Investment Sales Market Trends Not as Clear as Participants Would Like

The building sales market continues to bounce along the bottom as the volume of sales trends and value trends fail to show consistent performance.

With regard to sales volume, we had seen 6 consecutive quarters of volume increases in the New York market through the second quarter of 2010. While our 3Q10 statistics are not completed yet, it appears that this trend will not continue.

Generally, in New York City, volume trends have been positive. Beginning at the start of 2009, we saw the volume of sales, both in terms of number of properties sold and the dollar volume, increasing. The Manhattan and Northern Manhattan markets led the way, turning positive prior to the outer boroughs. In 2Q10, we finally saw Queens and Brooklyn turn positive and we had been expecting the Bronx to turn in 3Q10. The 3Q10 numbers thus far appear that they may show these positive trends have taken a step backwards.

Given the relative strength of markets like New York and Washington D.C., if we are seeing volume trends like this here, it is easy to surmise that volume is squishy across the nation.

Value trends have not experienced the same consistency, over the past 6 quarters, as we have seen in volume. After we hit what appeared to be a bottom, approximately 32% below the peak, value appears to be bouncing along the bottom as for some product types in some sub-markets values are up slightly, and for some product types in other sub-markets values continue to slide. This volatility is representative of a market which is trying to find its natural bottom.

As we move forward, we expect continued volatility in both of these important market metrics. On the volume side, we have seen the supply of available properties pick up as distressed sellers continue to put assets on the market with greater frequency. We are seeing banks and special servicers move aggressively to clean up balance sheets by monetizing sub-performing assets. These sellers are being joined by discretionary sellers who have been sitting on the sidelines for too long, creating pent up selling demand, and those who wish to sell in order to take advantage of this year’s advantageous capital gains rates. Most market participants believe that capital gains rates will be higher next year. If the existing tax rates are allowed to sunset, the gains rate will go from 15% to at least 20% on a federal level. Many participants also believe local capital gains taxes will increase as well as municipalities struggle to bridge budget gaps.

The sellers who are trying to beat the gains tax increase will accelerate some transaction volume, effectively “stealing” activity from 2011. We saw this same dynamic with the cash-for-clunkers program and the first-time-home-buyers tax credit which accelerated volume in the auto and home sales markets. After these programs expired, volume dropped like a stone. For these reasons, we believe transaction volume will be higher than usual in the second half of 2010 (particularly in 4Q10) with a drop in volume as we enter 2011.

Total volume in 2011 will be dependent upon several factors. Increased capital gains taxes will exert downward pressure on volume while continued pace in the distressed asset market should exert upward pressure. The majority of submerged assets (properties where the debt amount is higher than the value – “under water”) have debt which was placed in 2006 and 2007 when values and loan-to-value ratios were their highest. Most of this debt is maturing in 2011 and 2012 and, due to extremely advantageous mortgage terms, many of these loans are still performing although they possess significant negative equity positions. As these loans mature, these assets will have to be recycled as refinancing will not be possible unless the owner has the ability, and is willing, to inject additional equity into the property.

An additional factor to consider is that the inheritance tax is scheduled to go to 55% in 2011. Surprisingly, an overwhelming percentage of real estate investors are not well diversified as most of their wealth is in real estate investments. As these investors pass away, estates may find no option other than being forced to sell properties in order to pay these taxes. This dynamic should exert upward pressure on sales volume.

This data demonstrates that we have not seen a clear trend and that our real estate recovery has a lot more work to do before we can all feel comfortable that things are tangibly better and that a recovery can be sustained.  

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of nearly 1,100 properties having a market value in excess of $6.8 billion.

Is Keynesian Economic Theory Good for the Commercial Real Estate Market?

A couple of weeks ago, my column on this blog entitled “Higher Taxes Mean Sluggish Employment” created a significant number of responses and provided a microcosm of on of the biggest debates going on in Washington today. It is the debate between those who believe that the government should create another round of stimulus, thereby increasing spending to stimulate the economy versus a focus on deficit reduction.

The pending expiration of the Bush tax cuts, which are scheduled to sunset at the end of this year, is prompting heated debate in Washington regarding which of these two strategies, or a combination of each, to implement. If you read the comments made in response to the above mentioned column, you will see what appears to be a debate fit for an episode of Face the Nation rather than a commercial real estate blog.

So, you may be asking why a real estate investment sales broker cares so much about government policy as described herein. The fact is, that our real estate market relies heavily upon the performance of the economy as that economic performance greatly impacts the employment picture. Employment is the economic metric which most profoundly impacts the underlying fundamentals of our real estate market. This is why policy is so critical and is worthy of close scrutiny.

During the past two years (yes it did begin under the Bush administration), we have seen an unprecedented level of government intervention in the form of stimulus spending. Unfortunately, this spending has not produced the desired results and it appears that, to the majority of Americans, spending our way into prosperity is going out of style (according to this morning’s Rasmussen poll, 58% of Americans are pessimistic about the U.S. economy). Most economic indicators are falling well short of the administration’s expectations given the massive intervention.

The U.S. economy is losing momentum and, in the second quarter, consumers remained frugal and employers failed to create jobs at any level near what is necessary to begin eating into the 8.4 million jobs lost in any meaningful way. The latest and most far reaching snapshot of the U.S. economy showed that gross domestic product, which is the value of all goods and services produced by the economy, grew at a 2.4 percent annual rate during 2Q10. This figure was down from an upwardly revised 3.7 percent in 1Q10 and 5 percent in 4Q09. Unfortunately, this low GDP growth level bodes poorly for the balance of 2010.

Also, last Friday, the government released revised GDP numbers for the past three years showing that the recession was worse than previously thought. With GDP growth stalling and the specter of future tax increases, higher interest rates and more government control over nearly every aspect of the economy, businesses nationwide are stuck in a holding pattern relative to job creation. Consumer confidence and consumer spending are low, the housing market is petering along and exports are not nearly at the level that anyone would like. For these reasons, consumers are also stuck in a holding pattern, unwilling to open their purse-strings.

The inertia in the economy is being fueled by the tremendous uncertainty in the marketplace. As we know, markets like nothing less than uncertainty. Uncertainty revolves around, not only future tax policy, but the impact on businesses and individuals of healthcare and financial regulation. There has also been a lot of talk about cap and trade and a potential value added tax. How can businesses and consumers do anything but take a conservative approach under these circumstances? These are not the conditions which motivate private sector investment.

For nearly three years now, the world’s economic policy has been dominated by a revival of the once popular idea that massive amounts of public spending could cure a recession and create a new era of government led prosperity. Unfortunately, this Keynesian economic theory has, once again, proved incapable of doing so.

Now the political and fiscal IOU’s are coming due and, unfortunately, U.S. and European economies are moving forward well below expectations. Many European nations have implemented austerity programs while our present administration has maxed-out our credit cards and appear to be willing to obtain more cards from other willing lenders in order to keep their spending capability intact.

The current Keynesian revival began under George W. Bush with a spending program of about $168 billion which was “urgently needed to boost consumer demand”. This first round of stimulus produced a statistical blip in GDP growth in mid-2008 but it didn’t stop a more severe downturn in the economy accompanied by the failure of Lehman Brothers and many other significant U.S. institutions.

“Stimulus Two” occurred under the present administration which was originally to be a $500 billion package. As the pork-laden bill became law, the amount blew up to $862 billion. The White House told us that with the passage of this bill, unemployment would not rise above 8 percent. Clearly, this was not the case. And, of course, we know proponents of the stimulus will say that unemployment would be significantly higher without the stimulus and millions of jobs have been “saved”, a position which is nearly impossible to prove.

Today, a third phase of stimulus is being considered. This is causing a heated debate between the spenders and the cutters. The recent revival of Keynesian economic strategy, and the results observed thus far, seems to prove that the failures of this theory (which became evident in the 1970’s) had been lost on present policy makers. Forgotten is the much longer than usual period of prosperity experienced in the U.S. from 1982-2007. During this period Reagan and Clinton implemented strategies of lower taxes and spending restraint. Under G.W. Bush, GDP grew by 15% in eight years but spending ballooned, increasing by 58%.

Unfortunately, today the U.S. Federal balance sheet has exploded and all of the “stimulus” has produced underwhelming results thus far. The fantastical multiplier effect of government spending under the Keynesian model is demonstrably not meeting expectations. A theory which says that a large government body can deploy capital more effectively and efficiently than a private individual simply has no merit. Government cannot do things better than the private sector can. For example, in New York, Off Track Betting is the only bookie joint in history that looses money. The amount of waste, fraud and abuse imbedded in government oversight can simply not be denied. Every dollar the government spends is “taken” from a private individual (in one form or another) and how much of that dollar gets put back into the economy after taking into consideration “administrative costs”, waste, fraud and abuse?  

Recent economic data seems to provide clear evidence that Keynesian theory does not work.

The mid-term elections in November will present an opportunity for the American people to weigh in on these issues. From a real estate perspective, market participants hope that those voices lead to policies which eliminate uncertainty and put us on a path for economic and employment growth. Nothing would be better for our real estate market than that. 

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,075 properties in his career having a market value in excess of $6.5 billion. 

Get Ready for the Investment Sales Surge

In the first half of 2010, we have seen a significant increase in the number of investment property sales in New York City. I understand, from speaking with many of you across the country, that this trend is being seen elsewhere and, while perhaps it is not as sharp and increase as in New York, the trends are positive nonetheless.

In all of 2009, 1436 properties were sold in the Big Apple and, in the first half of 2010 (1H10), there were 818 buildings sold. The dollar volume of sales also increased significantly, going from $6.26 billion in all of 2009 to $6.49 billion in 1H10.

The projected annualized increase in the number of buildings sold is 14% while the annualized dollar volume increase is projected to be 131%. These figures illustrate two very tangible dynamics. The first, and most obvious, is that activity is picking up significantly and, the second is that the average sale price of transactions is increasing sharply.  The average sales price of a New York City transaction in 1H10 reached $7.9 million, up from $4.4 million last year.

We believe that, although we have seen very significant volume increases thus far in 2010 from 2009 levels, the activity will pick up even more dramatically during the second half of the year as several important factors come into play.

The first of these factors involves distressed assets. We are seeing distressed properties and notes coming to market in much greater frequency as lenders and special servicers look to take advantage of current market conditions. As I have written about frequently on StreetWise, current demand substantially outweighs supply leading to achievable pricing that is surprising (to the upside) many market participants. Lenders and servicers have been noticing the recovery possible on these sales which is proving to be compelling.

Additionally, the Fed’s highly accommodative monetary policy has allowed for a massive recapitalization of the banking industry over the past two years. The profitability these banks have enjoyed is affording them the ability to absorb losses incurred due to the disposition of distressed assets. Many have indicated a desire and/or a need to clean up balance sheet problems by the end of 2010. We believe that we will see increasing activity with respect to REO and note sales as this balance sheet cleanup occurs and the necessary deleveraging process occurs.

The second factor revolves around the interest rate environment. Rates hover around record lows as the Fed is keeping them there to help stimulate the economy. Trouble in Europe has created a flight to safety and quality which has exerted significant downward pressure on Treasury rates. The 5-year has been well below 2% for weeks and the 10-year has been below three for a good part of that period. This is keeping commercial lending rates down, which, in turn, is keeping capitalization rates down and prices up. As economic indicators are weak and not responding they way anyone would like them to, it would appear that the Fed will keep rates low in the short to medium term, unless of course, indicators dramatically improve. This low interest rate/high value dynamic is luring both distressed and discretionary sellers alike.

The third factor involves tax policy. We are seeing significant activity from discretionary sellers who are concerned that capital gains tax increases in 2011 will create a disadvantageous selling environment. We have received dozens of exclusive listings over the past few months from discretionary sellers who are desirous of beating the capital gains tax increase.

If you do not believe that tax policy impacts private sector decision making, look no further than the dreaded New York State capital gains tax (the “Cuomo Tax”) increase implemented in the Empire State in the 1980’s. This tax was an additional 10% tax on top of the existing capital gains tax on any property sale over $1,000,000. Then Governor, Mario Cuomo, felt that this tax on “rich real estate investors” would raise needed revenue for the state. Transaction volume slowed to a crawl during this period. Ironically, when the tax was eliminated, the tax dollars collected actually increased as transaction volume exploded.

If we examine history, it is not surprising that we are seeing this activity in anticipation of a tax increase. In 1981, when Ronald Reagan announced tax cuts, which would become effective in 1983, economic activity ground to a halt in anticipation of a more tax-friendly environment. Today, the reverse is true and, as they anticipate a less friendly tax environment next year, investors will be rushing to get transactions done this year.

These factors will increase the supply of properties for sale which will increase transaction volume across the board. Demand exceeds supply to such an extent that this additional supply should not impact value in a negative way… least for the rest of 2010.  We, therefore, believe that we will see significant sales volume increases in the third, and particularly the fourth quarters of 2010.

The balance of this year should be very strong for the investment sales business. How things proceed from there will be dependent upon many things. I will keep you posted.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has sold over 1,075 properties in his career having a market value in excess of $6.5 billion.

Employment and Pending Tax Increases

If you are a regular reader of this StreetWise column, you know the importance that I believe the employment picture has on our commercial real estate markets. In fact, there is no other metric that more profoundly impacts the fundamentals of both residential and commercial real estate.


This is why last Friday’s jobs report was particularly troubling. In June, U.S. payrolls lost 125,000 jobs, the first monthly loss of 2010. These losses were due, mainly, to the elimination of 225,000 temporary government census workers. Just as 441,000 new census temporary jobs skewed the numbers higher months ago (and the administration seemed downright giddy over this “job growth”), June’s job eliminations have skewed the numbers to the downside.


The official unemployment rate, interestingly, dropped from 9.7 percent in May to 9.5 percent even though the market lost 125,000 jobs. You may ask how this can happen as elementary school mathematics would indicate this is an impossibility. The fact is that something called the “participation rate” impacts the official unemployment rate calculation. While the market lost 125,000 jobs, simultaneously, 652,000 discouraged Americans stopped looking for work. After their job search has ceased for more than 30 days, these unemployed workers are no longer technically considered unemployed. This quirk in the official rate calculation caused the reduction seen in June.


However, if these discouraged workers are counted and those who work part-time wishing to be employed full-time are included, the unemployment rates balloons to 16.5 percent. Equally troubling is the fact that the median duration of unemployment rose to 25.5 weeks in June from 23.2 in May.


The most important thing to extract from the jobs report is that the private sector created only 83,000 jobs in June. This comes after an equally disappointing private sector job creation number, in May, of only 33,000 private sector jobs.


During this recession, our economy has lost 8.4 million jobs. It is important to note that, depending upon which analysis you read, our economy needs between 100,000 and 150,000 jobs created per month just to keep up with population growth. Therefore, even with monthly job creation on the order of 300,000 or 400,000, it will take many years to regain the jobs that have been lost.


Additionally, in June, employers cut the average the work week of existing employees. The average work week fell to 34.1 hours after rising for the previous 3 months. Average hourly earnings also slipped in June down to $22.53 from $22.55.  


So, why isn’t the private sector creating jobs at the typical rate seen at this point in a recovery?  Economic growth shifted positively almost one year ago. In typical recoveries job creation becomes self sustaining. Jobs are created, more people have disposable income, and this creates demand, which creates profits, which leads to more new jobs. This process normally works very nicely.


Unfortunately, we are presently seeing an employment picture that is merely muddling along. The fact is that private sector employers are in a holding pattern. Hiring decision are being delayed as employers wait to see how much more politicians are going to increase their costs of doing business. Job creation and new investment have suffered from the destructive impact of trade restrictions, additional regulation and, most importantly, higher taxes.


Even before any new taxes are proposed to address budget deficits, Americans are bracing for the biggest federal tax increase in America’s 234 year history, which is expected in six months. Naturally, Washington will portray this tax increase as a “restoration” of old taxes, not new taxes.


 In 2001 and 2003, Congress enacted tax relief that spurred economic growth and development. These cuts will expire on January 1, 2011. Income tax brackets will shift significantly. The top income tax rate will rise from 35 percent to 39.6 percent. The lowest bracket will increase from 10 percent to 15 percent and all other brackets will increase by 3 percent annually.


Additionally, itemized deductions and personal exemptions will phase out which effectively create even higher marginal tax rates.


On top of these tax hikes, the marriage penalty will return and will be applicable to every dollar of income. The child tax credit will be cut in half and dependant care and adoption tax credits will be cut. The estate tax will increase to 55 percent on estates over $1 million.


Important to our real estate markets, capital gains rates will increase from 15 percent to 20 percent in 2011. The dividend tax rate will rise from 15 percent this year to 39.6 percent next year. Additionally, the new healthcare bill will increase both of these rates by 3.8 percent beginning in 2013. This increase will bring capital gains rate to 23.8 percent or 60 percent higher than its present level. Dividends will be significantly impacted as the top dividend rate will escalate to 43.4 percent or nearly three times today’s rate. The healthcare bill includes 20 new or higher taxes, several of which become effective January 1, 2011. In the face of these increasing costs, is it any wonder why private sector job growth is moving like a glacier?


For the sake of the commercial real estate market let’s hope policy makers realize the importance of job growth and that they understand what the real drivers of private sector job creation are. A clarity with regard to future costs, particularly taxes, and elimination of much of the uncertainty, which presently exists, would induce private sector employers to begin hiring again. Our economy needs this and so do our commercial real estate markets.          

 Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,075 properties having a market value in excess of $6.4 billion.

Is the Investment Sales Market in a Mini-Bubble?

The investment sales market has been steadily improving over the last few quarters, as fundamentals begin to improve and economic recovery, while sluggish, is upon us. With regard to fundamentals, we have seen rent concessions evaporating and occupancy rates improving. The economy is moving in a generally positive direction but is having difficulty finding momentum as employment growth is well below expectation and last week it was reported that consumer spending experienced a decline of 1.2% in May, the first drop since September of 2009. While the investment sales sector appears healthy, the future of the market, however, is uncertain as market indicators are presently difficult to interpret. These conditions beg the question: Are we in another bubble at the bottom of a cycle?

Today, nothing is impacting the investment sales market more than the supply / demand relationship. Real estate markets are always dependant upon the supply  / demand dynamic, however; it appears to be impacting the market more acutely now than we have seen in the past. Presently, there is excessive demand met by a relatively weak supply of available properties for sale.

Demand drivers are active from every segment of the purchasing arena. When we first started to tangibly feel the impact of the credit crisis in the summer of 2007, the institutional capital, which drove up value in the bubble inflating years of 2005 -2007, all but evaporated from the marketplace. The overwhelming majority of investment properties that Massey Knakal closed from mid-2007 until recently have been purchased by with high-net-worth individuals and families that have been investing in the market for decades. Recently, we have seen a reemergence of institutional capital as these investors have formed distressed asset buying funds and opportunity funds to take advantage of perceived opportunities in today’s market. Add to this the significant numbers of foreign investors and we have a demand side of the equation that is overwhelming.

On the supply side, we have seen historically low levels of properties for sale. Typically, the supply of available properties is fed by discretionary sellers who decide it’s time to sell. Typically, when values decrease, as happened beginning in 2008, discretionary sellers withdraw from the market. As this occurs, normally distressed sellers will emerge to fill the void left by the withdraw of discretionary sellers. In this cycle however, this has not occurred. Everything that has happened from a regulatory perspective has provided distressed sellers the ability to avoid dealing with their problems if they choose to.

The result is a very low supply of available properties to satisfy the excessive demand that exist in the marketplace. Due to these conditions, properties are selling for more than fundamental economics would dictate they should be selling for. Consequently, the “great opportunities” and “great deals” that were expected at the onset of this credit crisis have simply not emerged.

The supply of available properties is, however, increasing. We have seen a tangible increase in distressed assets coming to market and these distressed sellers are being joined by discretionary sellers who are, once again, coming back into the market. They have been waiting for a while to implement sell decisions and they simply are not willing to wait any longer to pull the trigger. Some of our clients are selling today because of the looming increases in capital gains taxes next year. Others are selling because of the likelihood that “carried interest taxes” will increase next year from the capital gains rate to the ordinary income rate.

The opinion that discretionary sellers are returning to the market is supported by the fact that we have seen a palpable resurgence of 1031 exchange transactions. We know that these are the result of discretionary sales as distressed transactions rarely have any residual equity which could be reinvested utilizing the 1031 mechanism.

Given this increase supply and the excessive demand that exists, we expect investment sales volume in 2010 to increase by at least 40 percent over 2009 levels. Granted, we are coming off anemic levels last year, but a significant increase in activity will be well received by market participants. In a couple of weeks we will be releasing our first-half 2010 statistics which will be a good indicator of how the year is progressing and should tell us something about what we can expect for the balance of 2010 in terms of volume.

With regard to value, as stated earlier, prices are increasing to levels above what economic fundamentals would dictate. It is almost as if the market is experiencing a mini-bubble at the low point in the cycle. Cap rates have remained at low levels after expanding significantly in 2009 and, remarkably, note sale recoveries have been extraordinarily high relative to collateral value. These conditions seem extremely positive today but, “Where we are headed?” is the bigger question.

Last month’s disappointing employment data has showed that employers are still leery about making commitments to new employees given the uncertainly surrounding the economic recovery and the vast array of tax obligations that are likely to increase substantially in the near term. Consumer spending and consumer confidence remains weak and GDP growth is challenged. Economists are, in increasing numbers, predicting a higher likelihood of a double dip recession.

We anticipate that the investment sales market, for the balance of 2010, will be very healthy as current dynamics continue. However, moving forward there are things to be concerned about. The deleveraging process, which is already in full swing, has a long way to go before all of the properties in negative equity positions are recycled or resuscitated. The 2006 and 2007 vintage loans, which are in the most distressed positions, don’t mature until 2011 and 2012 and are often being kept alive by advantageous loan terms such as interest only periods, interest reserves or are floating over LIBOR which remains at miniscule levels.

The anticipation that interest rates will rise, and rise dramatically, is still looming over the marketplace as well. Interest rate increases will have significant negative implications for the investment sales market and it is only a question of when, not if, these increases will occur.

With regard to supply, a regulatory change impacting the ability of lenders to hold loans on their balance sheets at par, even when they know the collateral is worth significantly less, could lead to significant increases in supply, exerting significant downward pressure on value.

Lastly, the expectations of increases in taxes of all kinds creates significant trepidation on behalf of participants in the marketplace. Capital gains taxes will increase from 15 percent to 20 percent when the Bush tax cuts sunset as they are expected to at the end of the year. Obamacare will add to this capital gains increase and personal taxes on federal state and local levels are sure to rise as politicians across the country demonstrate an inability to effectively cut spending. This is the case in all that but a couple of states which have seen shifts in policy recently.

Therefore, it is easy to understand how bearish participants are using this opportunity to sell and take advantage of the extraordinary supply / demand imbalances, very low interest rates and a, currently, friendly tax environment.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,075 properties in his career having a market value in excess of $6.4 billion.

It’s Time for FIRPTA Modification

Commercial real estate markets across the country are overleveraged. It is estimated that for the next several years, approximately $350 billion of commercial debt will mature annually, much of which will have difficulty finding replacement leverage given the reductions in value that we have seen coupled with today’s more conservative loan-to-value ratios being used by lenders. The deleveraging process that our markets must go through will require massive amounts of fresh equity.

Demand drivers are excellent today and, if you are a frequent StreetWise reader, you know that I have illustrated numerous times the acute supply / demand imbalance that exists today with little available product meeting extraordinary demand. High-net-worth domestic investors and families which have driven the markets for the past couple of years have met a resurgence of institutional capital which has come back to the commercial real estate sales market with a vengeance. Additionally, foreign investment is very apparent in today’s market and foreign high-net-worth investors are appearing in numbers not seen since the 1980s.

With this excessive demand, why would I be focused on a law that, if modified, would result in even greater foreign demand? There are several reasons we will discuss.

Foreign investors in U.S. real estate are disadvantaged by a law which should have never have been put into the tax code to begin with. The Foreign Investment in Real Property Tax Act of 1980 which is commonly referred to as FIRPTA. This U.S. tax law unfairly (relative to other non-real property investments in the U.S.) imposes excessive tax barriers on foreign capital investment in U.S. real estate and should be withdrawn or modified significantly. FIRPTA is the central obstacle to greater capital investment in U.S. real estate by non-U.S. investors.

Based upon the fears of some politicians in the Midwest, who were originally concerned about limiting foreign control over U.S. farm land, FIRPTA was proposed and passed by congress to limit what foreigners could do with “our property”.  FIRPTA requires foreign persons who dispose of U.S. real property interests to pay taxes in the U.S. on any gain realized on the disposition over and above the tax burden they would be faced with if they invested in any other type of asset.

This process imposes considerable administrative burdens, not only on foreign investors disposing of their U.S. real estate assets but also, on the purchasers of such properties who are responsible for administering withholding taxes. Additionally, the law requires foreign investors to file a U.S. income tax return at the end of the year in which they sell their real property interests.

Further political support for FIRPTA was seen noticeably in the mid 80’s when Japanese investors were actively purchasing trophy assets in New York City, most notably Rockefeller Center. It is hard to imagine that there is any fundamental basis for this concern. Properties controlled by foreign owners are generally managed by U.S. companies, leased by U.S. companies, serviced by U.S. companies and produce tax revenue paid to U.S. municipalities.

The attorneys representing these investors are likely U.S. firms, as are their title insurers. What is the basis of the fear people have about buildings being owned by overseas investors? In the 26 years that I have been selling properties, I have yet to witness a foreign investor acquiring a property in the United States, picking it up, and transplanting it back to their homeland.

By virtue of FIRPTA, real estate is discriminated against relative to other types of investments in the U.S. by foreign persons as they are not required to pay gains taxes upon the disposition of any other assets. Thus, FIRPTA unfairly treats U.S. real estate as an asset class. We believe that U.S. policy makers should move swiftly to eliminate or modernize FIRPTA.

Our markets need massive amounts of equity to accomplish the deleveraging we must go through. While there is tremendous demand currently existing, the need is going to grow over the next couple of years and the more capital we have in the market, the better for all participants. While many actions taken by policymakers over the past couple of years may lead you to think differently, we are still in a capitalistic, free-market society.

If  FIRPTA were to be eliminated or a tax holiday were given on transactions over the next few years, demand from foreign investors would undoubtedly increase. We need equity investments from any source as this would be stimulative to our market and our economy. The extent to which the U.S. and its citizens would benefit, is positive regardless of the benefits which might inure to foreign investors. The additional capital would be accretive to a healthy dynamic within our marketplace, would help to create jobs and allow for growth.

In January of this year, a bill ( H.R. 4539 – the Real Estate Revitalization Act of 2010 “RERA”) was introduced in congress to modify FIRPTA. The bill was touted as something which would reduce barriers to foreign investment in U.S. real estate. This legislation would amend FIRPTA by removing some the artificial tax barriers created by the law. These changes would go a long way towards rectifying the unfair treatment of real estate investments relative to other asset classes. This would allow property owners to access equity capital from around the world at a time when it is sorely needed.

RERA would eliminate the “U.S. Real Property Holding Corporation” provisions of FIRPTA and characterize REIT capital gains distributions to foreign shareholders as ordinary dividends. It would also treat REIT liquidating distributions as ordinary dividends to the extent that a distribution exceeds the foreign investor’s basis in its REIT stock.

Under RERA, shares in REITS and other real property holding corporations would not longer be “U.S. real property interests”, thereby eliminating part of the discrimination against real estate investments. FIRPTA would, however, continue to apply to gains from the disposition of direct foreign investment in U.S. real estate; therefore, we do not believe this legislation goes far enough to meet the objectives we seek. 

The U.S. has much more to gain than to lose by embracing and working with the global community. Technology has changed the way world commerce functions and there is much to gain from working with other nations. While total economic growth is not dependant upon foreign real estate investment, our real estate market would be enhanced significantly by the elimination or modification to the FIRPTA laws. All this would do is to put real estate on a level playing field with every other type of investment that foreign investors can make in the U.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 1,050 properties in his career having an aggregate market value in excess of $6.2 billion.

The Implications of a Falling Euro


The European Central Bank is the central bank for Europe’s single currency, the “euro”. The euro was first used in 1999 at which time there were 11 member nations in the European Union. Today, there are 16 countries which are members.

The credit crisis we have experienced in the U.S. was not isolated. Counties all over the globe have been affected and, most recently, the so-called PIIGS nations have been suffering significantly. Economies in Portugal, Italy, Ireland, Greece and Spain have seen debt to GDP ratios explode and needed austerity measures have already prompted both strikes and riots, most notably, in Greece. All of the uncertainty surrounding many of the EU economies has exerted substantial downward pressure on the euro.

Last Friday, the euro closed at 1.2381 to the dollar, its lowest level since April of 2006. So, what are the implications for the commercial real estate sales market of a euro at this level?

Many participants in the market felt that the strength of the euro (or conversely the weak U.S. dollar) was the main reason for the increase of foreign investment in the U.S., and particularly New York and Washington D.C., markets in 2008. From February 2008 through the end of the year, the euro was hovering slightly above or slightly below $1.50. During this period, we saw a tangible increase in the number of foreign high-net-worth investors looking to purchase investment properties in New York, which has continued since. Those who thought that the strong euro was the reason for increase foreign demand have speculated that the falling euro would cause a reduction in the amount of foreign demand. We do not, however, believe that the weak U.S. dollar was the primary stimulus for this foreign interest and that this factor is highly overemphasized as the reason for foreign demand.  

Consider the following: If a foreign investor is purchasing an investment property in the U.S. because the dollar is weak relative to their currency, they are receiving gross rents in the weak currency, they received net operating income and cash flow in the same weak currency and, if they choose to sell the property, they receive their profit in the same weak currency. Therefore, the only way the weak U.S. dollar creates an incentive to invest here is if the foreign investor is utilizing a currency arbitrage strategy whereby they believe the value of the U.S. dollar will increase at a greater rate than their own currency over the holding period.

We believe that foreign investment in the U.S. is much more a function of the relative economic and political stability that the U.S. offers. The present uncertainty oversees is driving investment capital into America in quantities not seen since the mid-1980s. We have closed numerous transactions with foreign investors recently with many more looking to deploy capital here. The number of foreign investors looking to purchase real estate is simply staggering and adds to the overwhelming demand that exists today.

Perhaps the most impactful implication of the falling euro is its impact on interest rates. This is significant as rising interest rates are one of the biggest downside risks the market is looking at.

When the fed ended its asset buying program at the end of March, it exerted upward pressure on interest rates. We saw the 10-year treasury rise from about 3.5% to over 4%. About 3 weeks ago, the fed announced that it would begin a program to sell its $1.3 trillion of assets over time. This method of exiting the market would also serve to exert upward pressure on interest rates. However, with all of the debt problems and uncertainty in global economies, and particularly in Europe (as illustrated by the falling euro), there has been a flight to quality and safety which means a flight to U.S. treasuries. Given the overwhelming demand for treasuries, we saw the 10-year close at 3.44% on Friday.

These lower rates have positive implications for our real estate market. When interest rates stay low, commercial mortgage lending rates stay low as well. This is a necessary and important factor for the health of the investment sales market. We still have a massive amount of deleveraging to deal with and low mortgage rates make dealing with deleveraging that much easier. Additionally, to the extent rates rise significantly, it will create even more negative equity and distress in the market as values fall based upon higher borrowing rates.

The falling euro has, therefore, had a beneficial impact on our market, not directly but indirectly. The causes of the euro’s fall have created a flight to quality and safety which has kept interest rates down and the falling euro has not eliminated any of the foreign purchasing demand from the marketplace.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty services in New York City and has brokered the sale of over 1,050 properties in his career having a market value in excess of $6.2 billion.

Note Sales are Taking Off!


As we have discussed in several previous StreetWise columns, the distressed asset pipeline, which has been clogged for nearly two years, is beginning to loosen up. Lenders and special servicers are faced with thousands of distressed assets on their balance sheets and in their portfolios, yet until recently, only a small number of these assets have made their way to the market.

Everything that has happened from a regulatory perspective has provided these entities with the ability to avoid having to make decisions relative to these distressed assets. These regulatory changes have included changes in the FASB market-to-market accounting rules, modifications to REMIC guidelines and bank regulators letting banks hold notes on their books at par even though they know the collateral is worth substantially less.

The Federal Reserve’s highly accommodative monetary policy is allowing for the recapitalization of the banking industry which is relieving pressure on lenders to deal with distressed assets quickly.

Additionally, the foreclosure process can be particularly long, cumbersome and complicated (particularly in states other than Texas and Georgia). Many holders of distressed assets are choosing to sell notes rather than wait for the foreclosure process to be completed which would allow them to sell the assets rather than the paper.

Note sales can take two forms. The first is simply a financial transaction in which a bank or special servicer will pool many disparate loans with disparate collateral spread throughout a state, region or the entire country. These loans will typically be sold to what we call a “financial engineer” which will look at each loan, determine where it is in the foreclosure process, what can be done to enhance the note’s value and how to maximize the value of the individual loans for resale. These buyers are simply buying on a percentage-of-par basis and are looking to make a profit on the slicing and dicing of these pools.

The other approach to note sales is to simply sell a single note, collateralized by a property or a portfolio of properties. The typical buyer here will be a real estate investor who is buying the paper to get to the title of the property and own the assets on a long-term basis. These buyers typically pay much more for the note than a financial engineer will because they don’t have to build a profit into the process of administrating the foreclosure process. This is the type of note sale transaction that Massey Knakal has focused on in our Special Assets Group.

If we look at the distressed assets that we have sold recently and are currently working on, 78 percent of them have been note sales as opposed to REO (“Real Estate Owned” is  a typical term used by lenders for properties they take title to after a foreclosure) sales.  We expect this percentage to decline as time goes on and the foreclosure process is allowed to finish. Our large percentage of note sales versus REO sales is not surprising when consideration is given to the percentage of recovery sellers are achieving on note sales relative to collateral value.

Collateral value is the key measuring stick by which we determine how effective a note sale recovery can be. I am often called by investors who claim that they want to buy distressed notes, however as soon as they tell me that they wish to buy paper at 50 cents on the dollar, meaning 50 percent of par value, I immediately know that they are not serious note buyers and let them know that they will be unsuccessful in this endeavor.

The reason I say this is because if the collateral value is only 40 percent of par, they will be overpaying at 50 percent and will lose money. If, however, the collateral is worth 90 percent of par, and they are only offering 50 percent, they are not going to be able to buy anything as savvy investors will certainly outbid them. Therefore, we see that par value is really irrelevant relative to what a recovery will be.

A much more important indicator is collateral value or what the asset is worth if the deed were to be delivered. When we are retained by an institution to sell a note, the first thing we do is calculate the value of the collateral. This amount is then discounted by a percentage which is derived based upon taking the entire scenario into consideration. The variables include how far along the institution is in the foreclosure process, whether the borrower is being cooperative and the quality of the documentation.

Clearly, if a foreclosure process is nearing its conclusion, it is a very different situation than if the foreclosure process has not even begun but the note is in default. Similarly, if a borrower is cooperative, it adds value to the recovery. We have done transactions in which the borrower had a completely adversarial relationship with the lender, such that we could not even gain access to the property. In cases like that, we may not even be aware of the the tenancy in the property. In a scenario like that, the discount for the note would be much more significant than if the borrower is cooperative and we have a sense of how the real estate is performing.

Additionally, it is important to do significant due diligence on the quality of the documentation that exists. All documents must be reviewed including the note, the mortgage and the intercreditor agreements (to the extent that there is subordinate debt on the property). A summary of all interaction between the borrower and the lender can also be helpful.

When marketing a note, we move down two parallel paths simultaneously in that we must not only perform due diligence on the real estate asset, we must perform due diligence on the documentation to fully understand what exactly it is we are selling. This takes tremendous amount of time and effort but is important to make sure that all participants in the transaction fully understand what they are stepping into.

Another factor which greatly affects the recovery on a note sale is the extent to which the seller of the note is prepared to make representations. Some lenders have very complete files and are willing to make substantial representations about what they have and what they have done. Here , recovery is enhanced.  

There are, however, some lenders that will only represent that they own the note and have authorization to sell the note. They will not make any representations beyond this. I am often asked by a lender or a special servicer if a note can be sold under those circumstances. My answer is always that everything can be sold and everything has a price; it is only a question of what the highest price will be. Understandably, the more definitive the representations a lender is willing to make, the higher the final price and, therefore, the recovery.

Note sales have been dominating the distressed asset market recently and are becoming more and more popular. This is particularly true as distressed asset holders attempt to take advantage of the supply / demand imbalance that I often refer to in this column which provides the seller the ability to achieve pricing higher than what current economic fundamentals would dictate. There is significantly more demand than there is supply which is resulting in dozens of investors competing for each availability.

Under these circumstances, there is no wonder why distressed asset holders are eagerly entering the note sale market.                

Mr. Knakal is the Chairman and Founding Partner of  Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having an aggregate market value in excess of $6.2 billion.

1031 Exchanges Come Roaring Back to the Market


Welcome back old friend! Yes, we have seen a re-emergence of the blessed 1031 tax-deferred exchange in recent weeks, and what a welcome sight it is.

The opportunity to protect hard earned equity in the sale of an investment has been available to investors since 1921. However, this part of the tax code was so complex that only a small segment of the investment community took advantage of this mechanism.

In 1990, the Omnibus Budget Act provided more widespread access to a broader set of investors as this option was clarified and simplified. Section 1031 exchanges are often mischaracterized as “tax free” when they are actually “tax deferred”.

The theory behind this mechanism is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay taxes. Only the form of investment has changed, therefore, it would be unfair to collect a tax on a “paper” gain.

When an investor utilizes this mechanism, the deferred gain is payable when the replacement property is sold and is not part of yet another exchange. At that point, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

1031 exchanges in the investment property market have been growing in popularity since the mid-90s and fueled a majority of transactions in the mid to late 2000s. With falling property values and transaction volumes beginning in late 2007, we saw a significant reduction in 1031 transactions.

In previous StreetWise columns, I have gone into detail about the supply / demand imbalance and the fact that the volume of sales was so low due, mainly, to lack of supply as opposed to waning demand. The supply of available properties for sale is generally fed by discretionary sellers. When value falls, as it has done since 2007, discretionary sellers withdraw from the market and the supply is then fed by distressed sellers. Distressed sellers have not fed the supply in numbers which were expected because everything that has occurred from a regulatory perspective has allowed these sellers to avoid dealing with their distressed assets.

Recently, we have seen the flow of distressed assets begin to loosen as banks and special servicers are beginning to clean up their balance sheets and portfolios. Simultaneously, we have seen discretionary sellers returning to the market. The tangible evidence that this is actually happening can be seen in the 1031 activity we have seen recently. Distressed sellers are rarely left with any equity to reinvest in the form of a 1031 exchange. Discretionary sellers, on the other hand, often have significant equity to redeploy via this tax-deferred vehicle. We are, once again, seeing sellers ask for flexibility in closing periods to provide them with better chances of being able to effectuate an exchange.

During the past 4 weeks alone, we have signed 12 contracts with purchasers who are investing 1031 funds. Moreover, we are receiving multiple calls each day from investors who are looking for properties to complete exchange transactions. This is certainly reminiscent of 2006 and 2007 when so many transactions were motivated by tax-deferment. The demand side has been very strong for quite a while as institutional capital has returned to the market, joining the high-net-worth individuals and families which have dominated the horizon for the past couple of years. Foreign high-net-worth investors are present in rapidly growing numbers and the re-emergence of 1031 capital adds more pressure to already overwhelming demand for investment properties.

Don’t mistake my perspective as I am not suggesting that market conditions are back to the go-go, bubble inflating, years of 2005 to 2007. I am, merely, passing along a trend that we are seeing which has, for the most part, been absent for quite a while. It is yet another sign that the recovery is upon us.

From an intermediary’s point of view, or anyone’s, who is reliant upon transaction volume for their livelihood, it is positive to see this type of activity returning to the market. To the extent that distressed sellers continue to dispose of assets and discretionary sellers return to the market, transaction volume has no choice but to increase. As sellers with real equity sell, each transaction is likely to stimulate another transaction as a 1031 is contemplated.

This trend certainly bodes well for our projection that transaction volume will increase by about 40% this year over last year. Welcome back old friend, indeed!

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having a market value in excess of $6.2 billion.

Can the Building Sales Market be Good and Bad at the Same Time?

In recent weeks, Streetwise has looked at the divergence of opinions and perspectives present in the marketplace. There is significant optimism and pessimism present at the same time so the question becomes, Can market conditions actually be positive and negative at the same time? I believe the answer is yes but it is dependent upon individual circumstances.

There are many indicators in the market which lead us to be optimistic. Unemployment, the metric which most profoundly impacts the fundamentals of real estate, appears to have bottomed and we are starting to see job growth. Inflation appears to be in check and even the most bearish economists don’t see inflation as a short-term problem. Interest rates, while edging up, have not caused any significant increase in borrowing rates. When the Fed ceased its asset buying program at the end of March, we saw upward pressure on interest rates, particularly at the long end of the curve as the 10-year T-bill, which had consistently hovered around 3.5%, rose to over 4% for a brief period. Last Friday it closed at 3.625%, a surprising result after the Fed announced 10 days ago that it would begin a program to sell a trillion dollars worth of assets over time.

Rental rates appear to have bottomed as well. In both the commercial and residential sectors, concessions are being reduced and, in a few cases rents are rising. I actually spoke to two bankers last week who told me that they were dropping commercial lending rates due to the competition with other banks to put money on the street. This, to me, was a remarkable and eye opening occurrence.

In our building sales business, the positive signs are abundant. The supply of available properties for sale is growing. This supply is increasing as lenders and specdial servicers are coming to terms with assets that are underwater and have little hope of being turned around. We have seen a tangible increase in notes and REO that these entities are coming to market with. Additionally, discretionary sellers are beginning to place assets on the market as they feel the palpable optimism that exists in the market.

While supply has increased, this additional supply has been met step-for-step by increasing demand. Activity on all of our listings continues to be excellent as all three of the demand “food groups” are in full swing. These include high-net-worth individuals and families, institutional capital and foreign buyers. Due to this overwhelming demand, we saw, for the first time in many quarters, prices rise in the first quarter of 2010 in some segments of the market. In other segments, prices continued to slide. This dynamic, however, is certainly indicative of a bottoming in pricing.

This all sounds very positive, but you may ask, What about all of the properties with negative equity in them? The fact is that, even with fundamentals becoming healthier, they will not revive at a pace quick enough to bail out most of the distressed assets that are in the market. Therefore, it is entirely likely that we will have improving positive conditions in the market while simultaneously seeing an active distressed asset component. Based upon the substantial number of distressed assets that exist, it would not be at all surprising to see distressed assets come to market over an extended period of time, two or three years perhaps.

One investor I spoke to last week told me that he believed distressed assets would be present in the market as far out as 2016 and 2017 when the 10-year CMBS loans that were originated in 2006 and 2007 mature. His belief was that growth will exist but will be too slow to recoup all of the losses experienced in this market downturn. I certainly hope he is not correct.

Presently, we see many positive signals in the market indicating that we are emerging from the malaise we have been living with.  Things are certainly looking up for our market; however, distressed assets will be part of our playing field for years to come. So the answer appears to be, “Yes”, things can actually be good and bad at the same time. It all depends upon which side of the fence you are sitting on.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having a market value in excess of $6.2 billion.


August 2021

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