Archive for December, 2009

10 Things to Watch in 2010 (part 1)

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

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

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

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

The country braces for the H1N1 flu epidemic.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.


Thoughts About the Holidays


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

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

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

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

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

“Fifty cents,” she answers.

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

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

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

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

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

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

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

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 during his career.

Economic Recovery Likely to be Subdued

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

How is the economy doing?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Distressed Asset Update

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.