my intentions here.  I know that times are difficult, the economy is hurting and to those who have lost jobs or are suffering financial hardship, they really don’t care how the economy is characterized, they only care about paying this month’s bills. My heart goes out to them, and I am not making light of their circumstances. The fact is, however, that today the state of our economy is much more similar to the recessionary period of the early 1980’s than it is to the Great Depression in the 1930’s. Let’s compare these points in time.

Because there is not much real estate information available from the Depression period (other than knowing that the construction boom of the roaring 20’s came to a screeching halt), let’s take a look at employment, which is the metric that has the most profound effect on real estate fundamentals. Extrapolations can be made from there. In 2008, the US lost 3.4 million jobs which represents 2.2% of the labor force. From November of 1981 to October of 1982, 2.4 million jobs were lost but because the labor force was smaller, this reduction also equaled 2.2%. During the Great Depression, job losses were of a completely different magnitude. In 1930, the labor force shed 4.8%, in 1931 6.5% and in 1932 another 7.1%!  The overall unemployment rate today is 7.6%. At the peak in 1982 the rate reached 10.8% and in 1932 the rate was 25.2%. (Using the same formula to calculate the rate that was used in the prior periods, today’s rate would be 13.9%.)

If we look at GDP, in 2008 total GDP rose notwithstanding an abysmal 4th quarter which showed a 3.8% reduction in output (look for this figure to be revised downward). The Congressional Budget Office projects a decline of 2% for 2009 while several economists are projecting reductions of 3% to 4%. In 1982 GDP contracted by 1.9%. Compare these figures to 1930, 1931 and 1932 when the contractions in output were successively 9%, 8% and 13%.

During the Depression, 10,000 banks failed. Thus far in this cycle, approximately 35 have failed with another 200 on the FDIC watch list. In 2008, the Dow Jones lost 36% of its value while in the early 1930’s the crash reduced equity values by 90%. Auto production declined by about 25% last year while in 1932 the reduction was 90%. The Depression lasted 11 years while this recession has been with us for only 14 months thus far.

So yes, things are tough today, very tough. Unemployment will continue to rise, and more pain will be experienced. But a comparison of the two eras leads us to the conclusion that we are not in a depression……yet!

Published February 25, 2009

Owning a brokerage business puts me in a position of wanting to encourage and inspire my troops, particularly in times like these when adversity is around every corner. We are all bombarded with negative news from every direction these days. Even speeches at industry events can leave you more depressed and wondering when the heck things might start getting better. So today, I thought I would share with you my closing remarks from a speech I gave last night at the Community Bankers Mortgage Forum in Westbury, Long Island. The audience consisted mainly of bankers, appraisers and brokers. After discussing the economy, politics and the current state of the investment sales market in New York City, here is my wrap up:

“I believe there has never been a better time to be alive in human history. Today, we have MORE opportunities, to accomplish MORE things, in MORE different ways, utilizing MORE tools than ever existed before.

One of the great rules of success states that, ‘It doesn’t matter where you are coming from – all that really matters is where you are going.’

You can make your future bright IF:

IF you resolve to make this coming year the best year of your life

IF you resolve to draw a line under your past and focus on your future

IF you resolve to set goals

IF you resolve to make plans

IF you resolve to take actions, and

IF you resolve to achieve more this year than you ever thought possible.

Remember that the very best days, weeks, months and years of your life lie ahead. Your greatest achievements are still to come.

Shakespeare once said, ‘The past is merely a prelude’.

You need to be able to see what things will look like in a year. You need to have vision. Throughout all of history, the most successful men and women have had this quality of vision…….

They can see their future well in advance of it becoming reality. They can see the steps which are necessary to take to get there. And they can visualize the results.

How can you make success happen? You need to set goals and to make those goals multi-dimensional. This will enable you to balance every part of your life. Set goals for, not only your career but for your health, finances, relationships, personal and professional development, community service, and spiritual growth.

Nothing happens by accident. It is often said that everything happens for a reason. YOU are that reason. YOU are the primary creative source in your life. Dare to be the person you always wanted to be. You can do it!

If you can come out of this crazy market in great shape you will have earned a badge of honor you can wear proudly on your lapel, gaining the respect and admiration of your peers. It is all within your control. Go get ’em!”

Published March 3, 2009

Opportunistic buyers call me every day looking for “good deals” on “distressed assets”. I have not had much to send them recently. Thus far, we have not seen tremendous buying opportunities with enticing cap rates because of the distress in the market. Why are these opportunities not presenting themselves?

In order to answer that question, let’s take a look at some history. In the early 1990’s, the S & L crisis created buying opportunities but only after banks had gone through a long foreclosure process. The Dow crashed in October of 1987, but the effects were not felt in the real estate market until 1990 when the number of sales started to shrink, and prices finally started to drop and drop they did. As an example, multifamily properties that we sold in 1988 for 14 times the rent for co-op conversion (condos were very rare in NYC at that time) were being sold for 4 times the rent in 1992 and 1993.  As prices started to fall in 1990 and 1991, defaults began, and the foreclosure process was initiated by lenders.

This foreclosure process took 12 to 18 months. While the wave started in 1990, properties did not start to hit the market until 1992. Most of these foreclosures came to the market in 1993 and 1994.  There were real opportunities available for cents on the dollar. The reason why these opportunities were so good was that few people had equity, of any substance, that they were willing to invest.

We are once again in troubled times. Thus far, the properties in financial trouble are still working their way through the pipeline and have not found their way to market in substantial numbers. Lenders are still going through the process of determining whether they will sell their notes or go through the foreclosure process. The insatiable need that lenders have for cash today is likely to lead them to sell notes to get cash today rather than go through a foreclosure process, which would delay the cash injection which is so desperately needed. 

So, where are we in this cycle of processing these troubled properties? I believe we are at the beginning of the process. We determine turnover, or volume of sales, as the number of properties sold out of the total stock of existing properties. In New York City, we track 125,000 multifamily and mixed-use properties which have had a turnover rate which has been averaging 2.5% annually of that total stock, over the past 20 years. This volume hit an all-time low of 1.6% in 1992 and again in 2003. We believed that this 1.6% level of turnover represented a baseline of turnover consisting of only those sellers who had to sell without discretion. They sold for reasons including death, divorce, taxes, insolvency, partnership disputes, foreclosure, etc. Both of these years ended in recessions and experienced peaks in cyclical unemployment. In 2008, this volume of sales hit 1.9%, which was down about 40% from the 3.0% experienced in 2007.

We are projecting a turnover rate of 1.6%, or less, in 2009 as discretionary sellers are not yet capitulating to current market conditions and sellers who will be forced to sell, are still going through the process of determining how they will be going to market and what they will be going to market with, notes or real estate. We expect unemployment to hit its peak in 2009 or 2010, which is when we should see turnover hit its cyclical low point.

We are currently faced with constrained supply, and we do not expect this supply to increase, in any meaningful way, until later in 2009 which will result in sales in 2010.

Opportunistic buys are in the marketplace now but only sporadically. Could we hit a volume of sales lower than the all-time low of 1.6% in 2009? Sure, we could. We expect a trough in 2009 with volume picking up in 2010. 

A key difference today, as opposed to the early 1990’s, is that there is plenty of equity on the sidelines waiting for opportunities to present themselves. They are starting to appear and will continue to over the next few years as deleveraging progresses.

Published March 10, 2009

There has been virtually no new issuance of CMBS since the summer of last year. The result has been a reduction in the number of investment sales in New York with prices over $100 million of 85% in 2008 versus 2007. Thus far in 2009, there have been only 2 transactions which have exceeded $100 million. Securitizations are used for smaller loans as well, however, the majority of this sector consists of larger loans.

Various reports have indicated approximately $180 billion to as much as $400 billion of commercial real estate financing maturing in 2009. Most of this financing is CMBS and a significant percentage is collateralized by assets located in New York. The market does not have the ability to refinance this magnitude of capital without access to the public markets. Even performing low LTV (even using today’s adjusted values) loans with strong sponsorship will find refinancing challenging if the aggregate amount of dollars needed is too large. It is, therefore, critical to get the CMBS market operating again, in one form or another.

The government is trying to stimulate all credit markets including the CMBS market. The TARP includes TALF 1.0 which is geared towards supporting asset backed securities collateralized by credit card debt, student loans and auto loans. It also has an allocation to purchase newly originated AAA tranches of  CMBS. TALF 2.0, which was born out of the “Geithner Plan”, has an interesting component which will attempt to create a pool of buyers of legacy CMBS as well as other toxic assets. Created via the formation of public/private partnerships, this pool of buyers will consist of competitive bidders for these assets. Leverage will be available at a ratio of as much as 10 to 1. The balance sheets of financial firms could be significantly enhanced based upon the extent to which this process is successful.  

How did the CMBS market deteriorate?   Similar to the mechanism which caused problems with RMBS, no one had any skin in the game……. until the end of the process. Along the way, fees were made and exposure was passed on to the next one in line. Loans were originated and sold to the secondary market. Pools of loans were securitized and divided into traunches. Rating agencies gave their blessing and when the securities went bad, the investors who purchased them were left holding the bag.

The question is, What will convince investors to purchase these securities in the future? Perhaps something like this could help:

The originator of the loan should be required to keep a first loss position of let’s say 20% on their balance sheet and could then sell 80% of the loan to the secondary market. The lender would then be compelled to make prudent decisions about what loans they are making because they will have skin in the game. The secondary market securitizer should have to keep a second loss position of let’s say 10%, which would make them scrutinize the collateral, layering in another slice of due diligence. The securitizer could then sell the balance of the securities to institutional investors. With a 30% loss position in front of the investors, a rating agency would no longer be necessary to give comfort to the investors. The percentages of loss positions could vary greatly, but the concept is to have market participants put their money where their mouth is rather than merely processing a financial instrument for a fee and then passing all the risk on to someone else.

The market desperately needs access to massive amounts of capital and a fix to the CMBS market would be a start.

Published March 17, 2009

I am asked this question several times every day.  The true answer is that I do not know, and no one knows. We are in unprecedented times.

There are so many factors to look at to try to figure out when this market will start to correct but nothing that has happened, thus far, has indicated that we are headed for clear skies in the short term.  There are several things we need to see and several hurdles we need to overcome before we can say that we are headed for recovery.

There is no doubt that many people will be financially disadvantaged and billions will be lost only to provide others with the opportunity to make fortunes. We saw this during the early 1990s and today the circumstances are much more acute.

Last week the stock market rallied leaving some pundits proclaiming that we are at the bottom and the recovery has begun.  I do not think so and I will try to explain why.

We have said for many quarters that in order to believe that a recovery has begun, we need to track three indicators: 1) a couple of quarters where banks are not compelled to raise capital, 2) leveraged loan spread regulating and 3) credit default swap premiums attaining stabilized levels. Let’s look at each of these indicators.

Bank capital is stressed. Banks currently have more cash than they have ever had but distortions caused by mark-to-market accounting rules have forced banks to write down assets to levels where bank capital levels are marginal. Due to reserve requirements, while banks have huge levels of cash, they are not lending as much as they could because of their capital ratios. Mark-to-market accounting is stifling the appetite for banks to originate new loans.

Leveraged loan spreads are at all-time highs. These spreads indicated the willingness of banks to make loans. Based upon these spreads, it would appear that banks are less eager to lend than they should be. Several banks publicly state that they are lending and lending more than last year, but who is seeing this liquidity in the market? We could also include TED spreads in this category. This is the spread on bank loans to other banks which has historically been 5 to 10 basis points. In September, this spread hit 470! Today it is around 100.

Lastly, let’s look at credit default swaps. They are indicative of the perception peers have of the credit worthiness of other companies. The premiums that these swaps have been trading at are indicative of a general skepticism that exists in the equity market today.

Notwithstanding Citigroup and Bank of America recently announcing that they do not require any additional cash injections from the government, banks still need to raise cash and capital. Leveraged loan spreads are still bloated and credit default swap premiums are still far too high. Based upon all of this, the recent bear market rally does not seem to be indicative of  a bottom in the market.

We believe that the housing market needs to bottom out before the economy can bottom.  Can housing bottom before unemployment peaks? Many economists do not think so. Neither do I.

Optimistic economists believe the economy will bottom out in the third quarter of 2009 and the pessimists are projecting a bottom in the second quarter of 2010. Unemployment is a lagging indicator and will, likely, not peak until 3 or 4 months after the economy bottoms. If we assume that the optimists are correct, we should have unemployment peak in the first or second quarter of 2010. This is when the housing market will probably bottom, and the big 3 indicators (mentioned above) will start to regulate. This is also the point at which we should start to see improvement in the fundamentals within the commercial real estate market.

Based upon all of the data available today, it would seem that we are looking at about a year before the correction begins. I certainly hope it happens sooner.

Published March 25, 2009

Treasury Secretary, Timothy Geithner, rolled out some of the details of what insiders are referring to as TALF 2.0.  This program has two components, the Legacy Loan Program and the Legacy Securities Program. These programs are expected to help the commercial real estate industry based upon the premise that loans and securities collateralized by real estate are fundamentally undervalued due to a liquidity discount as opposed to drastically reduced cash flow expectation.

The public/private partnership investment program will create a pool of buyers for a market in which there are currently no buyers. For the securities program, the Treasury will oversee the auction process and for the loan program the FDIC will provide the oversight. Buyers will partner 50%/50% with the FDIC or the Treasury and that partnership will borrow money from the government to create purchasing power of up to $1 trillion in the first phase of this program (I am calling it the first phase because there will undoubtedly be additional capital required to address the massive amount of toxic assets on the balance sheets of institutions). The newly formed entity will borrow on a non-recourse basis and the private sector component of the partnership has losses limited to their initial investment. The substantial incentives and debt guarantees provided by taxpayers to private asset managers should be enough to drive prices to levels satisfactory to sellers.

The questions, however, are several and the primary question of whether the credit supply resumes depend on the true health of banks. Some of the questions revolve around the appetite hedge funds and private equity investors will have for a program controlled by a government that is prone to changing the rules midstream. The recent furor in Congress over executive compensation has been frightening and with the way the White House has tongue lashed Wall Street at every turn, will the Street want to help? Sure, they will. Why? Because it is a tremendous money making opportunity and billions will be made by those who can maneuver through the system. Another question is whether this can be accomplished without unduly wasting taxpayer money.

Other questions revolve around whether banks will decide to sell their assets through this program. To what level have the assets been written down? What is the expected sale price via the auction? Can the bank set a reserve? How will these assets be valued? Many of these questions have not been answered yet.

To the extent participants do indeed participate, the result will likely be an easing of credit as the capital ratios at banks should be greatly enhanced by these programs. Banks have more cash than they have ever had but capital levels are stressed due to the mark-to-market accounting rules which force banks to mark assets to “market”. But the fact is, when there is no market, you are only guessing at what market is. A few forced transactions do not make a market.

An enormous issue for the commercial real estate market which these programs do not directly address is the status of CMBS loans and how a borrower can deal with maturing loans in a market where there is no replacement financing available and, moreover, there is no one to speak to at “the lender”. A borrower with a performing loan, who is making their monthly payment, which is approaching maturity, will be in technical default if they cannot refinance. Today, it is unlikely they will be able to and the effects of TALF 2.0 will probably not be tangible enough in the short term to address the massive refinancing needs commercial real estate is facing in 2009. A solution to this dynamic is needed quickly as the first performing loan to be held in technical default because of maturity could be the first of many dominos to fall.

Published April 1, 2009

The commercial real estate market needs money. We need investment dollars to pour into the market. Should we encourage foreign investment? Do we really care where the cash comes from? As Jerry McGuire’s client said, “Show me the money”! FIRPTA creates a speed bump for foreign capital. It may be time for a change.

The Foreign Investment in Real Property Tax Act (FIRPTA) is a statute that requires that a seller, who is a foreign person, permit a withholding of a part of the selling price (generally 10%) against the United States gains taxes that the foreign person will owe on capital gains earned on the sale of real property.

A foreign person, for federal income tax purposes, is generally any person who is not either a resident alien or a United States citizen.  If an owner of real property is an entity formed outside of the United States, it is also deemed a “foreign person” under the IRS code.

The FIRPTA law creates a tremendous disincentive for foreign entities to invest in domestic real estate.  This primary obstacle facing non US investors who invest in US real property – the FIRPTA – should be repealed. The law has profound implications for non US investors in US real estate. FIRPTA’s discriminatory application (aimed solely at real estate) coupled with onerous reporting requirements impedes foreign investment in US real property, which in turn, has negative effects on the vitality of the US economy.

FIRPTA was enacted in 1980.  A senator from Michigan was concerned about farmland and wanted to protect “the American heartland” from foreign interests. The world has changed, but FIRPTA has not. Many of the rules that were written in the 1980s look outdated and unsuited to modern investment practices because they were written with a particular paradigm in mind, that being a single foreign investor or a small group of foreign investors acquiring US real property.

Today, investments in US real property are being made in many different forms. They include REITs owned in part by foreign persons, private equity partnerships, and collective investment funds organized outside the US, making ultimate ownership difficult to determine.  

The United States generally has no jurisdiction to tax foreign persons on capital gains that are sourced within the US, unless those gains are “effectively connected with a US trade or business”.  The US taxation of international investors is governed by either the Internal Revenue Code or income tax treaties that the US has signed with other nations.

Non US investors in US real property are subject to fundamentally different US federal income tax rules than those that apply to their investments in US corporations or other capital assets.  Most notably, a foreign person’s gains attributable to the disposition of capital assets other than US real property interests are not subject to US tax. FIRPTA discriminates against the asset class of real property.

Credit availability in our market today is scarce, creating a greater need for equity. Foreign investors and entities are a tremendous potential source of this greatly needed equity. Unfortunately, many foreign sources of equity investment have expressed little desire to make investments in US real estate when future gains will be taxed at marginal rates ranging from 35 to 50 percent, according to The Real Estate Roundtable.  These sources of potential investment are looking for positions as lenders with contingent interest debt instruments to minimize their incidence of taxation in the United States.  Property owners are reluctant to offer senior positions in the capital stack that could effectively diminish future upside in their investments.

The US tax system should not be a barrier in the competition for institutional investment in real estate.  As emerging economies grow, destinations for international institutional capital will grow and the US has to be competitive in this global market.

The US real estate market has benefitted immensely from having an open economy that allows for the free flow of capital and goods with foreign trade partners.  The continuation of policies such as FIRPTA will have negative effects on both real estate markets and the US economy. Foreign investors should be allowed to invest in US real property without any more disclosure other than that required of a US investor.  Similarly, tax law affecting foreign investment in US real property should not be any more burdensome to foreign investors in the US than those that apply to US investors.

Our market needs capital and if the foreign market wants to provide that capital, we should encourage that investment.

Published April 8, 2009

Yes, I know that I am a commercial investment property sales broker, so why do I track the national housing market so closely? The answer is that this market has the most profound impact on our financial system, which affects our capital availability, which in turn affects our commercial real estate markets. Let’s look into this dynamic.

The most recent housing bubble that we experienced has upended our financial system. History helps us to understand where we are today. Since 1970, there have been two other major housing bubbles, with peaks in 1979 and 1989.

The most recent bubble started in 1997, ignited by rising household income which began in 1992 in concert with the 1997 elimination of taxes on residential capital gains up to $500,000. Investors are attracted to markets with rising values and the early stages of this cycle had this usual, self-reinforcing feature.

The collapse, which created the recession beginning in 2001, could have ended the bubble but unusually expansionary monetary policy was implemented by the Fed to counteract the downturn. As the Fed increased liquidity, money naturally flowed into housing, which was the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding the homeownership rate. They encouraged Fannie Mae and Freddie Mac to purchase just about any mortgage in sight and lender’s credit standards eroded.

Lenders and the investment banks that securitized the mortgages used ever increasing housing prices to justify loans to buyers with limited income and assets. Rating agencies accepted the supposition of ever increasing house prices and issued investment grade ratings which lured buyers for these securities from around the globe. Mortgage loan originations increased an average of 56% per year for three years – from $1.05 trillion in 2000 to almost $4 trillion in 2003! This trend continued.

Home prices started to decline in late 2006. The latest Case-Schiller index, which tracks housing prices in 20 major metropolitan areas, fell by 19% for the three months ending January 31, 2009. This is a new record low for this index. Many of the buyers of houses in this bubble had far less than 19% equity in their homes, some with 3.5% or less. According to First American CoreLogic, 10.5 million households had negative or near negative equity in December of 2008.

The result of all of this was: Bear Sterns, Merrill, Lehman, AIG, Fannie, Freddie, IndyMac, Countrywide and the dozens of other bank failures and general distress in our financial system. Government intervention we are seeing at every turn. The FDIC has asked for and received access to an additional $500 billion in government funds in anticipation of future needs.

Not many people are talking about it but rising mortgage defaults could force the FHA to seek a taxpayer bailout for the first time in its 75 year history. The Obama administration will have to decide whether to ask Congress for taxpayer money or raise the premium it charges to borrowers. Roughly 7.5% of FHA loans were seriously delinquent at the end of February, up from 6.2% a year earlier. The FHA’s reserve fund fell to about 3% of its mortgage portfolio in the 2008 fiscal year down from 6.4% the prior year. By law it must remain above 2%. A strong FHA is essential for a recovery in housing.

We have seen reports recently that the housing market has bottomed out. It is difficult to believe this is the case as we are not close to seeing unemployment peak, which will be critical for housing to bottom.

The lack of equity in homes has greatly affected consumer confidence and consumer spending, both of which affect corporate earnings which effects demand for office space, retail space and apartments. As housing prices stabilize and begin to rise, the wealth effect will be tangible, and the downward spiral will reverse. Housing got us into this mess and housing must pull us out of it. Let’s hope it is sooner rather than later.

Published April 21, 2009

For those of you who are golfers, you will appreciate the following tale.

I was playing my first round of the year this past weekend and thought I was having one of the best rounds of my life. I warmed up on the range for an hour before I teed off and spent another thirty minutes on the practice putting green. I approached the first tee and launched a drive 275 yards right down the middle of the fairway. My approach shot landed 5 feet from the pin. I walked up the fairway looking around at the trees and the blue sky and feeling like “Wow, this is great”. I stepped up to the ball and confidently sank my 5-footer for a birdie on #1.

The round continued, in pretty much the same way, for the rest of the afternoon and, after 15 holes, I was even par. Boy, I felt great. A beautiful day, a fantastic round, life was good. Then, on the 16th tee, I was approached by the Starter, who is the policeman of the course. It was not Harry, the usual Starter on Saturdays, but some guy with “DC” on his golf hat. As he approached, he said, “Hi, I’m from Washington and I’m here to help”.

I was perplexed by his approach and even more so by what DC started to tell me.

He said that, although I may have thought I knew what the rules were, they had been changed. It did not matter that DC was actually involved in writing the original rules and voting on the rules to make them valid. The rules were now changed. “How could the rules change in the middle of my game?” I asked. He said, “I am DC, and I can do anything I want”.

DC went on to tell me that under the new rules, (which were formulated because I was having such a good round) each time I hit my tee shot in the fairway, I was penalized one stroke. Each time I put my approach shot on the green, I was penalized one stroke and each time I sank a putt on the first try, I was penalized two strokes. If I hit the ball into the water or into a bunker or off the roof of the clubhouse, I could deduct one stroke from my score. After the recalculation of my score, it turns out that my scratch game (even par) equated to a score of +38. Moreover, my score is to be posted on a nationally advertised website, national tv advertisements and multiple print ads in national publications. Additionally, politicians go on tv and revel in saying how badly I played even though I did not know the new rules they created after the fact.

People who think my score stinks, blog about how much I suck, harass my kids at school and a bus load of crazy people show up at my house in the suburbs with hurtful signs and chant profanity at my family. Would you like this to happen to you?

This is what the government has done to AIG employees. The government passes legislation which provides for “bonuses” to be paid to employees. After these knuckleheads read the legislation they passed, (why read the stuff you actually vote on?) they decided they were wrong and wanted to tax these same bonuses they approved to be taxed at 90%. And if you took TARP money, the government now, after you took the funds with “no strings attached”, decides that you can’t pay employees what they are worth. Who cares that these rules will eliminate the possibility that you can pay back the $173 Billion you received from the government, we don’t want you to give out 1% of that to keep the very people that will enable us to pay that money back. How can you trust this government?

The real estate industry has been hopeful that the TALF and its PPIP would stimulate the secondary market for CMBS and, therefore, make the availability of credit more abundant. TALF 1.0 was supposed to create $250 billion of transactions in the asset backed security market. The first auction raised $4.7 billion. The second raised $1.6 billion. Hardly a success. Why?

Who can trust the government to not change the rules in the middle of the game? I have many clients considering participating in the PPIP but they ALL feel like they would be taking a big risk that the government will screw them if they end up making large profits. Will the president vilify those making big buck, will the House tax these profits at 90%, will people in busses show up at the homes of the employees of the companies profiting from this program? Who wants to deal with this?

The TALF and the PPIP will not hurt our commercial real estate market. The question is, Will they help our market? The jury is still out on this. If the government can’t make rules and stick to them, the programs will surely fail. Investors will not play a game in which the rules might change after a commitment is made.

Our market participants need to get credit for a birdie. Don’t change the rules after people have put their faith into the program.  If no one plays, no one wins….

Published April 29, 2009

The government has seized the opportunity of not letting a good crisis go to waste.

They have forced banks to take TARP money, against their will in some cases, and when those banks want to pay it back, they are discouraged from doing so. Why? The government wants to control the banking industry and dictate what bankers can earn. You know that the TARP money “lent” to the auto industry will likely be converted to common equity in order to provide additional control. Even without common equity they had enough influence to fire the chairman of GM.  Money is being printed and spent at unprecedented levels because we are told that, “The world will end if we don’t do this”.

All of this spending could balloon the deficit to the point where our interest payments could approach $500 billion per year. That would be just the interest and that is more than any deficit we have ever had.

For more than 50 years, democratic capitalism constructed its modern framework against the backdrop of its death match with totalitarian communism. In the last 20 years, the American model of capitalism was largely unchallenged by ideological alternatives and became increasingly dominant around the world. It drifted toward what conservatives viewed as a purer form of economic liberty and what liberals came to view as misguided free-market fundamentalism.

Today, we hear a lot of ideas coming out of Washington regarding the need to diminish the consumerism that has been the backbone of economic growth in the United States. They say we should move away from consumerism and reorient towards saving and investing. They say wealth should be redistributed and we should make the rest of the world less dependent on the US market for their prosperity.

They argue that an activist government is an acceptable and necessary partner for a stable, market based economy. Smart political advisors describe philosophy in terms of pragmatism rather than ideology.

Transparently, the government is trying to have much easier access to manipulating the private market economy. This philosophy and approach are not limited to the federal government as state and local governments have been following suit.

In New York, our multi-family housing market is subject to a rent regulation system which is advantageous for tenants at the expense of the property owner.  Rent controlled and rent stabilized housing is misallocated, as financial need is not part of the equation. The laws provide maximum benefits to those who have been in place for a long time regardless of their financial status and need. This results in a system that makes tenants resistant to moving which constrains the supply of available units and puts upward pressure on the average rent a New Yorker pays.

Recently, the New York State Assembly passed a package of bills to strengthen the laws to an even greater extent in the tenants’ favor. Even before the present package was passed, over the long term, allowable rent increases did not keep pace with the increases in operating expenses. If the Senate passes these bills in June, making ends meet will be even more difficult for owners. (go to and check the “Reel” for a commentary piece I wrote on April 20th which goes into greater detail about the potential impact of the pending bills).

Moreover, this past week, Housing Preservation and Development Commissioner, Rafael Cestero, announced that he is concerned about how much debt property owners place on their properties. He claims he has spoken to officials in Washington “to discuss how to make sure future property sales are sound” and that they are “looking at ways in which we could potentially work with the federal government to bring resources to bear that will help us ensure that ownership – when it needs to be transferred – is transferred to responsible owners.”

Is “property ownership” becoming an oxymoron?

If Jane owns a 50-unit property and wants to sell it to Joe, will Jane have to get approval from the government to sell the property? Will it be rubber stamped if the price is low enough? Will the sale be disallowed if the price is too high or if the amount of the mortgage exceeds some limit? What will Joe have to do to prove that he is “responsible”?

The argument is that the quality of life for the tenants is jeopardized if debt service eats up too much cash flow to allow the owner to make improvements. Oddly enough, most of the owners on the “slumlords” list published each year are long time owners with little or no debt on their properties. Additionally, more capital improvement money is poured into properties in the first two years of new ownership than at any other time.

George Orwell would love our Bizarro world……Remember, Big Brother is watching!

Published May 13, 2009

There was a point in time when I was applauding the Governor for his position on the state budget. Very early on, he was beating the drum of favoring reductions in government spending as the way to solve the state budget deficit. He gave speeches and lobbied for spending cuts. At the end of the day, this position was abandoned and 80% of the pending budget deficit of approximately $17.7 billion will be bridged by 137 new taxes, fees and charges that New Yorkers did not have to pay before.

Recently, the New York State Legislature passed a$131.8 billion budget, an increase of 10.1% or $12.1 billion over last year. State officials have maintained that the growth in spending is the result of spending the Federal economic stimulus funds. Unfortunately for state officials, we were paying attention in first grade and know how to count. Excluding the federal stimulus funds, state spending increased by 4.7% or $5.9 billion. This increase is greater than the rate of inflation by a long shot and is much greater than the increases in budgets of most businesses around the state.

New Yorkers will have to pay more taxes than before as local politicians would not allow NY to take second place to any other state in terms of the taxes that we pay. For a short period of time, we were no longer the highest taxed state in the country, but that lasted for only a nano-second. New taxes, fees and stimulus funds from the government account for almost 80% of the deficit gap. Genuine spending cuts represent only 20% of the deficit reduction.

New York state’s economy will be much worse off due to this increase in spending.  Businesses and families are getting by via cutting costs and doing more with less, but the State cannot seem to get it. This stimulus money will not come every year and the tough decisions have simply been put off. This budget does not address the structural problems in the state’s finances that will surely re-emerge when the stimulus funds cease. And how long can these personal income tax increases stay with us until New Yorkers head for New Jersey or Connecticut?

The new taxes which will help to bridge the budget gap are estimated at $4.1 billion consisting of income taxes on taxpayers with incomes above $200,000 (the same group the City Council believes is in need of rent welfare) including sub-S Corps, LLCs and partnerships. New York state residents earning over $200,000 will see a state tax increase of 12.7% and those earning more than $500,000 will pay 23.6% more. These tax increases are scheduled to expire in three years. Do you really think they will?

Running a municipality is just like running a business. You have revenue and expenses. When revenue is down, you have to adjust expenses. Why don’t any of our elected officials understand this? The federal government has been berating anyone who makes a decent living, many of whom are New Yorkers working on Wall Street. Additionally, the state has decided that TV commercials criticizing potential budget cuts are like pouring salt on a slug and they can’t bear to see them, so they wilt and continue to spend when there is no money to spend. Is there a backbone out there somewhere? High school biology taught us that vertebrates are supposed to be more evolved than amoebas which seem to be calling the shots when it comes to balancing our budget.

What are the implications for our real estate market? The added taxes will translate into reduced consumer spending which will hurt retailers. Expect downward pressure on retail rents and increased vacancies. While decision makers do not believe so, look for people to leave the City for lower cost alternatives. This dynamic has begun which will add negative pressure to home prices and add downward pressure to residential rents. Lastly, with so many of these taxes aimed at business, look for businesses to also consider lower cost alternatives which will add downward pressure to office rents with increased vacancies. In order to make ends meet, these businesses will have to continue reducing payroll, adding to an already high unemployment rate.

This year was a great opportunity to make fundamental changes in our financial structure and that opportunity has been missed.

Published May 19, 2009

I’ve been selling investment properties in New York City for 25 years and have never seen anything like the low level of sales that the market experienced in the first quarter of 2009.

In order to know just how abysmal the volume of sales has been, let’s review a little history. In order to study volume of sales we tracked a sample of 125,000 properties which fall into the C, D, S & K classes of properties which include multifamily apartment buildings, retail and mixed-use properties. During the last 25 years, the average volume of sales has been 2.5% of this total stock of properties or about 3,125 sales per year. The best years we have seen were 1986 and 2006 with 3.4% turnover, 1988 with 3.5% and a pinnacle in 1998 at 3.9%.

On the other side of the coin, we experienced the lowest level of turnover in both 1992 and 2003, which were both years at the end of recessionary periods and were years in which we reached cyclical highs in New York City unemployment. The volume of sales in those years was 1.6%. We had always thought that this 1.6% level of turnover was a baseline representing only those sellers who had no choice but to sell due to reasons such as death, divorce, taxes, insolvency, partnership disputes and the like. Our assumption was that volume would never get lower than the 1.6% threshold. Enter 2009.

If we annualize the turnover of the market experience in the first quarter of 2009, in which there were only 233 sales closed, the volume of sales would be only 0.7%!

We certainly do not expect this trend to continue to an annual level of 0.7% but it is very likely that we may not see enough activity to hit the 1.6% level.  We believe that this extraordinarily low level of sales was created by the virtual paralysis that the market experienced after the fundamental dismantling of Wall Street on September 15th. Contract executions evaporated in the fourth quarter of 2008 as investors became timid and credit markets froze which resulted in the endemic number of closings in 1Q09.

We believe the volume of sales will increase as the year progresses as it simply could not get any lower. A factor which will artificially add to the low volume will be the fact that many lenders will opt to sell notes rather than going through the foreclosure process and then selling the assets. If the lender wants to maximize their note sale proceeds, they will sell the notes to real estate investors who will want to own the assets on a long term basis.  Many properties which were financed in the 2005-2007 period have negative equity to an extent that it is highly unlikely that the borrower will be able to pay off the loan or would even want to. This will result in the buyer of the note foreclosing and holding the asset. This “shadow” sale market will not be reflected accurately in the 2009 numbers.

While all of the percentages mentioned above related to the number of transactions, we track the aggregate sales price volume as well.  Let’s compare the first quarter of 2009 with the first quarter of 2008 and the height of this market cycle – the first quarter of 2007. 

The best performing submarket was Brooklyn which was down by “only” 56.5% in the number of sales and 63.5% in aggregate sales price from 1Q08.  When comparing 1Q09 with 1Q07, the number of sales was down by 65.6% and aggregate price was down by 68.7%. Remarkably, those numbers were the most positive.

In Queens, 1Q09 number of sales was off by 68.5% and aggregate sales price was down by 82.9% from 1Q08. When comparing 1Q09 to 1Q07, the number of sales was down by 71.5% and aggregate prices by 77.6%.

In Northern Manhattan, 1Q09 number of sales was down 62.3% and aggregate sales price was off by 88.9% from 1Q08. Comparing the numbers to 1Q07, the number of sales was down by 77.1% and aggregate sales price dropped by a staggering 93.5%.

The Bronx experienced a reduction of 74.4% in the number of sales and a reduction of 75.7% in aggregate sales price in 1Q09 from 1Q08. Comparing 1Q09 to 1Q07, the number of sales was down by 86.7% and aggregate sales price was down by a whopping 93.8%.

Manhattan activity has fallen off a cliff as comparing 1Q09 to 1Q08, the market experienced reductions of 85.5% in the number of sales and 86.9% in aggregate sales price. Compared to 1Q07, these numbers were down by 88.2% and 92.0% respectively.

Clearly, there is nowhere to go but up from here, but the question is: How rapidly will the rate of activity increase? The degree of seller capitulation we see, and the availability of debt will be two important factors in answering this question.

Published June 3, 2009

If you look in a dictionary, the definition of capitalism goes something like this: “An economic system in which investment in and ownership of the means of production, distribution, and exchange of wealth is made and maintained chiefly by private individuals or corporations operating in a free market, especially as contrasted to cooperatively or state-owned means of wealth. The creation of ideas and taking advantage of conditions to provide services or supply goods to the free market via privately controlled production and consumption, the success of which is dependent upon the accumulation of profits gained in and reinvested in a free market”.

“Capitalism has failed” is a popular outcry today but those who believe this have misread the causes of our current economic conditions. If we consider our position today from a macro perspective, it is quite apparent that our economic distress has been caused by a failure of our regulatory framework, not the failure of capitalism.

There are several blatant examples of these regulatory failures: 1) the failure of the SEC to investigate Bernard Madoff after several accusations of his operation being a Ponzi scheme over a 15 year period, 2) the failure of bank regulators to understand the risk position of the institutions they were charged with overseeing, 3) the Fed’s ruinous interest rate policy under Alan Greenspan during 2002-2005 during which interest rates were kept too low for too long, 4) a failure to regulate the credit default swap market, the ramifications of which are still unknown to most on The Street and off The Street, and most importantly and outrageously, 5) the absolute collapse of economic policies in favor of ad hoc “deals” which are more politically influenced than economically influenced.

Let’s be clear, government non-performance is the reason for our current economic circumstances, not the failure of capitalism. We should not be surprised by this as history has shown us the US has a long tradition of regulatory failure under all administrations.

In the fall of 2008, the Treasury and the Federal Reserve were empowered to take actions which threw out longstanding rules of economic behavior. As the US transitioned from longstanding policy to ad hoc decision making, predictability and transparency disappeared in a matter of weeks. Decisions were made in a matter of hours regarding the fate of companies. Moreover, these decisions were made with limited and poor information.

The result was that the politically blessed received billions, but these actions have produced disastrous results. Hundreds of billions of taxpayer dollars were wasted, trillions of wealth were destroyed and 4 million jobs have been lost…….so far.

Ad hoc decision making is not how things should be. In the US economy, winners and losers should be determined based upon the old fashioned principles of 1) satisfying customers, 2) controlling costs and 3) constantly adjusting to changing markets. Today, we have devolved into a nation similar to Russia or Venezuela where your success is predicated upon your political connections rather than your economic ability.

In order to have a prosperous economic system, we must have certainty, transparency and people must win or lose based upon economic ability not political ability. When we saw rules replaced by fiat, we saw investors and consumers move to the sidelines in droves.

To say that we have witnessed, since the fall of 2008 (which encompasses both Republican and Democratic administrations), the most abysmal economic leadership since the 1970s era of wage and price controls is not an overstatement. Economic analysis has been thrown out the window because the government has replaced the precepts of economics with government mandate.

There is, however, a reason to be somewhat optimistic. While Hank Paulson was an ad hoc deal junkie, Larry Summers and Paul Volker, two of the present administration’s key economic advisors, are policy oriented. whether we love or hate the policies, we must remember that policies are better than deals.

Capitalism has not failed; our elected decision makers have.

Published June 19, 2009

The most common question I am asked these days is, “When will the good times return to the commercial real estate market?” That question is impossible to answer with accuracy as we are in unprecedented times with unprecedented government intervention and an unprecedented global recession. Below is a scenario that I think could be possible and may even be probable based upon what we are presently seeing in the market.

I have read many reports recently stating that “experts” are seeing a turnaround in several segments of both the commercial and residential real estate markets. Intuitively, it is difficult to put any credence in these reports due to one very important fact. There is no other metric that is more closely tied to the fundamentals of real estate than employment and there is no indication that we are close to seeing a peak in unemployment. We are presently at a rate of 9.4% nationally and economists’ estimates have risen from a peak of 9%-10% to as much as 11% before the trend reverses. The implication for real estate value is acute.

As unemployment rises, people who have either lost their job or fear losing their job do not move to a larger rental apartment and do not move from a rental unit to purchase a residence whether it is a single-family home, co-operative apartment or a condominium. As unemployment rises, companies do not increase their need for office space and may shed excess space adding to the vacancy and availability rates. It is easy to see how the fundamentals of real estate are most stressed when unemployment reaches its peak.

The most optimistic economists predict that the economy will begin to turn during the third quarter of 2009 (the most pessimistic see the turnaround sometime during the first half of 2010). Unfortunately for the real estate market, unemployment is a lagging indicator, and it is likely that unemployment will peak three to six months after the economy turns. That would place the peak at the end of 2009 or the beginning of 2010 in the best-case scenario.  This is the point at which the fundamentals of our market will be suffering the most and this is the point at which values will hit a bottom.

The question then becomes, when will value start to climb? In order to answer that, we must consider the potential impact of inflation. Will we have above trend inflation? It is hard to imagine that inflation will not be well above trend as the amount of government spending, we have seen, coupled with the overtime the printing presses at the Treasury have been putting in, is creating a very likely potential for excessive inflation.

If this inflation kicks in, what are the ramifications for real estate values? There are two impacts, one positive and one negative.  In an inflationary environment, a flight to hard assets is prudent as cash in the bank loses purchasing power each day. Commercial real estate is a great hard asset to own so demand for the asset class should increase. But with inflation comes intervention from the Fed in the form of increasing interest rates. The Fed’s comfort zone on inflation has been in the 1%-2% range on an annual basis so anything over this range will prompt the Fed to tighten monetary policy i.e., raise interest rates. Currently in the 6% range, mortgage rates could climb to 8%-9%

If interest rates rise, mortgage rates will rise. Given economic conditions, we are likely to see an extended period of positive leverage again as we did throughout most of the 1990s after the S&L crisis of the early 1990s left lenders underwriting in a very disciplined manner for the balance of the decade as the “sting” of the crisis was still fresh in their memories. If we see positive leverage, we could see cap rates rise into the high single digits to low double digits range. This dynamic will have a negative impact on real estate values.

Rising interest rates will be only one of a two part wallop to the market. The other is the impact of a deleveraging process which will play out over a multiyear period as it is based as much on mortgage maturity as a deterioration in fundamentals.

After value hits its low point, it is likely that value will simply bounce along this bottom for a period of years as the dynamics mentioned above play out and distressed sellers consistently add to the available supply of properties for sale.  It might be 2012 or 2013 before any meaningful appreciation is seen in the market. If this happens, why should an investor buy now not waiting for value to clearly hit a bottom? There is a good reason.

Calling an absolute bottom of a cycle is nearly impossible and if you want to buy a hard asset as an inflation hedge, you want to buy that asset at a time before interest rates start to meaningfully rise. Buying an investment property today will give the investor the ability to lock in fixed rate financing at today’s low rates. The asset will have steady debt service payments while inflation increases rents and the value of the asset over time.

This is only one of a number of scenarios that might play out in the coming years. No one knows for sure what will happen but if I was a betting man, my bet would be on the analysis presented above.

Published June 26, 2009

Our economy has been in recession for more than 18 months now and for the past year our real estate fundamentals have been adversely affected. Investors are constantly asking me to show them all of the distressed properties that we are handling for sale. The fact is that everyone is looking for these assets but there is really not much of this product presently on the market.  

A major reason why sales volume is down by as much as it is, is due to supply constraint as discretionary sellers feel that it is unwise to sell into this market. But, what about the sellers that have no choice but to sell? Many lenders fall into this category as the need for cash has left many of them seeking conversion of bad loans into capital. Stress has been evident in the market for quite a while so investors assume that distressed properties should be coming on the market to a significant degree. They have not yet, and I will try to explain why this is the case.

As real estate fundamentals have eroded, defaults have been increasing and many lenders have had to put themselves in a position to deal with nonpayment’s. Many of these lenders have been very busy dealing with balance sheet issues, dealing with regulators and dealing with the government’s TARP initiatives. These issues, while very important, had “distracted”  lenders from addressing their defaulted loan issues.  

It has only been for the past few months that lenders have been figuring out what their exposures are and have been analyzing all of their troubled loans. Workout divisions within the banks have been staffed up and there have been significant enhancements to personnel infrastructure to deal with ever increasing piles of loan files that need attention. These “distressed” assets have been accumulating in a huge pipeline which is chock full of distressed properties and until now, these assets have only been trickling into the market.

We have brokered the sale of a few loans thus far in the cycle but are keenly aware of the potential supply which should reach the market in one fashion or another. Within the past 7 months we have provided lenders with valuations of several hundred nonperforming loans and their corresponding underlying collateral. Our agents have identified several hundred additional properties which we believe are likely to go into default based upon the prices that were paid for them over the last few years and the amount of leverage that was placed on them. We are watching those asset very carefully.

Many funds have been established to purchased distressed assets, whether these assets are notes or properties,  and the funds have not been all that active due to the lack of supply that exists. These funds are patiently waiting for their opportunities and these opportunities will come.

We have seen distressed assets slowly coming onto the market in greater numbers and feel that the massive pipeline of these assets will really start to open up during the third quarter of this year. We know that billions of dollars of these assets are in the pipeline and they will present a buying opportunity unlike anything we have seen since the early 1990s.

In addition to the funds that have been formed, we have seen a resurgence of high-net-worth individuals and the old line New York families that have not been as active as investors backed by institutional capital during the past several years. These were the same buyers who made fortunes buying properties during the early 90s. We have also seen a resurgence of foreign interest on an individual investor basis. These foreign high net worth investors are coming into the market in numbers not seen since the mid 1980s. We believe this is due to the perception that prices are low and good values can be obtained today.

Distressed assets exist because of prices that were too high and leverage that was too available in great abundance and real estate fundamentals have deteriorated.  These assets will consequently be a significant component of our marketplace for years to come as some of the distress will be caused by mortgage maturities which are spread over time. As these assets hit the market, investors will find opportunities and we will see market dynamics in which lenders and investors both end up winning. Lenders will be able to convert nonperforming assets to cash and investors will beef up their portfolios with great long-term assets.

Published July 10, 2009

This past week, we read an announcement about the Treasury selecting nine fund managers to implement the PPIP program. Is this a positive thing? Should we celebrate? Let’s take a closer look:

In what has been called, “The greatest program that never happened”, the government’s Public-Private Investment Program, or PPIP (which is part of the TALF) has lost significant momentum and is a mere shadow of what is was initially intended to be.  Originally slated to help banks rid their balance sheets of $1 trillion of toxic assets, the program is now targeting $30 to $50 billion. These toxic assets were to include bad loans and distressed securities. One of the main goals of the PPIP was to help create liquidity in frozen markets. Our real estate market was hoping that the program would provide a shot in the arm to the CMBS market, a desperately needed component of the massive financing the market requires. As real estate brokers, we were hoping that pools of real estate loans would be purchased by institutions in bulk and funneled back into the market expeditiously creating opportunities for us.

At the time of its initial announcement on March 23rd by Treasury Secretary Geithner, markets rallied nearly 500 points or about 7%.  Subsequently, some of the larger banks were able to raise capital based upon the resulting confidence the announcement gave to investors. Federal officials now say that the slimmed down PPIP has been trimmed due the banks’ becoming healthier. But are they really healthier?

Since the start of 2008, seventy banks have failed. Most of these institutions have been smaller community banks and regional banks. Banking analysts are projecting hundreds of additional collapses during the next two years. These smaller banks often play key roles supporting their local economies and, taken together, are important to our financial system and our economic recovery.

During the S & L crisis in the early 1990’s, the RTC was instrumental in selling off bad loans and securities of banks that failed. In this cycle, efforts to rid banks of toxic assets have sputtered repeatedly. In the fall of 2007, federal officials tried to implement a plan to establish a fund to buy securities from banks, but this effort was aborted. In 2008, the Bush Administration established, through the TARP, a $700 billion program to purchase banks’ soured assets. Mainly due to difficulties in determining the value of those assets, the US abandoned that plan opting instead to pump taxpayer money directly into banks. But the strings attached to the TARP funds left banks rushing to return the money rather than lending it.

Banks still have mountains of bad debt and devalued securities sitting on their balance sheets. As those loans and securities lose value, they are saddling the banks with losses and restricting their ability to lend.  Bankers had hoped the PPIP would help them unload bad assets (many of which were loans on commercial real estate) that were negatively impacting their positions. In June, the FDIC announced that it was indefinitely postponing its Legacy Loan program which was supposed to buy $500 billion of loans from banks. This month, the FDIC plans to use PPIP for a far narrower purpose which is to auction loans the agency has inherited from failed banks.

The new iteration of PPIP will focus not on bad loans but on purchasing toxic securities which are a problem for a relatively small percentage of the nation’s banks. This is terrible news for smaller banks burdened with growing piles of defaulted loans. These banks find it more challenging than their larger counterparts to access capital markets. They have been eager for the US to help them unload the loans in order to bolster their capital cushions.

Based upon these dynamics, it is hard to believe that “banks’ increased health” is the reason why the PPIP has been trimmed. There are several other challenges that the program has faced. One of these is the risks faced by program participants of being a business partner with the government. It is tough to play a game where the rules can be changed in the middle of play and the government has repeatedly demonstrated that they love changing the rules midstream. This is thought to be the main reason why PIMCO and Bridgewater Associates opted not to participate in the program. Hedge funds and private equity investors were unnerved by the restrictions placed on banks participating in TARP. Fund managers were also bothered by the President’s strong criticism of “all of the speculators on Wall Street” and, particularly,  hedge funds holding Chrysler debt who had refused the government’s buyout offer.

Questions remain. Will banks sell toxic assets into this program at significant discounts creating holes in capital? Will pension funds, endowments and municipalities gravitate to the program given they look like natural fits as partners with the government? Will the need for banks to raise capital or to get their Tier 1 ratios up be so compelling that deals can be made?

The answers to these questions will become apparent over time. Many banking experts contend that the financial system won’t fully stabilize until banks get rid of their bad assets. This is precisely why my firm and others have been focused on helping banks sell their troubled loans collateralized by real estate.

Published July 21, 2009

Your perspective on the relative success or failure thus far of the American Recovery and Reinvestment Act of 2009 aka “The Stimulus Plan”, probably depends, in part, on your political persuasion. Republicans have called it a failure and Democrats remain hopeful that the benefits will start to tangibly kick in. I would like to look at the $787 billion  (which equates to about 5.5% of GDP while the New Deal was only about 2% of GDP) the government has appropriated from the perspective of neither a Republican nor a Democrat, but rather from the perspective of a real estate guy or what I will call a Realestatarian.

In February, we were told that the Stimulus plan had to be approved by Congress “to avoid economic Armageddon” because “we are approaching a financial catastrophe unlike anything this country has seen since the depression.” The President told us that, “A new wave of innovation, activity and construction will be unleashed all across America” and that it would, “create up to 4 million new jobs” (“create or save” was the modification months later when it was clear that the projection was a fantasy). The Vice-President said that the spending plan would “drop kick” the economy out of the recession. The National Economic Director said, “You’ll see the effects begin almost immediately”.

These statements sounded very positive. The Realestatarian in me told me that it sounded too good to be true. When has the government, under any party, efficiently implemented a program like this? And by the way, how were we going to pay for this spending plan?

Another major concern has been the unprecedented shift in economic power from the private sector to Washington D.C.  Moreover, notwithstanding the party affiliation of the resident in the White House, programs like this have typically been riddled with waste, fraud, abuse, inefficiency, incompetency and corruption. With a unified government the potential for these outcomes is unavoidable.

From the Realestatarian’s perspective, what matters most? JOBS, that’s what. Employment is the single most important indicator affecting the fundamentals of our real estate markets. If people are out of work they are not spending money and if people are not spending, our retail tenants are not leasing new stores, let alone paying the rent on their present locations (70% of GDP is the result of consumer spending ). If people are not working they are not likely to be moving to a bigger apartment, or moving from a rental unit into a newly purchased home. If companies are reducing the size of their workforce, they don’t need to lease more office space and may even be disposing of excess space caused by contraction. We need jobs to stimulate growth and the Stimulus Plan has not produced new ones. Whether jobs have been saved is difficult to prove, hence a wonderful political thesis.

Today, the Bureau of Labor Statistics tells us that the unemployment rate is 9.5%. This is, however, just the tip of the iceberg. This is based upon a June number of 467,000 jobs lost. These numbers are typically revised and the revisions rarely are downward. 7.2 million people have lost jobs since the start of the recession wiping out the total net gains of the prior nine years making this the only recession since the Depression during which all of the job growth from the previous expansion has evaporated.

Additionally, the unemployment rate does not take into consideration all of the people who have given up looking for a job or workers taking part time jobs who would would like to work full time or workers who have been asked to take unpaid leave. If these groups were included, the unemployment rate reaches 16.5% leaving about 25 million people involuntarily idle. Projections from most economists now indicate that unemployment will peak between 10% and 11% and rates over 9% are likely to be with us throughout 2010. To say this is not good for real estate is an understatement.

The Stimulus Plan was supposed to yield $1.50 of economic activity for every dollar spent. Thus far, less than 20% of the money has actually been spent and the benefits have been difficult to see. Unfortunately, the Stimulus Plan is loaded with pork and too much of the money has gone towards transfer payments such as Medicaid and unemployment benefits, neither of which do anything to create jobs or stimulate economic growth. Jobs would be created by spending on infrastructure but only about 10% of the $787 billion is slated for this purpose.

Benefits to small businesses would stimulate job growth and are needed. Small business entrepreneurs have led America out of the last seven post-World War II recessions. They also create about 2 of every 3 new jobs during a recovery. Rather than providing tax savings to these businesses (which can be implemented quickly and efficiently), all indications are that small businesses will face rapidly increasing taxes whether it is because of a need to pay for a government run healthcare system, a need to plug budget gaps created by all of the spending the government has initiated or simply because inevitable inflation (caused by a doubling of the money supply in just 9 months) will increase the cost of borrowing. This is a major concern as the money supply has grown by more in the last 9 months than in the last 50 years in aggregate.

Unfortunately, the economic downturn has been used as an excuse to greatly expand the size of government. The Stimulus, and how the money has been allocated, clearly reveals that, presently, income redistribution is prized above all else, including job creation and economic growth. As Realestatarians, we can’t be feeling too good right now. We need to see a reversal in the direction of unemployment before a real estate recovery can occur.

Published August 4, 2009

The investment property sales market in New York City was slightly improved in the second quarter of 2009 (2Q09) versus the first quarter of the year. That being said, it couldn’t possibly have been worse than 1Q09 during which we saw the paralysis of 4Q08 manifest itself in a 1st quarter volume which we needed a microscope to see. However, even with an improved 2nd quarter, the first half of 2009 (1H09) was still a major disappointment for those of us relying on transaction volume for a living.

The total dollar volume of sales in NYC for 1 H09 was approximately $2.8 billion. This figure was down 81% from the 1H08 total of $14.47 billion and down a whopping 92% from the peak half year of 1H07 during which we had $35.8 billion in sales.

With regard to the number of transactions, in 1H09 we had 562 closed transactions. This figure was down 65.7% from 1H08 and down 75.3% from the peak half year of 1H07 during which we had 2279 sales closed.

Because some transactions involved multiple properties, we also track the number of individual properties which have been sold.  In 1H09, 670 properties were sold.  This figure is down 64.5% from 1H08 and down 75.5% from the peak half year of 1H07 during which we had 2738 properties change hands.

To put these sales figures into perspective, we must look at historical averages and milestones. Since 1984, we have tracked a statistical sample of investment properties in New York that consists of 125,000 properties. Over a 25 year period, the average turnover rate has been 2.6% with the all-time low level being 1.6%. The 1.6% level was hit in 1992 and again in 2003. Both of these were years at the end of recessionary periods and were also years during which unemployment reached cyclical peaks. We always assumed that this 1.6% turnover level was a “base line” which consisted only of people who were forced to sell because of death, divorce, taxes, insolvency, partnership disputes, etc. If we annualize the activity during 1H09, the turnover percentage is running at 1.07%!! We anticipate that activity will pick up slightly during 2H09 but that we will still hit a new record low of 1.2%-1.4% for the year.

Values are also taking a hit as office and retail properties have seen cap rates increase 200 to 250 basis points above their lows. The multifamily sector has held up the best with cap rates only about 100 basis points above their lows. In fact, in the Manhattan market (south of 96th street on the eastside and south of 110th street on the westside) during 1H09, walk-up buildings saw average cap rates of 4.58% with the elevatored average hitting 4.08%. Upward pressure on cap rates is present in every sector of the market.

In general, the New York City building sales market has seen a reduction in activity and value. The trend has certainly been towards smaller transactions, for which there is plentiful debt available from community and regional banks. We have also seen a resurgence of high-net-worth individuals and old-line families who had been overpowered by operators backed by institutional capital for the past several years. We anticipate the volume of sales increasing slightly as we move into the second half of the year. Based upon current market activity, we expect volume to increase as prices drop due to eroding fundamentals caused by increasing unemployment.

(For a copy of the 25-year study or to receive borough by borough building sales reports for the first half of 2009, please feel free to email me and I will be happy to send them to you)

Published August 17, 2009

Real Estate Investment Trusts (REITs) are a form of ownership which have been around for quite a while but really began going public in earnest to deliver their balance sheets in the early 1990s. And thrive they did in the mid to late 1990s. However, their dominance was somewhat muted in our most recent bull market in the mid- 2000s. I would like to share a perspective with you that I think is very interesting. REITs have the potential to become an even more dominant force in our investment sales market beyond where they are today. Let’s take a look at why this could be the case.

Let’s consider current market conditions. The speed of deterioration in loan performance is unprecedented, even relative to what was experienced during the Savings & Loan crisis in the early 1990s. The total delinquency rate has reached 4.1% recently which reflects an increase of over 350% from the rate at the end of 2008. Delinquency rates are likely to increase substantially over the next two to three years as billions of dollars of pro-forma loans that never reached stabilization mature. Loans which have interest-only periods expiring or interest reserves burning off will fall into this category as well. Additionally, numerous properties are hanging on by a hair only because the mortgage rates are floating over LIBOR, which is minuscule today.

In New York City, we had $106 billion of investment property sales in 2005, 2006 and 2007. Based upon loan-to-value ratios available during these years and the reductions in value that we have seen, an extrapolation would indicate that approximately $80 billion of this total or about 6,000 properties have negative equity today. Clearly not all of these properties (or the notes on them) will come to the market as distressed assets as many owners have the ability to service the debt and want to own the assets for the long term. Notwithstanding this fact, a substantial percentage of these properties will come to the market needing to be sold.

Refinancing requirements will add to stresses in the market and will prove challenging, particularly for larger loans which are not generally available from community banks and regional banks due to their magnitude.  They will also be challenging due to reductions in value and more conservative LTVs which will exacerbate the massive deleveraging that the market must go through. It has been projected that well over $2 trillion in commercial mortgages will be maturing between now and 2013.  Much of this financing was delivered to the market by banks, life companies and CMBS intermediaries.

The CMBS market has evaporated. In 2007, there were $230 billion of issuance and in 2008, this number dwindled to just $12 billion (all of which was in the first half of the year). Since July of 2008, there have been no new issuances. A disturbing fact is that even if the banking and insurance industries were operating at full throttle, they do not have the capacity to meet the refinancing demand. Access to public capital is crucial. Enter the REITs.

Not surprisingly, REITs have been negatively affected by current market fundamentals, as all sectors have.  The Dow Jones Equity and REIT Total Return Index, which tracks 113 stocks, had posted a negative return of approximately 68% from its peak in February of 2007. While the Index has improved, it is still well below peak levels and REIT stocks are trading at double digit percentages below net asset value (net asset value was nearly impossible to determine 8 months ago and, while it is not much easier today, there are some data points from which to form a reasonable estimate). By contrast, REITs traded at a 25% premium to NAV between 2004 and 2007. Presently, the REIT dividend yield spread to the 10-year Treasury note is approximately 260 basis points, well above the long-term average of 118 basis points. They are also trading at approximately 325 basis points below their long-term average FFO multiple of 12.8x. These facts should help REITs facilitate capital raising efforts.

REITs own a significant portion of the better-quality properties in the United States. They currently have access to over $30 billion in credit lines and have generated in excess of $5 billion of liquidity since mid-2008 via dozens of dividend reductions, eliminations and in-kind payments. Most importantly, REITs have access to the public capital which was regularly accessed via the CMBS market. Several well capitalized REITs have successfully raised capital recently, an extremely positive sign in a market sorely missing them.

Fortunately for the sector, relative to other professional commercial real estate investors, REITs were among the least active buyers as cap rates declined significantly between 2005 and 2007. REITs were the purchasers of only about 11% of investment properties during these years. During this same period, private equity funds and private owners acquired in excess of 55% of the investment properties sold. Therefore, a number of REITs should be well positioned to acquire assets from these entities at significantly more attractive prices as these over-leveraged properties and owners become distressed. Surely, some REITs will face challenging times and may need to be folded into other entities. The well capitalized players should be in great shape.

Access to public capital and large stockpiles of dry powder should make REITs even more powerful as we try to maneuver our way out of current market conditions. We clearly have a long way to go to get through this cycle. As we emerge, look for the well capitalized REITs to lead the way, particularly if CMBS fails to make a tangible comeback.

Published August 25, 2009

We are all, by now, well aware of the $400 billion travesty created by subprime lending and the fundamental structure of Fannie Mae and Freddie Mac.  A platform which includes private profits and public liabilities should have been conceptualized in a different fashion. In the 1980’s, the government thought an increase in the homeownership rate from 64% to 75% would be positive for the country and incentives were given to these government sponsored enterprises to help achieve that objective. They loosened their standards, expanded their platforms and supported riskier loans (over 20 years later the homeownership rate has only increased 3.4% to its present level of 67.3%).  Subprime lending was a central catalyst for the difficulties faced by Fannie and Freddie as loans were made to people who did not qualify for them. A bubble was created and spectacularly burst when we discovered that housing prices could not keep going up forever. Lesson learned, right? Think again.

Enter the Government National Mortgage Association, aka Ginnie Mae. Ginnie’s mission is to bundle, guarantee and sell mortgages issued by the Federal Housing Administration. The FHA is the government’s in-house mortgage operation which, given the difficulties in the housing and related markets, has grown spectacularly as it filled a void. As the FHA has grown, so has Ginnie Mae. FHA/Ginnie now guarantee $680 billion of mortgage securities, a 400% increase since 2006.

In June alone, Ginnie had issued $43 billion in mortgage-backed securities. By the end of next year, it is expected that Ginnie’s mortgage exposure will eclipse the $1 trillion mark. With the activity of late, Ginnie has now swapped positions with Fannie Mae in terms of loan volume.

Here is what is troubling: the government has eased FHA’s already loose underwriting standards while every other lender on the planet has tightened them. FHA’s program and oversight are notoriously lax. It accepts very low downpayments (3.5% generally) and will make loans to borrowers with below average to poor credit ratings. They also have other policies which, among other things, allow borrowers to finance closing costs which can reduce the downpayment to a mere 2%. Given the tremendous growth of the operation, it is even more likely than before that fraud protection mechanisms will be ineffective. This is called subprime lending and Washington is running the show.

Additionally, FHA has been the recipient of a Congressional blessing to assist with the refinancing of hundreds of thousands of subprime and other exotic loans extended to borrowers who can’t (or wont) make their mortgage payments. Through the Home Affordable Modification Program, the FHA will refinance these troubled loans by reducing the balances of the loans by as much as 30%. The stated purpose is to reduce foreclosures, but someone has to pick up the tab. Guess who? Right, the US taxpayer.

Fannie Mae and Freddie Mac carried “implicit” government guarantees. (These are off balance sheet liabilities for Uncle Sam which, if reported properly (no one believes the government won’t stand behind them), would increase our national debt by 75% to about $12.7 trillion and a more than 90% debt-to-GDP ratio, but questioning the integrity of the National balance sheet is another topic for another post). FHA and Ginnie carry “explicit” guarantees of the government.

HUD’s Inspector General issued a report recently indicating that FHA’s default rate has risen to 7% which is more than double the level considered tolerable for lenders. Moreover, the report found that 13% of the loans were delinquent by more than 30 days. Because of these facts, the FHA’s reserve fund has been reduced by more than 50%, going from 6.4% to about 3%. Why is a 33 to 1 leverage ratio ringing a bell to me? The report went on to say that “FHA may need a Congressional appropriation intervention to make up the shortfall.”  It sounds as if, yet another bailout is on the horizon.

Doesn’t Congress have a responsibility to the US taxpayer to secure the soundness and safety of FHA? Common sense reforms would show that attention was being paid to the extraordinary things that have occurred recently. Why not increase the downpayment requirement to a level where the borrower has something to lose by defaulting? This would be the best protection against default and foreclosure. Why not participate in the upside of the home’s value given the generous terms upon which loans are made. The “participation” could protect the taxpayer from inevitable losses.  This would allow those who benefit directly from the program to help support the program.

I know that the function of the FHA and Ginnie Mae are fundamentally well intended and necessary. The government needs to provide an overly reasonable path to the “American Dream” for those who need a helping hand. The point is that we were just afforded the opportunity to learn a VERY costly lesson about the dangers of subprime lending. It is a big concern that the lesson has seemingly been missed by those on Capitol Hill and the government is now explicitly running the biggest subprime lending operation in the world.

Published August 30, 2009

If you are a regular reader of StreetWise, you know that in New York City the community and regional banks have been the main driver of financing activity which has kept the sales market out of the morgue, especially for small to mid-sized assets. Ironically, these are the very types of banks which are suffering the most around the country, threatening our economic recovery. Banks are failing at an alarming rate and, as real estate professionals, it is important to be familiar with the status of this critical industry.

Last Friday, Bradford Bank in Maryland and Mainstreet Bank in Minnesota were closed by regulators marking the 82nd and 83rd US bank failures in 2009. This figure is greater than that seen in any year since 1992 and, what is most troubling, almost half of these have occurred since July 1st. In 2008, 25 banks failed bringing the total during this recession to 108. It is expected that this number will grow to as many as 1,000 over the next 18 months before the smoke clears. The FDIC seizes banks on Friday afternoons and the banks are reconstituted over the weekend to open as part of the acquiring bank on Monday morning. During the Savings and Loan Crisis, 853 banks failed, and today’s conditions are widely considered to be far worse than the conditions we saw in the early 1990s.  The problems this time around will result in hundreds of failures with some of the stronger banks growing stronger as they emerge from this cycle.

The FDIC insures deposits at 8,246 banks and keeps a “watchlist” of banks which are candidates for insolvency. This figure comes out periodically and at the end of March it was 305. Last Thursday, the FDIC said the number had grown to 416 which is the highest number since 1994. In 1988 this number was a record 2,165. Given the relative comparison, the watchlist level is expected to soar during the next year or two.

Stronger and larger banks, in addition to receiving TARP funds, have been able to raise $48.3 billion recently through a combination of strong earnings, dividend cuts, asset sales and equity raising. Unfortunately, it is estimated that $275 billion is needed to stabilize the industry. How did the industry get into this position? It did because far too many banks tripled down on real estate investments. Here is the triple-down scenario:

First, and most obviously, banks made loans on residential real estate, commercial real estate and development projects. Unfortunately, the present speed of deterioration in loan performance is unprecedented – even relative to the early 1990s. Particularly, some banks deployed over 100% of their risk-based capital into development projects. Many of those banks no longer exist.

Second, we must look at how some banks handled their investment portfolios. Thousands of banks and thrifts purchased securities tied to the housing market. Banks bought $2.21 trillion of these securities which represents 16% of the industry’s total assets of about $13.5 trillion. 1,400 banks purchased “private label” securities which are those not issued by Fannie Mae or Freddie Mac. It has been estimated that small and regional banks presently own $37.2 billion of these private issuer securities.

Third, the industry has been battered by $50 billion of “Trust Preferred Securities”. These are financial instruments issued by banks which are a hybrid between debt and equity. Between 2003 and 2008, 1,500 banks issued these products. Wall Street purchased these securities, created CDOs, and sold the resultant securities back to the same pool of banks! As market conditions weakened, the performance of these banks and of these securities weakened. In the first half of 2009, 119 of these banks deferred dividend payments on these securities and 26 banks defaulted altogether. The consequences of these stresses are cascading down to the buyers of the securities (the banks).

This tripling-down effect has created the difficulties in the banking sector. As the sector weakens and more banks fail, tremendous stresses are being exerted on the FDIC and its insurance fund which takes a hit each time a bank is seized. As the FDIC seizes banks, it prefers to have a buyer in hand prior to the seizure so that a conversion can be implemented over the weekend. Unfortunately, buyers, particularly for larger institutions, have not been plentiful in supply.

Two weeks ago, Colonial Bank, with $25 billion in assets, was seized and sold but there were surprisingly few bidders engaged in the process. When Guaranty Bank in Texas was sold, the FDIC, for the first time in history, sold the assets to a foreign bank. Banco Bilbao Vizcaya Argentaria, a Spanish bank, was the buyer.

The FDIC’s most important consideration is to limit the cost to its insurance fund, which covers losses from a failed bank’s troubled loans. In order to achieve this objective, having as many bidders as possible is in their best interest. Expanding the arena of foreign banks is part of this strategy and several have expressed interest including TD Bank (Toronto-Dominion Bank), Bank of the West (BNP Paribas), UnionBanCal (Bank of Tokyo-Mitsubishi UFJ) and Rabobank (Rabobank Group).

This past week, the FDIC also made it a bit easier for private-equity firms to purchase failed banks. Existing bank holding companies need a Tier 1 capital ratio of 5% to be a qualified purchaser while new banks require 8%. Private-equity firms were required to have a Tier 1 capital ratio of 15%. This has been reduced to 10%. By attracting private capital to buy these failed banks, the FDIC can reduce the number of liquidations and thus reduce the potential losses to taxpayers. The impulse to demand a higher capital cushion as proof of ownership commitment and staying power is exactly correct. The same goes for the requirement for non-bank holding companies to hold onto the bank for at least 3 years before it can be resold and the requirement that the buyer act as a financial backstop. The weak US banking system doesn’t need investors looking mainly for a quick spinoff that could leave a bank in poorer hands within a year or two.

Sheila Bair, the Chairman of the FDIC, has been one of the most on-point players in our financial markets during this cycle. She had the foresight to ask congress to provide access to a $500 billion Treasury line of credit several months ago. While she is reluctant to tap the line (for obvious reasons) it is good that the facility is in place.

We keep hearing from the Treasury and Congress that the US needs more and tougher bank regulation, even though regulators failed miserably to detect problems within the system. Yet the FDIC is being roughed up, by these same proponents of more regulation, for demanding capital and other standards from nonbank investors who won’t have to meet current bank holding company rules. This position is not the way to restore confidence in the banking system.

We need a healthy banking system to provide financing to our industry. There is a recycling process that it will have to go through, but we remain hopeful that a stronger system will emerge from the rubble.


Published September 9, 2009

A few times each week I am asked by clients and colleagues what my biggest concerns are in our current marketplace. One that has really been resonating with those that I speak with is the unprecedented shift in economic power from the private sector to Washington DC and how this fact could impact the commercial real estate market. Our CRE market (and the economy for that matter) needs job creation which does not seem to be on the minds of those with the economic power today.

While most Americans and businesses are cutting expenses and being prudent about spending under current economic conditions, the present administration has continued the reckless spending habits of the Bush administration. I am not criticizing Democrats or Republicans but all elected officials who are spending our way into serious trouble. If you read StreetWise regularly you know that I do not discriminate when objecting to policy implementation.

During W’s 8 years, the supposedly fiscally conservative President, oversaw a GDP increase of 15% while he allowed government spending to increase by 58%! The present administration’s stimulus plan is full of more pork than a butcher shop with only 11% of the $787 billion targeted toward infrastructure which is truly stimulative. A number of those on Capitol Hill had agendas other than stimulus and they were the ones shaping the package. Additionally, there are trillions in various programs which are in various stages of deployment and when there is that much cash being thrown around, you are kidding yourself if you don’t think waste, fraud, abuse, incompetency, inefficiency and corruption will exist. History has shown us that this is normal regardless of the party in control. The risk is, however, much greater under a unified government such as we have now. The midterm elections should be quite interesting.

We must remember that politicians do not grow economies. The truth about growth is that it is the product of millions of decisions made by millions of people about what to produce, buy and sell. Politicians can influence decision making by increasing or decreasing incentives about what we produce, buy and sell (like offering to paying $4,500 for cars that may have been worth an average of $500). Regardless, they cannot control today’s global economy.

In the most recent cycle, since output peaked, our GDP has contracted by 3.9%, the steepest decline since World War II. Many economists believe that our economy is at an inflection point at which we may need to shift to an export-based economy as opposed to continuing to rely on a consumer based economy.  We have had decades of growth led by consumer spending which, along with residential investment, grew from 67% of GDP in 1980 to 75% of GDP in 2007. During the credit crisis, $13 trillion of wealth has evaporated. We have seen an implosion of the shadow banking system and a tangible shift to thrift.

In 1980, the savings rate in the US was 10%. In 2006, the abuse of credit cards and readily available mortgage equity withdrawal catapulted us into a savings rate of -4%. During this period, we saw all borrowing in the form of household debt grow from 67% of disposable income to 132%. Today, the savings rate has risen to 6%. This 10% swing in the savings rate alone has eliminated $1 trillion from our total annual output. The stimulus, along with other government programs, combined with dramatic declines in tax revenues have created record budget deficits, now projected to rise to about 13% of GDP. To put this into perspective, this $1.8 trillion deficit amounts to $3.4 million per minute, $200 million per hour and $5 billion per day. Our federal debt is now 60% of GDP and it is projected to hit 82% by 2019. At some point the spending must stop.

Moreover, the off-balance sheet obligations of the US associated with Social Security and Medicare put us in a $56 trillion financial hole. Both of these programs are looming train wrecks if there are not fundamental changes made to the way they are structured. Fannie Mae and Freddie Mac liabilities are also off-balance sheet whollops to our financial picture – add $7 trillion more.

We are presently faced with 4 looming deficits: a budget deficit, a savings deficit, a value-of-the-dollar deficit and an economic leadership deficit. Political careerism must give way to the implementation of real solutions.

So why do I care about all of this political mumbo-jumbo? Because our real estate market needs real solutions. We need the government to focus on creating incentives for small business. We have been led out of the last 7 recessions by small businesses which have created two-thirds of all new jobs. Anti-business sentiment on Pennsylvania Avenue is not stimulative. We need small businesses to thrive. That will create jobs and those jobs will allow residential tenants to move from a one-bedroom apartment to a two-bedroom, or from a two-bedroom rental to purchasing an apartment or a single-family residence. The additional jobs will create demand for office space and the increased economic activity will increase room rates and occupancy levels in hotels. New jobs will put disposable income into the pockets of Americans who can go to retail stores and purchase goods which will allow retail tenants to pay better rents and open new locations. Small businesses have the power to create these valuable jobs. Where are the incentives for small businesses?

The massive deficits we are experiencing (at all levels – federal, state and city) will certainly create pressure for tax increases but tax increase is not the answer. We are all cutting expenses, why can’t the government – at all levels? If they can’t, we could be in this soup for quite a while.

Published September 20, 2009

One year ago, one of the most intriguing questions on the minds of commercial real estate investors was what was going to happen to large, performing CMBS loan that matured, and the owner was not able to refinance. Since then, 528 CMBS loans valued at nearly $5 billion matured and were unable to be refinance even though 75% of these loans were throwing off more than enough cash to service their debt. The evaporation of the CMBS market and the entire shadow banking industry has created an extremely challenging financing market for all large loans, even for properties which have the cash flow to cover debt service payments. This lack of liquidity has continued to be a tangible concern for the industry. 

A potential solution to this problem was announced by the IRS last week when they issued guidance (Revenue Procedure 2009-45) that provides significantly greater flexibility to modify the terms of commercial mortgage loans that have been securitized into commercial mortgage backed securities. RP 2009-45 makes it clear that negotiations involving modifications to the terms of these loans can occur at any time (the servicer only has to believe there is a “significant risk of default” even if the loan is performing) without triggering tax consequences. It applies to all modifications made after January 1, 2008.

Until now, a borrower with a CMBS loan had no one to speak to at the master servicer. The master servicer serviced the securitized loan, and the borrower would have to essentially go into default to have the loan transferred from the master servicer to a special servicer. The borrower could then have a dialogue with the special servicer to discuss reworking the terms of the loan.

Administrative tax rules applicable to Real Estate Mortgage Investment Conduits (REMICs) and investment trusts imposed severe penalties for changes made to commercial mortgages or investment interests after the startup date of the securitization vehicle. The trusts could have been forced to pay taxes if the underlying loans were modified before they became delinquent, according to the old CMBS rules. Therefore, borrowers were unable to even begin discussions with their loan servicers until they had already defaulted of default was imminent. Often, however, by the time a loan reaches this status, options are generally limited, and it is too late to work anything out. Foreclosure would be a likely result, further depressing valuations.

This new IRS guidance puts CMBS borrowers on almost a level playing field with borrowers who have loans with traditional banks. Those bank borrowers have always been able to call their banker at any time to discuss any potential problems that the loan might face. Now borrowers with CMBS loans can do the same thing thereby enhancing the possibility that the loan can be salvaged, and the property can be maintained.

While this modification is applauded by many in the industry, there are some concerns.

First, this program will really only help those borrowers who are conservatively leveraged and simply cannot refinance because of the extraordinary condition of the credit markets today. Any borrowers who have negative equity and are highly leveraged are out of luck (whether they can arrange a modification or not) and may only be delaying the inevitable if they are able to convince the servicer to modify.

Second, it is feared by many that the guidance could open the floodgates for everyone to try to get some sort of loan modification whether it is justified or not.  Some borrowers may take a shot just for the heck of it. It will be interesting to see what criteria servicers use to determine who gets help and who doesn’t.

Third, servicers will come under tremendous new pressures from several participants with different objectives such as competing classes of investors. Some investors holding CMBS bonds are watching nervously because the modifications might not always be in their best interest. CMBS have senior and junior pieces (known as the “A-note” and the “B-note”). The senior piece is in a better position and has incentive, in most cases, when a borrower defaults, to foreclose and liquidate the property. Junior holders, on the other hand, might benefit from a modification because they may not get any proceeds back in a forced sale.

Fourth, the fiduciary responsibility of the servicer is to all bondholders, and they should modify loans only when that can be expected to reduce losses. That puts servicers in the challenging position of trying to figure out which borrowers are essentially sound versus knowing when it makes sense to foreclose quickly. My guess is that, based upon the relentless pile of files mounting on servicer’s desks, modifications will be the path of least resistance.

Fifth, from the brokerage perspective, this modification will only further constipate the pipeline of distressed assets which is already moving like molasses. Many of the properties which would be considered “distressed” are financed with CMBS loans and, to the extent that brokers were looking forward to selling these assets, we will have to wait even longer for these opportunities to present themselves.

Importantly, the guidance only applies to outstanding loans and only to servicers who believe a loan modification is in the best interest of all of the bondholders. The servicers are still bound by the terms of the pooling and servicing agreements and the servicing standards (which are not affected by the guidance) but at least the tax rules will not prevent dialogue among the parties.

Published September 27, 2009

The title of this post says it all. Real estate is rarely in a state of crisis unless an earthquake or other natural disaster disturbs the structural integrity of the building. Real estate becomes distressed when too much leverage is used and the net income from the property is insufficient to meet debt service payments.

Even in today’s stressed marketplace, owners who are very conservatively leveraged are doing just fine. For those who were seduced by tons of plentiful, cheap debt which was available in the market in 2005, 2006 and 2007, things don’t look so good.

It is clear that the market must go through a massive deleveraging process. Properties simply cannot support the debt loads that currently exist and we have started to see this deleveraging process start. It is interesting to try to calculate the extent to which leverage must be taken out of the system. Let’s see what the New York City market shows us and try to determine what it means for the rest of the market.

In 2005 through 2007, there were $109 billion of investment sales activity in New York. Based upon a breakdown of property types and their corresponding current price levels and the LTVs that had been available during the 2005-2007 years, Massey Knakal has estimated that about $80 billion worth of those sales, affecting about 6,000 properties have negative equity in them. If we add to this total those properties refinanced during this period, we add about 10,000 more properties which have negative equity levels. This adds about another $80 billion to the total debt on properties with negative equity. Using today’s metrics, what is the correct amount of debt that should be on these 16,000 properties?

If we use a model which assumes a 20% reduction in rental revenue, a 200-basis point increase in capitalization rate and a loan-to-value ratio decrease from an 85% average to a more conservative 60%, the resulting debt level is 60% lower than the existing level. This implies that, of the $160 billion of debt on these underwater properties, the appropriate level of debt, based on today’s standards, should be only $64 billion!

How did the bubble of 2005-2007 get so out of control? If I had a nickel for every time I heard someone say that we were in a new paradigm……..

We clearly were not operating in a new paradigm. It happened because almost all of us lost sight of the fundamental rules of cyclical real estate markets. Our current economy and capital markets offer a reminder of some historically proven truths:

  1. Debt is wonderful when all goes well, but extremely punishing when things go wrong.
  2. Debt rollover renewal is the real risk of using short term debt, not an increase in the interest rate.
  3. Recessions and capital shortages are never incorporated into financial models, but are often incorporated into reality.
  4. Real estate is a long term asset (even though your planned holding period may be short) and therefore requires substantial amounts of equity in order to provide an appropriate asset-liability match.
  5. When money is available for everything from everyone, soon thereafter there will be no money available from anyone for anything.
  6. When money is easy, the benefits accrue to the sellers, not the buyers.
  7. When fear replaces greed and people seek absolute safety, all asset prices are essentially correlated and diversification does little good.
  8. Any rapid change (e.g., the spike in demand for condos and second homes) attributed to demographics must be wrong, as demographic changes move through the system at glacial speed.
  9. Your model’s worst-case scenario is not even remotely the worst that can occur.
  10. When you think things are too good to be true, they probably are.

As these rules were forgotten, aggressive plays were made and we have witnessed a cataclysmic bursting of the bubble.

I have seen estimates ranging from $1 trillion to $2 trillion of commercial real estate debt which is scheduled to mature between now and 2013. If we extrapolate the experience of New York’s market to this national total, it would appear that $600 billion to $1.2 trillion of debt must be withdrawn from the market. Much of this deleveraging will occur in the form of distressed note and property sales. It is apparent that due to the unwillingness of banks to realize the losses imbedded in their balance sheets, changes to FASB mark-to-market accounting rules and modifications to REMIC guidelines this process will play out over a very long period of time.

As things play out, it is becoming more apparent that our distressed asset flow will not be in the form of an early 1990s-like tsunami but rather a series of rolling waves extending as far as the eye can currently see.

Published October 3, 2009

During the past three years, the Federal Reserve Bank, led by Chairman Ben Bernanke, has reduced the Federal Funds Rate (FFR) from 5.25% to its present level which is a range from 0%-0.25%. While this 500 basis point reduction in FFR was occurring, our commercial real estate mortgage rates have remained fairly stable within the 5.75% to 6.25% range. This dynamic has implications for our future as many economists believe the FFR will be increasing, some say significantly, within the next few years. So the question is: Will the Fed increase the FFR and,  if so, what will be the impact on mortgage lending rates. The answer to this question has tremendous implications for our investment sales market.

Before we get into more detail, let’s take a look at exactly what the Fed is and how it operates.

The Federal Reserve System was created by an act of congress on December 23, 1913. Also known as “The Federal Reserve” or “The Fed”, it is the central bank of the United States consisting of a Board of Governors and 12 regional reserve banks. These regional banks are located in New York, Boston, Philadelphia, Richmond, Cleveland, Atlanta, St. Louis, Chicago, Minneapolis, Kansas City, Dallas and San Francisco. The Board of Governors is a federal agency located in Washington DC. This board is made up of 7 members with no more than one member from each regional reserve bank.

The Federal Open Markets Committee (FOMC) consists of the Board of Governors plus five regional reserve bank presidents such that each bank has representation on the committee. The FOMC is the group that makes key decisions affecting the cost and availability of money and credit in our economy which is known as monetary policy.

The Federal Reserve uses three main tools to implement monetary policy: open market operations, the discount window and reserve requirements. The most important of these is open market operations.

Through open market operations, the Fed buys and sells U.S. Treasury securities, trading with accredited primary dealers. When the Fed buys these securities it adds extra reserves to the banking system which puts downward pressure on the highly sensitive federal funds rate. When the Fed sells Treasury securities, it drains reserves and puts upward pressure on the FFR.

The level of the FFR is a target rate set by the Fed which has a significant impact on the marketplace as it affects yields on treasuries and, therefore, the cost of borrowing for other banks. The FFR is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. In June of 2006 when the FFR was 5.25%, if mortgage rates were around 6%, the spread for the bank was very narrow. The spread can be thought of as the profitability on each dollar banks lend. Today, with the FFR near zero and commercial mortgage rates still around 6%, the spreads banks are making is significant.

During his chairmanship, Alan Greenspan was applauded for the interest rate policies of the Fed. Today, it is largely agreed that, during this period, he kept rates too low for too long. In May of 2000, the FFR was 6.5% and by December of 2001, the rate had dropped to 1.75%. It fluctuated between 1% and 1.75% through 2004 and remained below 3% through mid 2005. Economists agree that this monetary policy exacerbated the asset bubbles which drove residential and commercial real estate values through the roof.

Today, our near zero FFR is providing the banking system with an opportunity to recapitalize itself. Solvent banks are making significant profits each quarter as they are borrowing at very low rates and lending at spreads ten times greater than they were two years ago. This is one of the many reasons for the slow drip of distressed asset out of what, we all know, is  a very jam packed pipeline.

Banks are getting very comfortable with these generous spreads and the question this piece is looking at is, what will happen to this spread when the FFR rises. During the past 11 months, the government has committed to a doubling of the U.S. money supply. This increase is larger than the aggregate increases in our money supply over the past 50 years. This massive increase has economists concerned that inflation will inevitably result, and in a very big way.

The Fed has historically had a comfort level of an inflation rate in the 1% – 2% range. Should inflation rise above this level, the Fed would use monetary policy to raise rates in an attempt to subdue it. This is referred to as tightening. Should the Fed raise the FFR, how will banks respond? Will they correspondingly raise mortgage rates to preserve the wide spread they are getting accustom to or will they keep their rates fairly stable and allow spreads to moderate? The answer could have a profound affect on the value of investment properties.

In New York City, a 25 year historical study, completed by Massey Knakal, of multifamily capitalization rates compared to mortgage rates is very illustrative of leverage cycles. In the mid and late 1980s, we see an extended period of negative leverage. “Negative leverage” is a condition in which cap rates are lower than mortgage rates. “Positive leverage” is the reverse. This negative leverage period was caused by the co-operative conversion craze the market was experiencing (up to and throughout the 1980s, to New Yorkers, condos were something retired Floridians lived in).

After the Savings and Loan Crisis in the early 1990s, lender underwriting standards became more conservative and investors became more cautious. This led to an extended period during which the market saw positive leverage; cap rates were higher than mortgage rates. This condition lasted through 2003. Then the low FFR rate environment began to tangibly take hold of the market , the condo conversion market went wild and a period of negative leverage followed repeating conditions experienced in the 1980s.  Where are we now?

Capitalization rates on all property types are increasing and, while the multifamily market is still in a negative leverage condition, it is teetering on a switch to positive. All of our other property type sectors are already in a state of positive leverage (if you can get leverage).

If history repeats itself, and we are going to be heading into a prolonged period of positive leverage again, the answer to the question of how banks will respond to the Fed tightening monetary policy is significant. If the FFR goes back up to 5% -6%, mortgage rates could hit the high single digits. With a positive leverage condition, cap rates would then hit double digits. Can you imagine the additional distress that condition would cause?

Fortunately, inflationary pressures have been moderate and are not expected to be above trend in the short term. When it does emerge, the Fed will react, and lenders will have to decide what their lending rate policies will be. After last week’s meeting of the FOMC, one of the members hinted that the tightening may begin sooner than anyone expects. What the Fed does and how lenders react is something to watch very closely.

Published October 10, 2009

If you are a frequent reader of StreetWise, you know that I am always following trends in unemployment, and for good reason. There is no other metric that more profoundly affects the fundamentals of our real estate markets.

If someone has lost a job or believes they may be losing a job, they will typically not move into a larger rental apartment or decide to move from a rental unit into a newly purchased condo or single-family residence. If employers are reducing the size of their staff, they no longer need the same amount of office space. These people watch their spending and tend to travel less. The effects on retail sales and hotel performance are obvious.

The news on the unemployment front of late has not been positive. The Bureau of Labor Statistics currently pegs the unemployment rate at 9.8% meaning that approximately 8 million jobs have been lost during this downturn. This rate has more than doubled from 4.8% just 19 months ago.  The cumulative job losses over the past 9 months have been far greater than during any other 9-month period since World War II, including the military demobilization after the war.

The job losses now exceed the net jobs gained over the previous nine years, making this the only recession to wipe out all job growth from the previous expansion since the Great Depression. Private sector payrolls today are lower than they were at the end of 1999.

The stress in the job market appears to be understated by the BLS as the calculation of unemployment was modified during the Clinton administration to make the numbers appear more benign. Nearly 2 million people are unemployed but have given up the search for work. If they have not been actively looking for a job within the 4 weeks preceding the latest survey, they are no longer counted as unemployed.

Part time workers who would prefer to be employed on a full-time basis are also no longer counted among the unemployed. The number of these “underemployed” workers has more than doubled in this recession to over 9 million, representing about 6% of the workforce.

If we add those who have given up the search for a job and the underemployed to the government’s estimate of 9.8%, the unemployment rate jumps to over 17%. And even this does not tell the entire story.

Nearly every day we read about additional companies that are asking employees to take unpaid leave or furloughs. They are not counted among the unemployed. The average work week for rank-and-file employees in the private sector, which makes up about 80% of the workforce, has been reduced to less than 33 hours. This is nearly an hour less than it was before the recession began and the lowest level it has been at since the government started tracking this data in 1964.

The average length of unemployment has now reached 26.7 weeks, the longest time period since this data has been tracked going back over 60 years.

These statistics do not bode well for the administration’s stimulus plan which was implemented initially to create 4 million new jobs. After the $787 billion package was passed and it became clear that there was nothing in the plan which would induce job creation anywhere near this magnitude, the goal was changed to 4 million jobs “created or saved”. We all know it is nearly impossible to prove what jobs were saved.

When will these jobs return? Not only do we need to replace the 8 million lost jobs, but our economy needs an additional 100,000 jobs per month to keep up with population growth. Even if job growth returns to the rapid pace of the 1990s, during which we were adding 2.5 million public sector jobs per year (double the 2001-2007 pace), the U.S. wouldn’t get back to a 5% unemployment rate until late in 2017. Other estimates are more bullish putting the estimated date in 2014. An estimate which is troubling for the commercial real estate market is that unemployment is expected to remain above 8% through 2012.

Many economists have stated that the economy recently entered recovery mode. It is important to note, however, that without jobs, you don’t have a genuine recovery. Consumer spending is the economy’s main driver and without job growth and pay raises, consumer spending will not revive substantially. This is particularly true because alternative sources of spending power, including home equity and credit cards, are largely tapped out.

During the last recession, in 2001, the number of jobless people reached a little more than double the number of full-time job openings. By the beginning of this year, job seekers outnumbered jobs four-to-one and, today, the ratio has reached six-to-one.

As the economy gets tangibly healthier, there is a fear that employers will continue to make strides wringing more production out of fewer workers. Even as demand picks up, they may be able to hold off on hiring.

There is some hope that the job market may rebound more quickly. One thing different about this recession is that so many of the job losses have been at service-related companies that have come to dominate U.S. employment. Since the recession began, 3.3 million service sector jobs have been lost, a 2.9% decline which is the largest recorded since 1939. In comparison, the previous two recessions each saw service sector jobs fall by only 0.5%. Service-related firms may have a more pressing need than manufacturers to rehire workers as demand comes back.

A key question remains: How bad do things have to get before the Obama administration and Congress make job creation a priority? The speed with which the health of our commercial real estate market returns may just depend on the answer to that question.

Published October 18, 2009

The volume of investment sales recently has been extraordinarily weak whether you look at aggregate sales price or number of transactions. In fact, we are on pace to see sales volume hit the lowest level we have seen in the 26 years we have been tracking these statistics.

Our recently completed analysis of the Manhattan property sales market, through the first three quarters of 2009, shows only $3.2 billion in volume: a remarkable reduction in the aggregate sales price of 82% from the first three quarters of 2008 and 92% from this cycle’s peak in the first three quarters of 2007. For those of you familiar with the Manhattan market, our study analyzes sales which occurred south of 96th Street on the eastside and south of 110th Street on the westside.

In the first three quarters of 2009, there have been 209 Manhattan sales. This number of transactions is down by 60% from 2008 and 75% from 2007.

The above data would lead one to believe that people are just not interested in purchasing investment properties in New York. Nothing could be farther from the truth. We have noticed trends in the marketplace and have been saying that the market is in a severe supply constrained dynamic since the middle of 2008. This is now manifesting itself in a very low volume of sales activity.

Average property value has falled in New York by 32% from its peak levels. Clearly, this percentage varies depending on product type and building classification. Multi-family properties have been performing best, having lost only 16% of value while office buildings with significant exposure to the marketplace have been the most negatively affected, seeing a reduction in value of about 70%.

These reduced values have peaked the interest from the buying community as investors are looking for core assets at greatly reduced prices. Conversely, discretionary sellers are seeing these pricing trends as a tangible reason not to place properties on the market at the present time. The difficulties in the financing market have been a major contributing factor to the reduction in value. With banks underwriting more conservatively, additional equity is required and , therefore, prices buyers can pay have been going down. We are all aware that equity costs a lot more than debt does.

This supply constrained environment is illustrated in the listing’s portfolio of my firm, Massey Knakal. At the height of the market in the first half of 2007, we had, at one point, 836 exclusive listings. Today, we have just 513 and have been below 600 for the entire year (I am only using Massey Knakal data because this exclusive listing data is not readily available from any of the research firms as brokerage companies are not required to publicly divulge their exclusive listings ).

These dynamics have not, however, reduced demand for New York City investment properties. For the transactions that we have marketed and sold thus far in 2009, we’ve been pleasantly surprised by the number of bids we have received. For stable cash flowing properties,  we have received dozens of offers on each listing. Properties which are vacant or have a value-added component have also seen above trend numbers of offers.

Most interestingly, for the notes that we have sold for lenders thus far in 2009, we have had in excess of 50 offers for each of them. Where is this demand coming from?

Institutional capital was a significant driver of the increase in values in the 2005-2007 period. When the credit crisis tangibly took hold in the summer of 2007, this institutional capital all but evaporated. Fron the summer of 2007 until recently, nearly all of our properties have been sold to high net worth individuals and old-line New York families that have been investing in the city for decades. These buyers remain very active today and continue to seek opportunities to buy well located assets at today’s reduced values.

Additionally, we have seen tremendous interest from high net worth foreign based purchasers. Remarkably, these foreign purchasers are typically not real estate professionals in their countries of origin. They have made money in other industries such as technology, manufacturing or financial services. They are choosing to deploy theri capital into the U.S. which is perceived to be at the very low pint in the value cycle. We have not seen the influx of foreign capital that we have seen recently since the mid-1980s.

In addition, on the demand side, we have seen resurgence, within the past month or two, of institutional capital. As I mentioned earlier, this capital all but evaporated from the marketplace in the summer of 2007 and many of these institutional real estate players have formed distressed asset funds looking to buy properties. These funds are now in the market actively bidding on opportunities.

This all leads to an extremely healthy demand side for New York investment properties.

We remain hopeful that the supply side of the equation will get better as distressed assets appear to be coming to the market in slightly better numbers than we have seen thus far in the cycle. There have been a number of legislative changes that have created tremendous inertia within the distressed asset marketplace but, notwithstanding these modifications, we believe that fundamentally troubled properties will ultimately come to the market, in one form or another, before too long adding to our supply. This would certainly be a welcome happening for the brokerage community and all of the purchasers waiting for opportunities.

Published October 25, 2009

So often I hear people in our industry say that the weak dollar is encouraging foreign investment in U.S. real estate. This is something that only makes sense in two ways: the first is if the foreign investor is purchasing a residential property for his or her own use and it is simply “cheap” to them because of the exchange rate. Think of the opportunity to buy a mansion on the water in the south of France for $10,000US. If this location is of interest to you, you might just buy that property because it is so cheap that you figure, why not?

The second reason a foreign investor might buy based upon the weak dollar is if they are looking for a currency arbitrage ie, they believe that the U.S. dollar will increase in value at a greater rate than their currency will increase.

Other than these reasons, the weak dollar is not a motivator. Consider this: if an investor purchases an income producing property because of a weak dollar, their gross revenue will be in that weak dollar, they will pay expenses in that weak dollar, they will collect net operating income and cash flow in that weak dollar and if they sell the asset, they receive the sale proceeds in that same weak dollar. That doesnt sound like great motivation to me.

Why is the dollar weakening as much as it has lately? Look no farther than the weak jobs numbers that come out month after month. With unemployment at 9.8% and climbing, it convinces markets that monetary policy will remain loose regardless of dollar weakness.

The dollar’s weakness also partly reflects fears that the economic recovery will take a lot longer than most economists anticipate. Besides being a deterrent to buying into America’s future, this sets up a classic deflationary mindset: Why buy now if the dollar may be even weaker in a few months?

You have to believe that the Obama administration wants the dollar to remain weak regardless of what they say publicly. The greenback has lost 11.9% of its value against a basket of currencies since the President took office. Treasury Secretary Geithner constantly says, “It’s very important to the United States that we continue to have a strong dollar…We’re going to do everything necessary to make sure we sustain confidence.” Unfortunately, the U.S. is willing to talk about a strong dollar but is unwilling to do anything about it.

With the amount of dollars that are being printed, it is no wonder that the dollar is increasingly perceived as the default mechanism for out-of-control government spending and, with this condition, its role as a reliable standard of value is destined to fade. Excess government spending leads to inflation, and inflation plays dollar savers for fools at home and abroad.

For now, the weak dollar helps our exports, by making them cheaper abroad, a welcome development at a moment of domestic economic weakness. Cheaper U.S. goods overseas could help achieve the long-sought rebalancing of the global economy in which the U.S. exports more, and others, including China, import more.

Public officials have been saying that the United States needs to become less dependent on domestic consumption which now makes up 70% of our GDP. Although politicians won’t say this means we need a weaker dollar, many economists take this as a given if rebalancing is to be achieved. This is one reason why all of the “strong dollar” talk coming out of Washington is not taken seriously.

One of the ways a country gets out from under its debt burden is to devalue its currency. On the surface a weak dollar may not look so bad to those on Wall Street. Gold, oil, the euro and equities are all rising as the dollar declines.

Some weak-dollar advocates believe that American workers will eventually become cheap enough, in foreign currency terms, to win manufacturing jobs back. In actuality, however, capital outflows overwhelm the trade flows, causing more job losses than cheap real wages create.

The unfortunate fact for the weak-dollar advocates is that no countries have ever devalued their way into prosperity.

If money is a moral contract between a government and its citizens, we are in a vulnerable position while the rest of the world simply wants to avoid having the wool pulled over their eyes. This is why China and Russia, the two largest holders of dollars, are advocating for a new kind of global currency for denominating reserve assets. It is also why OPEC is growing increasingly anxious about whether to continue pricing oil in depreciated dollars and why central banks around the world are turning their backs on dollars in favor of alternative currencies. This reduced global demand exacerbates the dollar’s decline.

If the President and Congress are serious about wanting a strong dollar, they need to show a genuine commitment to private-sector economic growth. The solution includes some key ingredients such as a strong U.S. jobs program, a flatter more competitive tax structure, significant reductions in future spending and common sense bank regulation so small business lending can restart.

In the short run, the weak dollar may bring international travelers to our cities and help our hotel industry but, if we are interested in real growth and long term prosperity, we need a stronger U.S. dollar.

Published November 1, 2009

This past Thursday, the government announced that our Gross Domestic Product – a broad measure of the economy that sums up all the goods and services produced in the U.S. – increased at a rate of 3.5% during the third quarter of 2009. The Dow Jones Industrial Average has been hovering around 10,000 and housing market indexes have been positive for months. These statistics might lead you to think that our economy was starting to briskly emerge from the recession, however,  let’s take a closer look at each of these green shoots.

During the third quarter of 2009, GDP did, indeed, expand after shrinking for four consecutive quarters, indicating an apparent end to the worst recession since World War II. The expansion was 3.5%, however, a majority of the increase was related to vehicle purchases and residential construction, both stimulated by government support. 2.2% of the increase was due to these two sectors and an additional 0.6% was attributed to government spending.

Additionally, inventories had been stripped to the bone and are now being rebuilt. In the third quarter, companies dumped inventory, though less aggressively than during the previous three months. By the math of GDP accounting, merely slowing down inventory liquidation will boost growth.

The most surprising result was the pace of consumer spending growth, although a significant portion of this appears to have been borrowed from the future. Consumers provided nearly two-thirds of the GDP growth with auto sales and parts alone adding 1% to the total. The cash-for-clunkers program stimulated significant increases in July and August sales but activity crashed in September after the program expired as demand was accelerated from future months.

The first time homebuyer’s credit has prompted residential investment to increase handsomely. Private residential investment, of which home building is a large component, surged 23.4%, the first increase in 14 quarters. This accounted for half a percentage point of GDP growth. We will look at this credit in more depth when we discuss the housing market.

Much of the growth relies on government spending or incentive programs which are either expired or expiring. Therefore, it is unclear if consumers and businesses have regained the strength to propel the economy on their own. Businesses remain cautious and American households are still burdened by mountains of debt, two factors that have economists predicting growth will slow considerably in the coming months.

The Dow Jones Industrial Average has closed near 10,000 for a couple of weeks as a healthy majority of firms have exceeded earnings expectations recently. Unfortunately, these earnings are the result of companies cutting jobs and working hours and squeezing costs mercilessly.

While 73% of firms beat earnings expectations, 58% had worse than expected revenue. High unemployment has created significant slack in the economy with tremendous excess capacity. Productivity has increased at a rate of 6.4% as employers are squeezing more work out of exisitng workers.  It is very typical to see productivity increases as an economy emerges from recession as firms wait until the last possible moment to begin rehiring.

These favorable earnings are, unfortunately,  not sustainable without revenue growth as there is only so much overhead that companies can eliminate.

With regard to the positive news coming out of the housing sector, most in the media point to the S & P Case Shiller Index. This index has seen strong gains for five months running. Unfortunately, many economists discount the accuracy of the index as it only tracks 20 markets, representing only approximately 38% of all homes in the U.S.  It is thought that this index overshoots reality both on the upside and the downside.

While the housing numbers appear positive, economists warn not to make too much of them because low prices and low mortgage rates, along with the tax credit, have spurred a home buying bonanza, at least in the low end of the market. Roughly one-third of home resales are foreclosures or short sales, where the mortgage exceeds the sales price.

The $8,000 first time homebuyer credit has catalyzed much of the activity in the sector and there is good reason for this. The average home price in the U.S. is $178,400. Given FHA’s 3.5% downpayment requirement (which amounts to $6,244 for the average home) the government is, essentially, paying people to buy a home.

This program has been ripe with fraud as is often the case with government run programs, particularly those with “refundable” credits that guarantee that claimants will get cash back even if they paid no taxes. A lack of documentation requirements make this program a layup for scammers ( You really couldn’t even make this stuff up!).

The Treasury tax-oversight office said at least 19,000 filers who hadn’t purchased homes claimed $139 million in tax credits and were reimbursed. Officials have found an additional 74,000 tax credit claims, valued at $500 million, where evidence of previous homeownership could make their claims invalid. More than 500 people under the age of 18, including a 4-year-old child, also had their names on applications for the credit which has no minimum age requirement. Most of the claims involving children were made by parents who purchased homes but would not qualify for the credit because their incomes were too high.

These problems show the dangers in creating refundable tax credits that give money to filers even if they don’t owe any taxes. The Internal Revenue Service and Justice Department are investigating more than 100 suspected criminal schemes involving the credit. The IRS is conducting more than 100,000 examinations that could require filers to give back the credit and pay civil penalties.

This program was set to expire at the end of November, so naturally given its record of abuse, Congress has extended and expanded the program. Not only is the program extended into 2010 but now existing homeowners, who have owned their present home for at least 5 years, can qualify for a $6,500 credit in the event of a new purchase.

So let’s recap the housing situation: 1) the government is providing tax credits to buyers through which buyers are “paid” to purchase a house; 2) there are no documentation requirements for the reciepients of the credit; 3) the government guarantees 92% of all single family mortages through Fannie, Freddie or FHA; 4) the government purchases most of those mortgages. Does everyone on Capitol Hill have amnesia?

While the credit seems to have boosted home sales, many of those sales would have happened anyway and have merely been stolen from the future. Meanwhile, the credit continues to distort the housing market and delays the process of home prices achieving a natural bottom which would serve as the basis for a fundamentally sound recovery.

There has only been modest growth in business investment which reveals how wary companies are about taking new risks or committing to expensive projects or new job creation in the current political and economic climate. The fiscal stimulus has pounded the federal balance sheet. With a deficit of $1.4 trillion in 2009, and $9 trillion more predicted over the next decade, every investor and business in America can see a gigantic tax bill coming right at them. The House health-care bill, which was released last week, takes another major wack at the job creators who own small businesses. The uncertainty of the Washington policy outlook is, no doubt, putting a significant crimp on future investment plans.

The simple truth is that without a recovery in the job market, consumers will not be able to carry the expansion for long and real growth is just an illusion. I guess it was heartening when, last week, after the recession has been with us for 22 months, Nancy Pelosi finally said the the focus has to be on job creation. Washington’s current policy makers are growing increasingly concerned about the jobless rate and the looming mid-term elections in 2010. They should, however, remember that the best way to nurture an expansion isn’t to feed it recklessly with easy money and more stimulus in order to meet an election timetable. Let the economy’s natural animal spirits revive at their own pace.

We are certainly in a better place than we were one year ago, but we still have a long way to go and should not be misled by data that inaccurately reflects reality.

Published November 8, 2009

I know what you’re thinking: Why is Knakal addressing unemployment yet again? Simply, it is because last week’s announcement that the official rate has climbed to more than double digits further illustrates that the administration is incorrectly focused on things other than job growth.

As I have always stated, our commercial real estate markets need employment more than anything else to enhance our fundamentals and turn our outlook around. As unemployment increases, our fundamentals degrade and as our fundamentals degrade, our values drop. Until the trend in unemployment reverses, it will be nearly impossible to see tangible health return to any segment of commercial real estate. Our rising unemployment rate begs the question: How did job creation get put on the back burner?

In October 2008 in Toledo, Ohio, a major economic speech was delivered by then candidate Barack Obama. Let’s take a close look at what he said:

“Right now, we face an immediate economic emergency, and that requires urgent action. We can’t wait to help workers and families….who don’t know if their jobs……will be there tomorrow. … We need to pass an economic rescue plan for the middle-class, and we need to do it not five years from now, not next year, we need to do it right now. It’s a plan that begins with one word thats on everybody’s mind, and its easy to spell: J-O-B-S.”

That sounds pretty good and is pretty powerful. That sounds like focus. Mr. Obama gave the impression that job creation would be his top priority and that his action would be swift.

Gandhi once said that, “Action expresses priorities”. If this is true, job creation has, clearly, not been one of the president’s priorities. Recently, the administration has begun talking about job creation but this provides little comfort as this recession began two years ago.

The results of the off-year elections in Virginia and New Jersey have demonstrated that Americans are increasingly believing that the administration should not be prioritizing health-care, climate change, and financial regulation while hundreds of thousands of people continue to lose jobs each month. Nearly 90% of those voting in these gubernatorial races said they were worried about the direction of the economy and the majority of those who held that view voted for the Republican candidate. Are we looking at another 1994 (a year in which we saw a dynamic shift in political power) in 2010? If jobs do not become the priority, we just may be.

Could it be any more obvious that the objective on Pennsylvania Avenue is to push an entire agenda through before power is potentially lost in the midterm elections? This could be a tragic policy flaw which could lead to relinquished majorities in the fall of 2010.

This lack of focus on jobs has resulted in an official unemployment rate of 10.2% (the highest since 1983) and an underemployment rate of 17.5%. The latter takes into consideration those who are out of work and have stopped looking for work and those who are employed part-time who are seeking full-time employment.

Clearly, job creation has dropped from a top priority to just one of many, and President Obama has been remanded to pandering for patience and offering excuses. On one hand he argues that there is some good news in the awful numbers as things are indeed getting worse but at a slower pace. On the other, he constantly reminds us that he inherited this mess. How long can he continue to do this? Fair or not, finger-pointing is not effective policy.

The administration now claims that the stimulus has “created or saved” one million jobs. Does anyone really believe that?  (Maybe if Congress spends another $787 billion, it can get the jobless rate up to 12%). The data upon which this claim is based is of extraordinarily low quality and are not reliable indicators of job creation or the even vaguer notion of job retention. There are two major problems with the data. The first is a strong reporting bias. Those providing data are those who have received stimulus funds. If they are creating or saving jobs, they are likely to get more free money, hence, a strong incentive to inflate reality.

The second is that the government is using what is referred to as “gains-only” reporting.  When the government reports this figure, it wants us to believe that the new hires came from the pool of the unemployed and that they are net additions to the stock of employed workers. The data do not speak to the number of workers who left their current jobs to fill government sponsored jobs.  Because these data do not tell us where the workers come from and what happens to the positions they left, the numbers cannot answer the ultimate question: How many net jobs were created? The government is reporting the gross positive figures, not the relevant net figures.

On a monthly basis, the Department of Labor reports activity from the Job Openings and Labor Turnover Survey (Jolts). The Jolts data show that, in August of 2009, about 4 million workers were hired. Unlike the administration’s new jobs-created-or-saved data, the Jolts data also lets us know that about 4.3 million workers lost their jobs. How difficult is it to figure out what the relevant numbers are?

It is difficult to imagine a more complete repudiation of Keynesian stimulus than the recent evidence in our job market. Only 11% of the stimulus money is actually stimulative (spent on infrastructure) with significant percentages being spent on pork projects and non-stimulative transfer payments such as Medicaid and jobless benefits. The net effect is that net job creation has been negative. The much ballyhooed Keynesian multiplier that every dollar of government spending yields 1.5 times that in economic growth has, once again, been exposed as false. Few people remember that Keynes developed his theory when government spending only represented about 2% of GDP, a far cry from where it is today.

The policy lesson here is for both political parties (if you are  a frequent reader of StreetWise, you know that I try to critique both parties equally and, I believe, fairly). In 2008, President Bush caved-in and initiated the first “stimulus”, a $160 billion program that was ill-conceived and not very stimulative. Mr. Bush lost policy bearings during his last year and forgot that in order for a tax cut to be stimulating it must be immediate, permanent and at the margin of the next dollar. Instead, for the past two years, the U.S. and most of the rest of the world have been pouring trillions into a Keynesian black hole. Let’s not forget that this spending must be paid for at some point. Tax increases are inevitable and this expectation continues to stifle consumer spending.

If the administration is serious about wanting to create jobs (a by-product of which would be to help our commercial real estate markets) the best policy action would be to ask themselves and Congress, Why?…..

Why create so much investment uncertainty and additional barriers to businesses hiring new employees?

Why raise the costs of doing business by making it easier to unionize workers via “card check”?

Why raise energy costs for businesses with a cap-and-trade (“cap-and-tax”) bill?

Why add to an already inflated budget deficit and future tax burden with a 12% increase (proposed in the draft budget) in domestic spending in 2010?

Why force through Congress, on a partisan vote, a health-care bill that imposes a 5.4% income tax “surcharge” on anyone making more than $500,000? The Joint Tax Committee reports that about one-third of this $460.5 billion tax increase will be paid by small business job creators who file their taxes under the individual income tax code.

Perhaps someone should read Mr. Obama a transcript of his Toledo speech. Then maybe he will be reminded that he cannot wait for next year, he needs to act now and, very simply, it’s all about J-O-B-S.

Published November 15, 2009

Whose kidding whom? Sellers will only sell if they want or need to and buyers will only buy if they believe they see a good opportunity. Brokers can’t “sell” a client into acting but I wanted to discuss some reasons why sellers might want to sell today and buyers might want to buy today.

Clearly, there is tremendous uncertainty in today’s investment sales market. Values are far below their peak and are expected to continue dropping. The volume of sales is also far below its record peaks as activity has ground to a halt. As a broker who sells buildings, the level of sales activity is far more important than the direction of prices. The activity just has not been there in 2009.

I am asked several times each day by clients who would like to purchase properties if the time is right to buy. They think prices will continue to drop so the inevitable question is, “Why not wait until prices hit bottom?”. Potential sellers constantly ask when the optimal time to sell is ( I rarely suggest that sometime in 2006 or 2007 would have been optimal). “If I wait a few months will prices be better?” and “How long do I have to wait until my value will be higher?” are the most frequently asked questions from them. As uncertainty rules the day, how do I answer these difficult questions without sounding self-serving? 

Let’s take a look at current market conditions to set the stage for the discussion of perspectives relayed to buyers and sellers. I will discuss conditions in the New York City market as that is the only market I know. I assume most markets around the country are experiencing similar dynamics, to differing degrees perhaps, but still heading in the same direction.  

Using the Manhattan marketplace, for example, in the first three-quarters of 2009, there were 209 investment property sales having an aggregate sales value of $3.2 billion. The $3.2 billion in sales represents a 92% reduction from the activity in the peak three-quarters of 2007 in which there were $40 billion in sales. The 209 properties sold represents a reduction of 74% from the peak number of properties sold in the first three-quarters of 2007 which totaled 803.

The Manhattan market has a total of 27,649 investment properties (south of 96th Street on the eastside and south of 110th Street on the westside). Over the past 25 years, the average turnover of this stock has been 2.6% or approximately 719 sales. The lowest turnover we have ever seen was 1.6% in 1992 and 2003, both years were at the end of recessionary periods and both years experienced cyclical peaks in unemployment.

If we annualized the activity in the first three-quarters of 2009, turnover was running at 1.0%. (It is actually trending up as, in the first quarter, the volume was running at 0.7%, in the first half it was 0.9% and 1.0% for the first three-quarters). We believe turnover will finish the year at 1.1% to 1.2%, establishing a new low since we began tracking this data in 1984. 

In the Manhattan market, the average sales price in the first three-quarters of 2009 dropped an average of 32% from the peak prices achieved. In order to understand this reduction more clearly, we need to look at how different property types are performing. 

Multifamily properties have performed best with walk-up properties having lost only 16% from the peak with elevatored properties dropping 20%. Given the fact that consumer spending has been greatly reduced, retailers have had a difficult time which has resulted in large reductions in retail rents. It is, therefore, not surprising that mixed-use properties (those having at least 20% of their square footage occupied by retail tenants with apartments above) have lost 46% of value while retail properties have lost 49% of value from their cyclical peak.

Office buildings have lost 62% of their value from the peak. However, if we look at office properties which are well-leased on a long-term basis without market exposure, average values have dropped only 25%. Those with significant vacancy, or a large percentage of leases rolling in the short-term, have seen values fall by 70%.

We believe that value will continue to fall into 2010 as unemployment continues to rise. As unemployment rises, real estate fundamentals become stressed and as fundamentals become stressed, value falls. Economists expect unemployment to peak in the first half of 2010. It is at this point that fundamentals will be at their weakest and value will, presumably, be at its lowest.

Why should sellers sell today?

With values well below their peak and expected to fall a little more, why should a seller sell today? As counterintuitive as it may be, there are several reasons why a seller could benefit from selling today. This, of course, assumes that an owner is compelled to sell or has some external pressure motivating them to sell within the next year or two.

The first thing to consider is that the extremely low volume of sales has been caused by supply constraint not a lack of demand. The fact is that demand is significant. We have received dozens of offers on each of the income producing properties we are selling and have received over 50 offers on each of the notes we have sold this year.

Additionally, there is a massive amount of capital sitting on the sidelines waiting for an opportunity. We can refer to this patient capital as “shadow demand”. Much of this is from institutional distressed asset funds which are currently being pressured by their investors to show some activity. The lack of supply has created frustration for these funds and their appetite is currently very large.

Another reason to put a property on the market today is that the supply of properties available for sale is extraordinarily low. The massive demand that is chasing few assets is actually driving property prices above the level that fundamentals would dictate (notwithstanding the price reductions we have already seen). It is anticipated that distressed assets will be coming onto the market in significant numbers over the next couple of years which will provide more choice for investors, placing downward pressure on prices.

Potential sellers should also consider that prices have not yet hit bottom and they may be able to get out prior to the market hitting its bottom. Value will be lower in the future before it increases.

Financing, particularly for smaller multifamily properties, is plentiful from portfolio lenders for cash flowing properties. Community banks and small regional banks have remained very active and continue to look for additional opportunities.

Additionally, mortgage rates are very low by historical standards providing buyers with the ability to pay a relatively aggressive price. Given how much the Fed has increased the money supply and has increased spending, there is nowhere for rates to go but up. We will have to pay for these policies in the form of higher long-term interest rates , higher taxes or, most likely, a combination of both. As mortgage rates increase, values will face additional downward pressure.

Today’s market also provides an opportunity for portfolio reallocation. Several clients are looking to sell “maxed out” properties or smaller, non-core assets in order to take advantage of the more reasonable pricing of core assets.

Why should buyers buy today?

So, with value expected to drop further, why should buyers look to purchase now. The first reason is that it is nearly impossible to time the exact bottom of the market. Value has fallen so much already that it is expected to bottom out in the short-term, only falling another 10% or so. If this is the case, and a buyer has a long-term investment strategy, buying today may not be such a bad move.

The supply of available properties in New York is always very low. If you consider that the average turnover rate during a 25 year period has been 2.6% of the total stock, this means the average holding period is 40 years. Yes, some properties like the GM building have traded several times within the past 15 years but properties like that are offset by properties which have been owned for over 100 years by the same family. For these reasons, when an asset becomes available, if an investor wants to own that asset, they should move on it because is will likely not be for sale when the buyer decides the market has hit bottom. (We will only really know we have hit bottom after we have emerged from it.)

If a buyer believes that the government’s reaction to the recession will lead to inflation, hard assets are great things to own in an inflationary environment. Commercial investment properties are excellent hard assets. Investors would want to ride the upswing in inflation but with inflation comes Fed tightening and higher interest rates. However, if properties are purchased now, locking in today’s low rates on a long-term, fixed-rate basis, they will be sitting pretty when inflation hits.

After the market hits bottom, we expect value to just bounce along the bottom for 2 or 3 years as the market goes through deleveraging. Whether, and to what extent, properties appreciate will be dependent upon a fight between upward pricing pressure created by excessive buying demand and downward pressure created by the massive deleveraging that will be necessary as 2006 and 2007 vintage loans mature in 2011 and 2012.

Regardless of the incentives created by the dynamics mentioned above, we still believe the volume of sales in New York City will be lower than the 1.6% level in 2010. We hope that we are wrong but the congestion in the distressed pipeline is not expected to loosen up until the later half of the year.

So, should sellers sell and should buyers buy? The answers to these questions will be decided by participants in the market and the timing of these decisions will determine who the winners will be coming out of this downturn. One thing is clear, a significant transfer of wealth will occur over the next few years and the results for each individual (other than those who are forced out of positions by lenders or note buyers foreclosing on them) will be based upon how they answer those two questions and the timing of the decisions they make.

Published November 22, 2009

This recession has hit the U.S. very hard causing an unprecedented level of government intervention. Trillions of dollars have been committed in spending, bailouts, tax credits and guarantees.  Eventually we must  pay for these financial commitments and we pay for them in the form of higher long-term interest rates, increased taxes or, most likely, a combination of both.

Not only is the federal government running massive and record-setting deficits but most states are in the same position.  While the fed is presently committed to keeping interest rates low (we know they will have no choice but to tighten monetary policy at some point), the tax picture is another story. There is no doubt that taxes are going to increase and increase across the board.  Federal, State and local taxes are going to increase and everyone, even those who were promised no tax increases constantly in pre-election speech after speech after speech.

The Bush administration’s tax cuts sunset at the end of 2010 which will push the federal capital gains rate up from 15% to 20%. It is expected that the present administration will raise this rate also by only three to five percent. They can get away with what looks like a small increase because they are not responsible for the 5% increase already built into the system. So we could be looking at a 23% to 25% capital gains rate beginning in 2011. But wait, there is more….

The healthcare proposals that are going to be debated in congress have politicians scrambling to find ways to pay for the (at least) $1 trillion program. In order to achieve their objective of making this program appear deficit neutral, we are seeing some of the most creative accounting techniques used, most of which increase taxes and on, just about, everyone. Some of these techniques would even make Bernard Madoff blush. (For instance, under the healthcare proposal, we are theoretically deficit neutral because we count revenue over 10 years but spending over only 6. Revenue comes in beginning in 2010 but payments are not made until 2014. I wish we could account for profits this way in the private sector. ) But let’s get back to taxes.

For the first time in over 30 years, we may see the return of income tax bracket creep. Buried deep in the 2,000 page healthcare bill is a provision which will partially repeal tax indexing for inflation. What this provision means is that, as earnings rise over a lifetime, Americans can look forward to paying higher income tax rates even if their income gains are not “real”. Two main features of the current version of the plan are not indexed. The first is the $500,000 threshold for the 5.4% income tax surcharge (does the word “surcharge” really sound more benign than “tax”?). The second is the payroll level at which small businesses must pay a new 8% tax penalty for not offering employees health insurance.

Let’s take a look at the true impact of the surcharge. This tax is set to begin in 2011 on all income above $500,000 for single filers and above $1 million for those filing jointly. Assuming a 4% inflation rate over the next decade (not an aggressive assumption given our fiscal picture), the $500,000 threshold for an individual filer would impact families with the 5.4% surcharge at an inflation-adjusted equivalent of about $335,000. After 20 years without indexing, the surcharge threshold falls to about $250,000.  As the real inflation rate rises, these thresholds drop further.

This mechanism is a covert way for politicians to dig deeper into more worker’s pockets each year without having to legislate tax increases. The negatives of failing to index compound over time, producing a windfall for the government as the years go by hitting unsuspecting taxpayers.

This trick is nothing new and its impact is tangible. For example, in 1960, just 3% of tax filers paid a 30% or higher marginal tax rate. By 1980, the inflation of the 1970’s resulted in that share increasing to 33% of filers! These stealth tax increases, which forced more Americans to pay higher tax rates on phantom gains in income, were widely thought to be unfair. In response, in 1981, as part of the Reagan tax cuts, indexing the tax brackets for inflation was adopted by a bipartisan coalition.

Another example of the impact of this stealth, inflation-ruse, technique can be seen in the performance of the Alternative Minimum Tax. In 1969, when this tax was first passed, it was intended to only hit 1% of all Americans. In 1993, the Clinton administration increased the AMT tax rate. At neither of these times was the tax indexed for inflation. As a result, the number of families hit by this tax more than tripled over the next decade. Today, unless congress passes an annual “patch”, families with incomes as low as $75,000 can be affected.

Importantly for our real estate industry, the 5.4% surcharge has been creatively written to be applicable to modified adjusted gross income. This means it applies to capital gains taxes. Piled on top of the increase caused by the sunsetting of the Bush cuts, our 2011 federal capital gains tax rate would balloon to 25.4%, even without any additional increases imposed by the present administration. If congress acts as expected, the new rate could top 30%.

With such a dramatic increase in the capital gains rate, sellers, who are considering the sale of commercial real estate in the short-term, must seriously consider the implications of this increased cost. Logic would dictate that this dynamic should catalyze an increase in sales activity in 2010 as seller’s rush to take advantage of the low 15% rate.  This increase in sales volume would be welcomed as 2009 will be, by a wide margin, the year with the lowest turnover (in terms of number of buildings sold) of investment property sales since at least 1984 (we do not have records prior to 1984).

The creative accounting in Washington could have another silver lining for our industry. Similar to the way the “modified adjusted gross income” includes capital gains, it also includes dividends. Adding the 5.4% surcharge to the increase caused by the Bush cuts sunsetting, the tax rate on dividends will explode from 15% to 45% ( 5.4% plus the pre-Bush rate of 39.6%). This dramatic increase would shift massive amounts of capital away from equities into other forms of investments, including commercial real estate.

I always try to figure out how our industry is affected by what goes on in Washington. While there may be some positives for commercial real estate, the present shenanigans are troubling. The return of the days without inflation indexing is nothing more than stealth taxation. It would repeal a 30 year bipartisan consensus that it is unfair to tax unreal gains in income. The result will be that millions of middle-class Americans will be hit with new taxes over time with taxes advertised as only hitting “the rich”.

Published November 29, 2009

I am often asked why I, a commercial building sales broker, pay attention to the residential housing market. It is because we landed in this recession due to stresses in the housing market and the roads leading out of the recession will run through the housing market as well. During the summer, that road seemed to be heading toward recovery.

Over the past few months, there have been some signs that the U.S. housing market had begun to stabilize. Some economists have even said that the market bottomed as early as the spring of this year. Let’s look at the reasons for the optimism.

Industry experts were cheering October’s new-home sales figures, which easily beat estimates by climbing 6.2%. Prices, which had been in free fall, dropped by the smallest margin in nearly a year. (The S & P Case-Schiller Index, which only tracks 20 markets suggests prices have been increasing for 5 months running). The National Association of Realtors reported last monday that sales of previously occupied homes in October jumped 10.1% from September to a seasonally adjusted annual rate of 6.1 million, the highest level since February 2007. The number of home listed for sale nationally was 3.57 million at the end of October, down 3.7% from a month earlier. Much of the sales activity was driven by buyers who rushed to claim the first-time home buyer’s tax credit before it was to expire on November 30th of this year. The number of homes for sale in September was 3.63 million, down 15% from a year earlier.

Mortgage rates have been at historically low levels. Mortgage backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae rose to their highest level of the year last week buoyed by strong investor demand. Risk premiums on the bonds, which measure their yield (moving inversely to the price), fell as low as 1.24 perceentage points above the yields of comparable Treasuries last Wednesday. The previous narrowest level was 1.29 in May. These dynamics have created an average rate on 30-year fixed rate mortgages at only 4.78%, which matches a record low from April. That rate was down from 4.83 the previous week and 5.97% a year ago.

If we look at the housing market dynamics more closely, however, it appears there is a good chance that government intervention may be creating a bubble of its own, artificially and unsustainably propping the market up.

Consider this: The average single family home price in the United States is $178,000. Most mortgages made today are guaranteed by the Federal Housing Administration which requires only a 3.5% downpayment (less in several circumstances) which is $6,230. With the $8,000 first-time home buyer’s tax credit, the government (the taxpayer) is paying people to buy houses (It has been estimated that 80% of the purchases that occurred using the credit would have occurred anyway so the “real cost” of the economic incentive to create a sale is $40,000, not $8,000). Buyers are utilizing artificially low interest rates as the Fed is buying a significant percentage of offered Treasuries to keep rates down. Without this quantitative easing, mortgage rates would be much higher. The Fed is also buying much of the residential mortgage-backed securities that are being sold. Between Fannie, Freddie and the FHA, the government( the taxpayer) presently guarantees 92% of all home mortgages in the country. To top it off, the government (the taxpayer) is also purchasing a substantial amount of these very mortgages that we, um – I mean the government, guarantees.  Does this sound vaguely familiar to you? Isn’t this type of shell game that got us into this mess in the first place?

We must not forget that the catalyst for most of the stress in the housing market was government policy aimed at increasing the homeownership rate through lowering mortgage lending standards. These policies began in 1977 with the Community Reinvestment Act (CRA) which targeted banks and encouraged them to increase lending in low- and moderate-income communities. From 1977 to 1991, $9 billion in CRA lending committments had been announced.

In 1992, congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, also known as the GSE Act (ironically, the name sounds so benign). The objective here was to force Fannie and Freddie to purchase loans that had been made by banks; loans that were made as part of the CRA. The GSEs had to do this to comply with the law’s “affordable housing” requirements. Since then, Fannie and Freddie have purchased over $6 trillion of these mortgages. The goal of community groups, of forcing Fannie and Freddie to loosen their underwriting standards in order to facilitate the purchase of loans made under the CRA, was achieved. Congress inserted language into the law encouraging the GSEs to accept downpayments as low as 5% or less, ignore impaired credit if the blotch was more than a year old, and otherwise loosen their lending guidelines.

The result of these loosened credit standards, and a mandate to make “affordable-housing” loans, created a massive pool of high risk lending that ultimately drowned the GSEs, overwhelmed the housing finance system, and caused an expected $1 trillion in mortgage loan losses by the GSEs, banks, and other investors and guarantors. Most tragically, there is an expectation that, at the end of this cycle, the U.S. will have seen 10 million or more home  foreclosures.

The refundable tax credit, available even if a family has no taxable income, will enable many more purchasers to buy a home, even if they are not qualified. But it could also bankrupt the FHA and, by doing so, would damage an already weak housing market.

This credit was initially available only to first-time buyers with a combined income of $150,000 or less ($75,000 for individuals). In 2009, about 40% of all first time buyers used the credit, so extending it was strongly supported by residential real estate brokers, home builders and their congressional allies. The recently passed extension (until April of 2010) makes the credit available, not only to first time buyers but, also to those who have owned a home for at least five years. In addition, it raises the maximum income for a qualified buyer to $225,000.

The first-time home buyers tax credit is expected to cost the Treasury about $15 billion in 2009, more than twice the projected cost when Congress approved the stimulus package (is it really hard to believe that the government could underestimate the cost of the programs it implements? – watch out healtcare reform!).

The problem here is that, as we discussed above, the FHA insures mortgages with such low downpayments that it can be funded completely by the refundable tax credit. Owners who don’t invest their own money into a house are much more likely to default on the mortgage. The FHA is already looking at a number of serious problems. Two weeks ago, the agency reported that its cash reserves, which are federally mandated to be no lower than 2% (down from 3% last fall) of its portfolio, had dropped to 0.53%.

The deteriorating quality of the FHA’s mortgage portfolio is a critical challenge to the housing market and the federal budget. A recent government audit concluded that the FHA would run out of money in 2011 and need a federal bailout if a recovery is not swift.

Presently, the percentage of U.S. homeowners who owe more on their mortgages than their properties are worth swelled to about 25% according to a report in the Wall Street Journal. Moody’ pegs this percentage at nearly 33%. Either way, this dynamic threatens prospects for a sustained housing recovery. These so-called underwater mortgages present a roadblock to a housing recovery as these properties are more likely to fall into foreclosure and get placed on the market, adding to an already bloated supply.

Over 40% of borrowers who took out a mortgage in 2006, when home prices peaked, are under water. In some parts of the country, home prices have dropped so much that borrowers who purchased homes five years ago now have negative equity. Even recent bargain hunters have been hit as 11% of borrowers who took out mortgages in 2009 already owe more than their homes are worth. Borrowers with negative equity are more likely to default and, today, about 7.5 million households are 30 days or more behind on their mortgage payments or are in foreclosure.

This level of negative equity has some economists projecting that housing won’t really bottom out until 2011. There are additional factors that lead to their conclusions.

The home sale statistics that are presented by the NAR and Commerce Department exaggerate activity as they double count some sales. If a foreclosure occurs and the bank sells the property to an investor at an auction who subsequently resells the house to someone who intends to live there, that counts as two sales. Additionally, “seasonally adjusted” numbers also will exaggerate the real level of activity.

Moreover, most of the sales activity is taking place in the areas which have been hit the hardest such as California, Southern Florida, Arizona and Las Vegas where we see the highest level of distress and very cheap condos, co-ops and single family residences.

Home prices are measured in three different ways: 1) median income to median sales price, 2) the cost of owning versus the cost of renting, and 3) the total housing stock value as a percentage of GDP. If we consider these three different methods of measuring home prices and affordability, it is possible to conclude that home prices have another 10% – 15% to adjust before the market actually hits its natural bottom.

All of the government intervention has prevented the market from hitting its natural bottom. No one wants to see people displaced but artificially propping the market up only makes things take longer to correct and simply delays the inevitable. The American consumer has had a long-held taboo against walking away from their home, but this crisis seems to be eroding that.

The Fannie and Freddie bailouts have already cost us $112 billion (and counting). How much will the FHA bailout cost? If housing values don’t recover, or the FHA cannot outrun its problems, the government audit suggests that FHA could ask for $1.6 billion by 2012. judging from history, that is probably a low-ball estimate.

Congress probably doesnt mind, however, because these liabilities are technically off budget, until they aren’t. i certainly hope the housing market recovers quickly but there appear to be many hurdles to overcome before this can happen.

Published December 6, 2009

Two years ago, almost everyone was discussing, and looking forward to, a tsunami of distressed assets which would be coming to market based upon the sub-prime mortgage crisis and the stresses it would exert on the credit markets in general. In September of 2008, when Lehman failed and Wall Street as we knew it was structurally transformed from an investment banking platform to one of bank holding companies, the “almost everyone” mentioned above was changed to “everyone”. But the tsunami has not arrived, not even close.

The fact that only a few distressed assets have been put in play is not because they aren’t out there. The pipeline is chock full of them.

Let’s use the New York City marketplace as an example. In the 2005-2007 period, there were $109 billion of investment sales in New York City. Based upon reductions in revenue (rent levels) across all product types including residential, office, retail and industrial and cap rate expansion, values have declined by 32%, on average, year to date. If we eliminate multifamily properties from this analysis, values have fallen from peak levels approximately 48%. Based upon these reductions, we estimate that, of the $109 billion spent on investment properties, $80 billion of that was spent on properties which now are in a negative equity position. This relates to about 6,000 properties.

If we include properties which were refinanced during the 2005-2007 period, the number of properties having negative equity jumps to 15,000. We estimate that there is about $165 billion in debt on these properties and, based upon today’s underwriting standards, there should only be about $65 billion in debt on them. This means that in order to have a conservatively leveraged marketplace, we would need to extract $100 billion in debt.

Clearly, this will not happen. Many investors have the ability to feed their properties and, based upon a desire to own them on a long-term basis, will do so. Other transactions will be worked out utilizing any of our favorite terms which have become commonplace in today’s vernacular including, “extend and pretend”, “delay and pray”, “a rolling loan gathers no loss” or “kicking the can down the road”. We do believe, however, that $30 to $40 billion will ultimately be extracted from the market in the form of losses.

So where are those distressed assets now? Some have not come to the market because they aren’t even in default yet due to mortgages which are still in interest only periods or are operating on an interest reserve set up by the lender when the loan was originated. Others have loans floating over 30-day LIBOR which closed on friday at 23 basis points (3-month LIBOR is only at 26 basis points). At 150 over LIBOR, the rate being paid on those loans would only be 1.73% and they can cash flow at those levels of debt service. While some properties are fundamentally under water, they are not yet in default, but likely will be when these advantageous terms expire.

Other distressed assets haven’t come to market because everything that has happened legislatively has allowed lenders to hide bad assets on their balance sheets. The FASB mark-to-market accounting rules have been modified to allow loss avoidance. Similarly, bank regulators will now allow lenders to hold a loan on their balance sheet at 100 even if they know that the underlying collateral for that loan is only worth 60. Additionally, modifications to the REMIC regulations have made it easier for CMBS loans to be kicked down the street.

Any of these delaying tactics will only be beneficial if appreciation is anticipated in the short-run. Given the massive deleveraging the market must experience and unemployment rates which are anticipated to remain elevated for at least another year to 18 months, we do not see support for the short-run appreciation argument.

We really don’t understand the reluctance of lenders to deal with these problem properties. Many of those that are in default are currently in the foreclosure process. This is a frustrating process, especially in New York, as it can take years to get through the process and obtain the title to the collateral. Many borrowers further complicate things by going into bankruptcy, which, based upon backlogs in the bankruptcy courts, adds additional time to the process.

It is very difficult to say this without sounding completely self-serving ( After all, I do sell buildings and notes for a living) but, if a lender wants out of a bad deal, selling a note today is likely to lead to a better recovery than waiting a year or two.

We believe this because the lack of product on the market toady has created a dynamic in which many investors are fighting over relatively few opportunities. Because of this, particularly on our income producing properties for sale, we are generally receiving 25 to 35 offers for each. Furthermore, on each note we have sold this year, we have received over 50 offers. This is due to the fact that buyers today would rather purchase from a lender than a private seller, believing they will get a better deal. “Believing” is the key word in the last sentence.

Due to the excessive demand for distressed assets, buyers are currently paying aggressive prices for anything banks are selling.  In many cases this year, we have obtained prices for notes that, we believe, are at or very near the value of the underlying collateral.

Some lenders are taking advantage of these dynamics to rid their balance sheets of underwater loans and are using the proceeds to make good loans today. Consider that two years ago, bank spreads, based upon all of the competition to put money out, were as low as 30 or 40 basis points. Those spreads can be 300-400 over corresponding treasuries today. Additionally, today’s loans have less risk associated with them as, rather than a loan to value ratio of 75%-85%, LTVs today are generally in the 60%-65% range. These loans are also significantly less on a price per square foot basis than they were two years ago.

If your business was 10 times as profitable as it used to be and there was much less risk involved, wouldn’t you be trying to do as much business as you could?

“Out with the bad, in with the good”, should be the mantra of lenders today. Until now, this has been slow to develop. To illustrate this, consider the following very telling statistics: Massey Knakal is asked by potential sellers to provide opinion of value reports and provide an explanation of our marketing program and we exclusively list about 31% of the properties that we are asked to analyze. It is just like a batting average in baseball, if we are hitting .300, we feel pretty good. With lenders and special servicers we are working with, we have completed just over 1,000 valuations and have exclusively listed just 12 properties/notes. That is a batting average of just .012. Many of these opportunities have simply not come to the market in any form. Perhaps the lender/servicer is waiting to see what the future will bring; perhaps they are simply making deals with the borrowers.

We have, however, seen this freeze thawing slightly as 2009 comes to a close. We expect to be coming to market with several distressed notes from lenders and special servicers right after the holidays and remain optimistic that we will be able to continue to achieve pricing at levels where the recovery versus collateral value is significant. There are also some foreclosures which should be concluding shortly which will lead to some REO which should be placed on the market shortly thereafter.

Let’s hope that 2010 sees a significant rise in these opportunities coming to market. It appears that the year will, at least, start out that way.

Published December 13, 2009

The U.S. economic recovery is very important to the commercial real estate recovery. As the economy recovers, corporate revenues will grow and companies will make profits. These profits will allow hiring to resume and as unemployment shrinks, people who get good jobs will resume renting apartments, buying residences and the companies that expand, will need more office space. Our commercial real estate fundamentals will improve and we will all be in a happy place once again.

How is the economy doing?

Equity markets have rallied, credit spreads are much better than they were a year ago and U.S. employment is showing signs of easing. The banking industry is making profits and consumer spending in November was up 1.3%, substantially better than the 0.7% that was projected. In the third quarter of 2009, GDP grew by 2.8% (revised down from an initial announcement of 3.5%). The housing market has expressed some positive signs as inventory is decreasing and it is suspected that as manufacturer’s inventories shrink, factory output will increase to restock bare shelves. In fact, the Institute for Supply Management reports that manufacturing had expanded for three months in a row. This may all sound pretty good but let’s not get too excited.

With regard to GDP growth, following postwar recessions, real growth, in the four quarters after the recessions were declared over, averaged 6.6%. During the five years following those recessions, the average growth rate was 4.3%.  While growth was 2.8% in the third quarter and is expected to be about 3% in the fourth quarter, most economists project growth to range from 1.5% to 3% for all of 2010.  If growth is limited in this fashion, it will be a new event for our postwar economy. There has not been a single deep recession that has been followed by a moderate recovery.

This may no longer be the case. The recession we have just emerged from (many believe we are still in the recession) lasted a record seven quarters and experienced a near-record average GDP decline of 1.8% per quarter. Based upon this, and history, we should be witnessing the start of a powerful and sustained recovery. However, all signals and projections from economists are that the recovery will be subdued at best.

Why all of the pessimism? There are economic reasons that support this pessimism and there are some philosophical reasons.

There appears to be a growing fear that the federal government is retreating from the free-market economic principles of the last 50 years. We have seen tangible evidence of this in many ways, most notably the anti-business and anti-Wall Street sentiment in Washington.

Some argue that the $787 billion stimulus was successful in that things did not get worse than they did. Others argue that only $86.5 billion of the stimulus money was targeted towards encouraging broad-based private investment and thus failed to stimulate true economic growth. With interest, the stimulus will cost the taxpayers $1.1 trillion. While this spending succeeded in temporarily and marginally increasing disposable personal income, it left personal consumption spending virtually unchanged.

Given the massive deficits created by the printing and spending of money in Washington, taxes will be going up across the board. We will see this in marginal income tax rates, capital gains rates, dividend rates and death-tax rates. Almost everyone will pay more taxes – significantly more. Hardest hit by these increases will be the new and small businesses whose investment and hiring decisions either drive or starve recoveries.

Business investment may be curbed due to the uncertainty created by extraordinary events like the administration’s intervention in the GM and Chrysler reorganizations. The mechanisms used by the government upset decades of accepted bankrupcy law by placing unsecured and lower priority creditors, like the United Auto Workers, in front of secured and higher priority creditors. This intervention has arguably had the effect of stifling investment as wary investors watched political considerations cast the rule of law aside.

Corporate earnings have been positive causing the equity markets to rally. However, earnings have been created by cost cutting and the productivity gains which generally follow prior to real recovery in the form of growing revenues. Thus far, revenue growth has been disappointing. Therefore, growth in corporate output will be far lower than what would normally be expected in a solid economic recovery. A crucial reason for this is the fact that bad assets on institutional (as well as personal) balance sheets are like a ball and chain strapped to the economy.

Near-zero interest rates are also creating some potential problems for our market. More than a year after the heart of the panic, the Fed is still promising near-zero interest rates for an extended period. They are buying over $3 billion per day of expensive mortgage-backed securities as part of a $1.25 trillion purchase plan. With the system somewhat stabilized, the Fed hopes that artificially low interest rates and its purchases of MBS will stimulate growth. Instead, they are pushing dollars abroad and wasting precious growth capital in asset and commodity bubbles.

Ironically, the near-zero rate policy, coupled with Washington’s preference for a weak dollar, has created a glut of American capital in Asia and other foreign markets as corporations and investors borrow in dollars and invest in other currencies and foreign assets. This creates a shortage of capital in the U.S.   For small businesses and new workers this capital rationing is devastating, advancing business failures and painful layoffs. Thousands of start-ups won’t launch due to credit shortages.

In a ninth consecutive decline, consumer lending shrank at an annual rate of 1.7% in October. This extended the dramatic evaporation of financing available to help fuel the economy. The $3.5 billion decline, calculated by the Fed, results in a 4% drop in consumer lending from its July 2008 peak. As our economy is 70% consumer based, curtailed lending to consumers could harm the chances for a strong recovery.

Moreover, it is not just consumers having trouble borrowing. Notwithstanding the perception that the economy and financial markets are recovering, many companies lack easy access to borrowing. All of the debt overhanging consumers and companies is the pivotal reason that we are seeing a free fall in bank lending. The nation’s lending markets have changed significantly as they adapt to post-crisis realities.

Markets where the U.S. government is either a big borrower or a defacto guarantor are ballooning. Simultaneously, corporate lending and consumer finance markets have shriveled. A Wall Street Journal report shows that these markets have shrunk by 7%, or $1.5 trillion, in the two years ending October 31st. The result of tighter lending is that consumers spend less and businesses are more reluctant to hire and invest.

Some of the decline in lending is due to lower demand as borrowers focus on paying down debt that they already have. In the past 25 years, household debt has exploded. It is now 122% of total disposable income, up from just over 60% 25 years ago. At the end of the third quarter of 2008, household debt began to decline as Americans started belt-tightening.

The most recent data shows that credit tightness peaked earlier this fall to the worst levels in 23 years. What we are all enduring, and what small businesses, workers and consumers continue to be pummeled by, is the dismantling of the great credit boom of the early 2000’s. This grueling, but necessary, deleveraging began last year and is now in full swing. We are seeing it in our investment sales market and expect that it will continue for 2 to 3 years as we face today’s problems and anticipate 2006 and 2007 vintage loans maturing.

In October of 2008, bank credit peaked at $7.3 trillion and is now down to $6.72 trillion. Banking sector debt, it is estimated, must fall by another $2 trillion or so and this should take over 2 years to complete. Since the peak, this 8% drop is enormous and it is accelerating. By comparison, the peak-to-trough drop during the Savings & Loan crisis in the early 1990’s was only 1.3%.

The last thing the central bank wants is a decline in the broad-based money supply. The Fed’s asset purchase program is not only about driving down mortgage rates. It is also about trying to prevent a collapse in the money supply. When the Fed buys assets, it creates deposits which, in turn, helps offset the reductions in available credit. If deleveraging and the credit contraction does last a couple of years, and if the Fed is interested in offsetting it, they will have to continue to buy assets through next year. Presently, they intend to stop the purchases well before that.

It appears clear that the economic recovery will not be as strong as history suggests it should be. We have a long way to go before we get back to above trend growth. The recovery in the commercial real estate market will come on the heals of the economic recovery as we generally lag behind the economy. As lenders put off dealing with the problems imbedded in their balance sheets,  the recovery simply slows down and credit markets remain soft. I certainly hope the recovery evolves more quickly and forcefully than it appears it will.  Our commercial real estate markets could use the help.

Published December 20, 2009

What a wonderful time of year it is. Holiday season makes us think of many of the things that have become synonymous with Christmas and Hanukkah: holiday music, gift-giving, an exchange of greeting cards (emails today), church and synagogue celebrations, special meals, holiday cookies, egg nog, singing carols, and the display of various decorations; including Christmas trees, menorahs, wreaths, colored lights, garlands, mistletoe, holly and nativity scenes. It is the time of year that many of us still enjoy watching Frank Capra’s 1946 classic, “It’s a Wonderful Life” starring Jimmy Stewart, Donna Reed and Lionel Barrymore.

It is a time of year to spend time with family and loved ones and a time to count all of our blessings. It is a time of year to remember those who are less fortunate than we are. There are many, particularly today, who need assistance and it is a time of increased charitable giving. Anything that can be done to help, should be done, especially when it comes to helping disadvantaged children who may be particularly sad at this time of year. A helping hand or an act of kindness can go a long way. It is a time when people devote time and energy to causes which are most meaningful to them.

Generally, at this time of year, people are in better spirits and “goodwill towards man” is commonly exhibited. On busy streets and in crowded stores, people tend to be more courteous and kinder towards each other. The holidays tend to put us in a good mood and cause us to think about others and their feelings more than we might at other times of the year. It is a time when we often put ourselves into the other person’s shoes to think about things from their perspective. When we do this, it encourages all of us to treat others with courtesy, dignity and respect.

To illustrate, I would like to share a story with you:

Years ago, a 10-year-old boy approached the counter of a soda shop and climbed onto a stool. “What does an ice cream sundae cost?” he asks the waitress.

“Fifty cents,” she answers.

The youngster reached deep into his pockets and pulled out an assortment of change, counting it carefully as the waitress grew impatient. She had “bigger” customers to wait on.

“Well, how much would just plain ice cream be?” the boy asked.

The waitress responded with noticeable irritation in her voice, “Thirty-five cents.”

Again the boy slowly counted his money. “May I have some plain ice cream in a dish then, please?” He gave the waitress the correct amount and she brought him the ice cream.

Later, the waitress returned to clear the boy’s dish and when she picked it up, she felt a lump in her throat. There on the counter the boy had left two nickels and five pennies. She realized that he had enough money for the sundae, but sacrificed it so that he could leave her a tip.

The moral of this story, before passing judgment, first treat others with courtesy, dignity and respect.

So at this wonderful time of year, I take a break from thinking about real estate and would like to wish each of you and your families a happy, healthy and joyous holiday season filled with love, hope and goodwill towards others.

Published December 27, 2009

I don’t know anyone who will not be happy to see 2009 in the rear view mirror. To say it was a challenging year is an understatement. Before we take a look at what commercial real estate market participants should be watching in 2010, let’s take a look back at some key events which took place in 2009:

In January, Barack Obama is sworn into the office of president of the United States making him the first African-American president in U.S. history.

In February, the president signs an unprecedented $787 billion stimulus plan which is touted as being necessary to keep unemployment under 8%.

The unemployment rate climbs to 10.2% (the highest it has been in decades) and drops to 10% even after a net loss of 11,000 jobs in November, demonstrating that discouraged people continue to drop out of the job market. They are no longer counted as unemployed and, if counted and added to those working part-time who would rather be working full-time, the unemployment rate is more like 17%.

The country braces for the H1N1 flu epidemic.

As the economy deteriorates, several frauds are uncovered led by the king of Ponzi schemers, Bernard Madoff, who is sentenced to 150 in prison.

To try to stimulate the economy, the government rolls out the “Cash-for-Clunkers” program paying $3,500 to $4,500 for cars which, in many cases, are worth little more than several hundred dollars. The program burns through $1 billion in the first week causing congress to provide another $2 billion to the program. The result is 690,000 cars sold of which only an estimated 125,000 would not have been purchased without the program.

The housing market becomes so stressed that the U.S. reaches a record rate of a foreclosure every 13 seconds.

With Fannie Mae and Freddie Mac hemorrhaging losses, FHA comes to the “rescue” as a new subprime lender requiring down payments of 3.5% or less. Between Fannie, Freddie and FHA, the U.S. government now guarantees 92% of all home loans in the country.

The $8,000 first time home buyer’s tax credit is launched stimulating home sales. The program is subsequently expanded to include a broader group of purchasers. Based upon the average U.S. home price of $178,000, and a 3.5% FHA down payment requirement, the government is “paying” people to buy houses.

Several banks turn very profitable based upon the Fed’s monetary policy, allowing them to recapitalize resulting in many of them repaying TARP money.

Chrysler and GM go belly up and get bailed out by the government. The atypical bankruptcy processes leave many wondering why highly sophisticated bankruptcy law is cast aside (along with thousands of senior secured creditors) for political objectives. Chrysler is taken over by Fiat and GM emerges as a zombie with UAW control and unsustainable  pension obligations which the taxpayers must swallow.

Based upon all of the government spending, the U.S. budget deficit triples in size to over $1.4 trillion.

Yes, it was an eventful year with many firsts and many unprecedented actions in response to uncharted territory. On the commercial real estate front, we saw the lowest volume of sales that we have seen, going back at least to 1984. We also saw prices tumble anywhere from “a lot” to “a real lot” depending on the property type in question. Volume appears to be on the upswing while prices continue to slide in tandem with increasing unemployment.  To figure out where we are headed in 2010, we will be watching 10 key indicators. Let’s take a look at them (in no particular order):

1) Unemployment. For those of you who are regular StreetWise readers, you know that I believe there is no metric that more closely impacts the fundamentals of the residential and commercial real estate markets than unemployment. If people have lost a job or fear losing one, they are not likely to move from a 0ne-bedroom apartment to a two-bedroom and are not likely to move from a rental apartment to a purchased residence. When employers cut staff, they are not likely to be taking more office space and, if anything, may take less space at renewal time. Similarly, those who have lost jobs are less likely to travel, leaving hotel occupancy hurting and they are also less likely to spend freely in retail stores, stressing that sector.

As indicated above, the present official unemployment rate is 10%, down from 10.2% even after a net loss of jobs in November. This indicated that dejected job seekers are dropping out of their search and after 30 days, they are no longer counted as “unemployed”. Currently, the average length of unemployment for those who have lost jobs is in excess of 28 weeks, the longest period ever recorded going back to 1948. 

If we add to these discouraged workers, those that work part-time that would like to be working full-time, the unemployment rate soars to about 17%. It is expected that the official unemployment rate will remain elevated throughout 2010 as discouraged workers begin to seek employment again as jobs are created. Over 7 million jobs have been lost during this recession. Add to this the fact that, simply based upon population trends, we need to add 1 million jobs per year and it is easy to guess that it may be some time before we get back to mid-single digit official rates. Net job creation will be a key towards a recovery in our fundamentals, particularly if it can be sustained.

On the positive side, we have seen productivity increases at typical “coming-out-of-recession” levels of 5%-6% which is, usually, a prelude to resumption in hiring. Similarly, temporary employment is also on the rise which also foreshadows permanent job creation.

2) Corporate Earnings. Corporate performance will be key to watch, especially on the top line. The stock market has rallied from a low in early March of about 6,600 to about 10,500 today. Much of this increase was caused by speculation and above-estimated earnings based upon companies slashing expenses (payroll being the largest of these cuts). While effective in the short run, reducing expenses is not a viable strategy for sustainable earnings growth. Top line revenue must increase and, thus far in the cycle, companies have not seen revenue growth in a tangible way.

3) Credit Markets. In order to make our commercial real estate markets function, we need available debt. In New York, we have been fortunate to have community banks and smaller regional banks that have been consistently lending since we started to feel the effects of the credit crisis in the summer of 2007. In many parts of the country, many of these smaller banks have tied up far too much of their capital in development and redevelopment projects which have been the property type hardest hit. This has resulted in 140 bank failures in 2009. We have not seen a meaningful number of large commercial banks or money center banks actively making commercial real estate loans and their re-emergence would be welcomed.

The TALF and the PPIP programs, did little in terms of direct activity, particularly compared to initial expectations, however, their mere existence brought credit spreads in appreciably. This dynamic could help rekindle the CMBS market which is so desperately needed by our marketplace. The shadow banking sector provided as much as 40% of lending in the bubble inflating period of 2005-2007. The present and near-term demand for refinancing proceeds is staggering. Unfortunately, even if the traditional banking sector and the insurance industry were both operating at full-throttle relative to real estate lending, they do not have the capacity to meet the demand.

Access to public capital is vital. In 2007,  CMBS was a $230 billion market which eroded to $12 billion in 2008 (all of which was in the first six months). From July 2008 thru just weeks ago, the CMBS issuance had been zero. A couple of transactions have now closed and others are in process. We will be keeping a close watch on continued CMBS activity and also on REIT capital raising activity ($20 billion recently) and the newly formed mortgage REITs for signs that public capital is again flowing into our market.

For numbers 4 thru 10, stop back to StreetWise next week….