Archive for October, 2009

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.