10.2% Unemployment and the Impact on Commercial Real Estate

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.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,000 properties in his career.

How Green are the Economy’s Green Shoots?

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.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,000 properties in his career.

Is a Weak Dollar a Good Thing?

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.

Low Volume of Investment Sales Caused by Supply Constraint; Demand Still Strong

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 variesdepending on product type and building classification. Multi-family properties have been performing best, having lost only 16% of value while office buildings with significant expoure 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 enviromnent is illustrated in the listings 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 pubically 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.

Unemployment’s Continued Climb and the Effect on Commercial Real Estate

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 preceeding 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 at 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 comparision, 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.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,000 properties in his career.

When the Fed Tightens, Will Mortgage Rates Increase?

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?

Capialization 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 imaging 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.

Its not a Real Estate Crisis, its a Debt Crisis

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 structual 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 nickle 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.

Mr. Knakal is the Chairman of  and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,000 properties in his career.

REMIC Modifications and Their Impact

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 morgage 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 transfered 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 morgages 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 possiblity 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.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,000 properties in his career.

Commercial Real Estate Needs Small Business Job Creation

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 ecomony 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 discrminate when objecting to policy inplementation.

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 withdrawl 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 are 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.

Banking Industry Woes to Strengthen Some While Others Vanish

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 occured 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 comparision, the watchlist level is expected to soar during the next year or two.

Stronger and larger banks, in addition to receiveing 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. Unfortunatley, 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.