Archive for January, 2010

The Real Estate Industry Should not Get Too Excited About 4Q09 GDP Growth

Hey, don’t get me wrong. We should be happy that GDP is growing after what we have been through during the past couple of years. We certainly should take it as it is preferable to well below trend growth. The big questions are: Is this growth sustainable? and, How will the employment picture be affected?

In order to answer these questions, let’s take a look at the components of our 4Q09 economic expansion.

The broadest measure of economic activity, Gross Domestic Product, grew at an annual rate of 5.7% in the fourth quarter of 2009 after growing at just 2.2% in the third quarter. This growth was the fastest for the U.S. economy since the third quarter of 2003 when it expanded at a rate of 6.9%. (Even after 4Q09 growth, GDP remains 1.9% below its peak 2008 levels) Overall, 2009’s GDP finished with the biggest contraction since 1946 when the country was still reeling from World War II. In 2009, GDP fell by a total of 2.4%.

Our economy has been able to grow without seeing jobs grow as employers have been getting more production out of fewer workers. The most recent data available is from 3Q09 where we saw that productivity grew at a robust rate of  8.1 percent. While positive from the perspective that productivity growth is always a precursor to economic recovery, the real estate industry needs job growth in order for our fundamentals to turn positive.

The dominant factor in fourth quarter growth was not consumer spending but was instead inventory related. Nearly 60% of GDP growth came from a temporary factor – the sharp slowdown in inventory slashing by American businesses. Inventories contributed 3.4% of the 5.7% expansion. It is interesting how fluctuations in inventories impact how GDP growth is calculated. You would think that in a robust economy, goods would be selling so fast that inventories would get depleted at a fast rate and that fast rate of inventory reduction would indicate the economy is healthy.

It is actually the opposite. In a healthy economy, inventory reductions are met with increased production which keeps inventories at relatively high levels. During a downturn, production is not initiated which causes inventory levels to shrink. The destocking of inventories in the fourth quarter slowed to the point where substantially more of final demand had to be satisfied by new production. Using this method of counting, even if destocking slows to zero in 1Q10, inventories will make a positive contribution to GDP growth.

The sharp decrease in inventory slashing, from $139.2 billion in 3Q09 to a much more modest $33.5 billion in 4Q09, also reflects a desire by businesses to be ready for increased demand and a recognition that they may have cut production too aggressively during the downturn.

(As we know, GDP figures are subject to revision and often these revisions are substantial. For instance, 3Q09 GDP growth was originally announced at 3.5%, was revised down to 2.7% and was finally revised to 2.2%. We expect another downward revision, in March, to the 4Q09 figures as inventories are such a big component and the real estate industry has seen industrial vacancy rates growing substantially and rapidly. If production was keeping pace at the rate projected, we find it hard to believe industrial (warehouse) vacancies would be at their presently growing and high levels.)

These inventory changes alone cannot sustain growth over an extended period of time. 70% of our output is consumer based and, thus far, final sales to consumers and businesses have been disappointing. Consumer spending in 3Q09 was 2.8% which fell to 2% during 4Q09. While the fourth quarter increase was more than expected due to the expiration of the cash-for-clunkers program which stimulated auto sales, in the past consumption has been a much larger driver of growth after a recession. Weak consumption figures are a reminder that 10% unemployment is causing Americans to hold back. This is the main reason why the Fed has no short term plans to reverse its highly accommodative monetary policy.

Perhaps the most promising aspect of last Friday’s report was the pickup in equipment and software spending. Businesses increased their investment in these areas at an annualized rate of 13.3 % in 4Q09 as compared with only 1.5% in 3Q09. Pent-up demand could be  a significant contributor to this gain.

Exports also grew nearly twice as fast as imports indicating that international trade increases, aided by a weak dollar, added to GDP growth as well.

But let’s look at consumers and jobs as these have the biggest impact on our commercial real estate markets.

The Labor Department announced Friday that wages and salaries of non-government workers rose at a seasonally adjusted rate of 0.5% in 4Q09. This was the largest increase in over a year, but was very weak by historic standards. Separately, consumer sentiment on the Reuters/ University of Michigan index rose to 74.4 for January, up from 72.5 in December. This is up from last February’s low of 56.3. While this reflects increased confidence among American households, confidence levels are still significantly below levels seen prior to the recession’s start in December 2007.

As I have said over and over again on StreetWise, commercial real estate needs jobs for our recovery to be tangible. It is upsetting to think that the Economic Policy Institute in Washington projects that even if our 5.7% GDP growth rate were to be sustained for three years, we would still not create enough jobs to climb out of the hole caused by this recession. Moreover, most economist project that GDP growth will moderate during the rest of 2010 with a more likely 2.0% to 2.5% total growth for the year. The fourth quarter spike reveals how deeply businesses emptied their shelves last year but gives no indication that they are confident in bringing back workers or hiring new ones.

There are presently two schools of thought on what the recovery will look like. The first is the “V – School” which says that production, employment and durable goods spending, which falls to excessively low levels will see activity bounce back just as strong as the pendulum swings back to compensate for the fall.

The second is the “U School” which says that the recover is more dependent upon the nature of the recession and not its depth. It says that there is no reason to expect that an asset bubble bursting that pushes spending down from unsustainable levels must give way to a strong recovery ( think 1991 and 2001).

Final demand appears to be tracking sluggishly towards the U.

In order for the recovery to be sustainable, businesses will have to start investing again and at a much faster rate than the 2.9% 4Q09 result which remains relatively weak for this juncture in a recovery. And for that to happen we need a resurgence of greed over fear and a revival of corporate animal spirits. Anti-business rhetoric coming out of Washington does little to rekindle this spirit.

Washington is now the main obstacle to a durable and sustainable expansion. Real job creation, which commercial real estate so desperately needs, will not be catalyzed by politically directed credit (by virtue of taking the big-bank tax and giving it to community banks to lend to small business) or government spending but from business investment and new-business creation.

It is difficult to imagine this happening with the uncertainty surrounding future taxes. If the government came out with a definitive tax landscape (related to the pending Bush tax cut sunset and other short-to-medium-term tax levels) and a believable plan for dealing with massive budget deficits, employers might start hiring again. And that would create real growth in our industry.

Forecast GDP growth of 2% to 2.5% for 2010 is hardly making anyone feel good. How it actually plays out is anyone’s guess and here are the potential deviations: To the upside, sharp easing of financial conditions could stimulate consumption and/or capital spending more than expected; To the downside, the effort needed to overcome the removal of unprecedented fiscal stimulus from the economy may be greater than anticipated. We could also suffer from any policy errors the Fed makes as it attempts to exit the market.

Our message to Washington should be, keep the TALF, keep the PPIP, keep everything but give us JOBS. Focusing on that a year ago would have been nice.

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.


The Massachusetts Election’s Potential Impact on Commercial Real Estate

Last week, we witnessed Scott Brown’s historic victory in Massachusetts as he captured a senate seat which had been held by Edward M. Kennedy for 46 years. Moreover, it hadn’t been since 1972 that the state last elected a Republican senator.

The people of the Bay State have spoken, but what did they say? Clearly, not all voters were saying the same thing. Some were protesting, some were fearful, some were angry, some were vacillating and some were rallying to old causes. Ted Kennedy was the U.S. senator most closely associated with the century old goal of universal “free” healthcare for every American. Astonishingly, the people who sent Kennedy to Washington for that cause 9 times rejected his legacy last Tuesday.

The people of Massachusetts, who already have a similar state program, could be the ones who defeat the present national health care reform bills that have been crafted in Washington by virtue of electing a senator who ran on the premise that he would be the 41st vote against it.

Perhaps the reason is that when Massachusetts passed their healthcare bill, it had a 70% approval rating and after just 3 years it now has a 70% disapproval rating. Perhaps the leaders in Congress antagonized some voters by working covertly to bribe a vote from Louisiana with $300 million in pork, agreeing to have the American taxpayers pick up the tab for all of Nebraska’s Medicaid expenses to win a vote there, and the consistent unfair accomodations granted to various unions.

Perhaps some of the anger had nothing at all to do with healthcare. Perhaps voters were trying to say how angry they were about the financial bailouts, banker bonuses, wars in Iraq and Afghanistan or, more likely, the continuing recession and unemployment. Yes, a recent NBC/Wall Street Journal poll indicated that 60% of the public believe the recession still has a long way to go, notwithstanding what the official definition of “recession” might be.

While the U.S. was suffering through a recession, compared frequently to the Great Depression, Congress wasted a year squabbling like unruly toddlers over healthcare reform. No on in his or her right mind could have believed a workable, efficient, cost-effective plan could have come out of the 2,000 page monstrosity that came out of the Senate after long months of shady alliances, disgraceful back-room deals, unconscionable payoffs and abject capitulation to the insurance companies and “Big Pharma”.

A year was wasted because it should have been spent working on job creation, not healthcare reform or other components of a bloated agenda making up the White House’s to-do list. Virtually everyone, even if they haven’t lost their job, knows someone who has. Nearly two-thirds of Americans say that 2009’s stock market rally has done nothing to make them feel better about things, indicates the recession is over or will make the job market better.

It’s all about jobs for our economy (and our commercial real estate market). Why Washington can’t seem to get this is beyond me. The December jobs report was yet another indication that the wasted year was, indeed, wasted. The Bureau of Labor Statistics (BLS) non-farm payroll data showed that December job losses totaled 85,000. Democratic strategists immediately point to the fact that monthly losses were significantly higher when the president took office. That is of little consolation to the 8.6 million Americans who have lost jobs since the recession began in 2007. And hardly matters to the 15.3 million people who are presently out of work or the additional 10 million who are under-employed. The idea that Congress is not spending every waking hour trying to fix the broken economic system and put suffering Americans back to work is beyond pathetic.

The BLS’s household survey, a better and more comprehensive measure of both the unemployed and underemployed, indicated a loss of 589,000 jobs in December. Small business is the normal source of new jobs in our economy and it seems that fewer than 10% added new jobs while 20% continued to cut payrolls. Those reducing jobs cut twice as many, on average, as did the growing companies add.

Is it any surprise that companies are not hiring? Corporate earnings continue to perform well but only in the face of sub-par top line revenue which indicates the relative level of consumer demand. Additionally, 2010 budget shortfalls at the state, county and city level are expected to hit an astonishing $200 billion nationally. By law, most states must operate on balanced budgets meaning we will see reductions in services, further layoffs and, the biggest problem, substantial tax increases.

Consumers and employers alike can no longer rely on home equity, rising values of stock portfolios, or borrowing as a basis for spending in lieu of savings. And what do they see on the horizon? Only two things: taxes and an anti-business perspective coming out of Washington unlike anything we have seen in a generation. To even the casual observer, it appears Washington is taking out its frustration on those who are successful by regulating them more and taxing them more. The American dream has never been to lay on your back and float as the government takes care of you.

The election in Massachusetts has provided the administration with an eye-opening opportunity to take a step back and rethink strategy and tactics.  Unless on another planet, they must be concerned about November 2010 potentially being remembered as another one of the great “wave” elections we saw occur in 1994, 1974 and 1946.

The question is whether the president will look at how President Clinton artfully moved to the center and got re-elected or will put blinders on and become another Jimmy Carter. Granted, today’s circumstances are much different than those facing President Clinton as the Democrats still have large majorities in both the House and the Senate.  Although it has only been days since the Massachusetts election, the president has, thus far, been defiant in the conviction for his continued agenda and policies without deviating form his pre-election tact.

Commercial real estate could be a beneficiary of the election results. More than anything, our market needs JOBS. The shocking results in Massachusetts could have put the spotlight on job creation. Unfortunately, the deficits that have been created must be addressed as average citizens are aware of, and are concerned about, massive and growing deficits. Deficit reduction is now the mantra in Washington which means that new large-scale investments in infrastructure and other measures to ease the employment crisis and jump-start the most promising industries of the 21st century are highly unlikely.

A rational person could have guessed that the administration’s focus would have veered away from healthcare, and other initiatives, and onto job creation based upon last Tuesday’s stunning results. Giving the benefit of the doubt, give the president time to adjust to the new reality of American’s obvious priorities. If the wake-up call takes hold, we should see a tangible shift to job creation. The more jobs that are created, the better for our real estate market. And we need a lot of jobs; 1.3 million per year just to keep up with new people who enter the workforce, forgetting about getting all of those who lost their jobs getting back to work.

So, will President Obama become Bill Clinton or Jimmy Carter? The answer to this question will have a significant impact on the speed with which the commercial real estate market recovers. And it will indeed recover;  it would just be nice to have it happen sooner rather than later.

Do Politicians Understand the Banking Industry?

Last week, the president announced a new “Financial Crisis Responsibility Fee” (he didn’t dare call it a tax!) to be paid by the largest banks in order to recover expected losses from the Troubled Asset Relief Program. Welcome to yet another chapter in the year-long crusade by legislators to revive private sector business by vilifying, assailing and soaking it.

The banking industry is a critical element of our commercial real estate market and we have been negatively affected by the disappearance of many of the large commercial and money center banks from our lending market for nearly two years now. For this reason we must look carefully at how Washington deals with these companies.

The president is asking for large banks, thrifts and insurance companies, those with assets in excess of $50 billion, to  foot the bill for all TARP losses. This would be done through the implementation of a 15 basis point tax on the liabilities of the banks, less Tier 1 capital, or high quality capital such as common stock, disclosed and retained earnings and capital which carries FDIC guarantees. It is expected that about $100 billion will be raised over 10 years from the new tax.

This proposed tax will surely pass in the House. Whether it passes in the Senate, or is even constitutional,  is another story.

One of the problems with this tax is that it does not take into consideration that banks were not the only recipients of TARP money. The auto industry, Fannie Mae and Freddie Mac (and a program to help homeowners avert foreclosure), and AIG also received funds from TARP. In fact, most of the banks have repaid their TARP money, including almost $20 billion in interest, and most of the losses are expected from the auto industry and AIG.

Some of the banks reluctantly took this money in the first place. Had they known, at the time, that their compensation would retroactively be scrutinized and capped and that their obligations would amount to joint and several liability, I doubt they would have signed up if they did not absolutely have to.

There are a couple of aspects of the TARP that we must consider. First, the capital doled out was in the form of “investments”, not corporate welfare or entitlement payments which the taxpayer never intended to get back. As it has turned out, some of these investments were sound, and some not so much.

Why should those in whom sound investments were made be forced to pay for those that the government was ill-advised to invest in?

Second, taxpayers were acting in their own interests in bailing out the system. They weren’t doing anybody a favor. Money wasn’t “spent” to bailout the banks. Taxpayers merely traded one claim for another, trading dollars for claims on real assets such as housing, commercial property, industrial equipment and corporate equity. The value of these assets had been depressed further than economics would dictate out of the fear that the taxpayer wouldn’t intervene. Taxpayers acquired these assets on a bet that asset value would increase simply based upon their intervention. In most cases they were correct.

In fact, the Fed now has a balance sheet about the size of Citigroup’s and, last week, reported gigantic profits of $52 billion for 2009. This is only slightly less than Wall Street reported as a whole. This throws interesting light on the president’s comments that the new tax must be imposed to “recoup” bailout costs.

But why single out the banks, which are showing the Treasury a handsome profit on its TARP investments? Are politicians now the judge and jury when it comes to attributing liability for the financial crisis? How many times have you heard officials say, “Wall Street caused this mess?”

It is dangerous for the U.S. to have politicians determine culpability and then use tax policy to penalize those who they indict without even going through a formal process.

There are many industries which had a hand in the crisis. It would be easy to point to the policies of many administrations which sought to increase the homeownership rate in the U.S. This exerted pressure on the GSEs to relax requirements which inflated housing bubbles  (Many believe this was the underpinning of most of the crisis. Most of the CDOs and derivatives which became toxic were based upon housing policies). In the early 2000’s, there were concerns that Fannie and Freddie were spiraling out of control. Barney Frank was outspoken about how they should be left to do what they were doing. How would Mr. Frank feel if the next administration raised his personal tax rate to 75% due to his contribution to the crisis?

Last week and again this week, we will hear about strong earnings from Wall Street firms and the customarily large bonuses which move in tandem with these earnings. These have caused resentment from Washington, which can’t connect the dots to see that the elimination of two giant competitors (Lehman and Bear) and, more importantly, their highly accommodative monetary policy is the main reason for the earnings. And yes, it is the administration’s monetary policy, not the Fed’s. Presumably, the White House approves of the Fed’s monetary stance or they would not have proposed Chairman Bernanke for another term.

This tax is all about politics, not about TARP repayment. Why are the automakers exempt? Why not consider a tax on General Motors, Chrysler and their unions? The automakers were the worst “investment” the government made and will likely be the largest source of TARP’s projected $68 billion in losses. These losses will stem from the political decision to restructure rather than liquidate GM and Chrysler which filed for bankruptcy protection last year.

The largest beneficiary of the car companies’ bailout was arguably the United Auto Workers Union which emerged with a far better deal than did bondholders and other senior secured creditors. The losses on TARP investments are compounded by the unaltered pension plans for union members. In a typical bankruptcy, a 10-year, $40 billion pension obligation would be reduced to about $10 billion or eliminated altogether. Add $30 to $40 billion to the taxpayer’s tab for this benefit and you really have to question the advisability of saving these companies, particularly when looking at their financial forecasts moving forward. They did, however, support the president in his election run, so there you have it. Throw in a juicy exemption from the additional taxing of their “Cadillac” healthcare plans for good measure!

So the administration goes after the banks because it is politically favorable. Do they really think this tactic will work economically? What is likely to happen if this tax is passed by Congress?:

1) It will exert even more disincentive for banks to lend. They will have less capital available to lend and the loans they do make would be subject to this tax. This flies completely in the face of the administration calling for banks to lend more to businesses. It would also be a setback for our real estate capital markets.

2) It would create a disincentive for banks to merge for fear of going over the proposed or amended asset threshold. Mergers are effective strategies, particularly in difficult times. This would also reduce the number of bidders the FDIC would see at their sales of banks they take over.

3) It could threaten U.S. bank’s ability to compete with overseas rivals which are not subject to the tax.

4) Some of the banks may try to avoid part of any tax by selling more brokered deposits in the wholesale market. If that happens, traditional commercial banks and the FDIC will not be pleased.

5) It is likely that the new tax would simply be passed along to consumers in the form of higher ATM fees or the like.

Jumping on the “Banker bonuses are too high” and “Make the big bankers pay” bandwagon is simply an attempt to gain political favor. The president suffers from the worst approval ratings and highest disapproval ratings a U.S. president has seen after 1 year going back to Jimmy Carter.

What Mr. Obama and others apparently fail to understand is that banks’ own shareholders benefit from these huge performance bonuses. The bonuses are typically tied to those who make large profits for their employers. Burst of outrage from politicians or even grilling bank CEOs in front of a congressional hearing will do little to impact this system. Bonuses may consist of more stock than cash today but the amounts are still high. The public has been giving the banks credible and convincing votes of confidence all year by bidding up the value of their shares. It cannot seriously be argued that investors are ignorant of bonus arrangements.

If Congress really wants to change the behavior of banks, they must convey that no bank is too-big-to-fail. This implicit guarantee keeps risk taking high and will cause a focus on the short-term as opposed to the long-term. The $50 billion litmus test is not the right answer either. CIT, an entity with over $50 billion in assets, just went through bankruptcy and, by any objective reckoning, there were no systemic consequences. The new $50 billion tax level has lowered the bar and increased the scope of future bailouts by drawing a wider circle around firms that can gamble with implicit federal backing. Do politicians really think about the ramifications of their positions before they publically announce their ideas?

Coming up with a plan that allows failure is, no doubt, hard work. Perhaps reintroducing Glass Steagall or a similar platform which separates traditional banking from hedge-fund trading. Perhaps the answer is what a bipartisan Senate effort is considering; the creation of a special bankruptcy court to decide whether an institution should go through bankruptcy or be subjected to an FDIC resolution process.

Another idea to reduce the moral hazard of too-big-to-fail would be to restore long-ago limits on leverage. For instance, eliminate the corporate income tax for financial companies and replace it with a tax on assets that rises with the bank’s leverage ratio. There could be a tax-free zone at leverage levels below present regulatory standards. Margin requirement reforms could also be a component of this platform.

If a bank is truly too-big-to-fail, it should be dismantled into smaller pieces that the economy can digest. Simultaneously, the government should make it clear that it will allow these institutions to fail.  This would do more to enhance the integrity of the risks that are taken, and the compensation that is given,  much more than any punitive tax policy would.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York and has brokered the sale of over 1,050 properties in his career.

10 Things to Watch in 2010 (Part 3)

And now, the conclusion of this three-part series:

7) Taxes. The tax landscape will have a huge impact on commercial real estate in 2010. Local, state and federal politicians have proven time and again that they simply do not have the will to reduce spending. “Fiscal responsibility” is not in their vocabulary.

In 2009, nationally, sales tax collections were down 9% and income tax collections were down 12%. Together, sales and income taxes make up roughly half of state and local tax collections. Property tax collections were up slightly but are expected to fall as tax assessments catch up with falling residential and commercial real estate valuations.

At a minimum, cities will be working through the catastrophic drops in revenue for the next 18 to 24 months as state and local tax revenues tend to lag behind the downturns, as well as the upturns, in the economy because of the time it will take for collections to catch up with increasing store sales and higher incomes when they arrive.

With tax revenues continuing to fall, several states are grappling to plug budget holes. The combined deficits of the states for 2010 and 2011 could exceed a quarter of a trillion dollars. Ten states have a deficit, relative to the size of their expenditures, as bleak as that of near-bankrupt California. In New York, we are literally down to our last dollar causing our governor to blast legislators in last week’s state-of-the-state address for their inability to make difficult decisions on spending cuts.

Most states misused stimulus money by spending on new programs rather than adjusting to lean times, just like almost every individual and company has done. Now that the stimulus money will no longer be coming, the states have to pay for these programs with their own money, money they don’t have.

So when states should be reducing expenditures to match a new normal of lower revenue collections, they have spent their way into a position which means they will have little choice but to raise taxes to meet their constitutional balanced-budget requirements. This means more income taxes, more real estate taxes, more sales taxes, more taxes of every kind and on every level: local, state and federal.

Capital gains taxes, on a federal level, will increase from 15% to 20% at the end of this year when the Bush tax cuts sunset. If the healthcare bill passes in its current house form, another 5.4% will be added to that. The president has mentioned potentially adding “only” 3% to 5% to the capital gains tax. Cumulatively, these could nearly double the capital gains tax in 2011 (which could stimulate some property sales in 2010).

The tax landscape could also change the way real estate transactions are structured. Carried interests will now be taxed as ordinary income as opposed to capital gains, potentially altering new partnership agreements for promoters.

I am going to discuss 8) Inflation, 9) Capital on the sidelines, and 10) Monetary policy together as they are all interrelated and will cumulatively impact the direction of the commercial real estate sales market over the next two to three years.

We believe that when unemployment peaks, real estate fundamentals will be their weakest and values will be at their lowest. After the market bottoms, we expect prices to bounce along that bottom for some time as a fight between inflation, capital and monetary policy plays out. The winner of this fight will influence whether values bounce higher or lower within a band around the bottom.

Inflation is now in check, at least as far as the core (which excludes volatile food and energy prices) indexes are concerned. “Slack” (excess capacity) is the best predictor of inflation both at the aggregate level and in individual sectors of the economy. Slack is pervasive throughout the economy, not just in the well-known data on unemployment and industrial capacity utilization.

The significant increases to the U.S. money supply in 2009 will, at some point, place tremendous upward pressure on inflation, likely causing it to rise above the Fed’s comfort zone of 1% to 2%. . When it does, the Fed will respond by raising interest rates. Increase rates exert downward pressure on real estate values.

There have been billions and billions of dollars raised to purchase distressed and core assets. Demand is being seen, both domestically and internationally, from institutions and high net worth individuals. This strong demand has resulted in competitive bidding for nearly all the properties we are currently selling.

In 2009, we would routinely get 25 to 35 offers for income producing properties and, amazingly, received over 50 offers on every non-performing notes we sold.  These numbers are due to the small supply of available properties and the overwhelming demand we are seeing in the market. All of this “capital on the sidelines” exerts upward pressure on value.

(While not officially one of the “top 10” things to watch, we will also be keeping an eye on the constrained supply of available properties. The market must de-lever which will, likely, cause additions to the supply of distressed assets coming to market. The 2006 and 2007 loans are the most underwater and most of them will be maturing in 2011 and 2012. We look for  these to add to the available supply over the next two to three years. Increase supply will exert downward pressure on property values.)

How will the Fed sequence its exit from the market? Each of the possible strategies for this exit have negative implications for real estate values. The four most likely strategies include: 1) terminating the current program of asset purchases (mainly mortgage-backed securities), 2) draining excess bank reserves via reverse repos and/or term deposit facilities, 3) its traditional method of raising short-term rates through parallel increases in the federal funds rate and the interest rate on reserves and, 4) selling assets outright.

Numbers 1, 3 and 4 above will increase interest rates. As these rates rise, they will put pressure on banks to make the difficult decision to either let spreads compress or pass the rate increases along to borrowers in the form of higher mortgage rates. The Fed’s current near-zero interest rate policy is allowing the banking industry to recapitalize itself and bankers are getting comfortable with the enormous spreads they are able to achieve. While some spread compression is likely, higher borrowing rates are inevitable as the Fed tightens.

If the Fed chooses to drain reserves using reverse repos or term deposit facilities it will encourage banks to park reserves at the Fed, rather than lending them out, taking money out of the lending stream ie, less money available for commercial real estate loans. Less available debt would exert downward pressure on commercial real estate values.

How these factors impact one another and the timing of them will provide us with an idea of the direction of value over time and the extent to which that direction has staying power.

So there you have it; 10 things to watch in 2010: 1) unemployment, 2) corporate earnings, 3) credit markets, 4) gross domestic product, 5) the housing market, 6) the political landscape, 7) taxes, 8) inflation, 9) capital on the sidelines, and 10) the Fed’s monetary policy. It will be interesting to see how these factors perform and impact each other.

As we enter 2010, I wish each of you health, happiness and prosperity… and the hope and anticipation of better days ahead.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York and has brokered the sale of over 1,050 properties in his career.

10 Things to Watch in 2010 (Part 2)

Below is a continuation of last week’s Part 1 of the 10 Things to Watch in 2010:

4) Gross Domestic Product. GDP is an important metric to watch to get a sense of how our economy is performing. In the third quarter of 2009, we saw GDP grow positively for the first time since the second quarter of 2008 marking a technical end to the recession (I could go on for pages and pages as to whether the  “recession” is really over). However, even in light of positive growth in GDP, we saw estimates of growth drop from an initial level of 3.5% (touted by Washington at every opportunity) to a revised estimate of 2.8% and then to a re-revised estimate of 2.2%. Unfortunately, the overwhelming majority of this growth was catalyzed by government intervention in the form of the Cash for Clunkers program and the first time home buyer’s tax credit.

The consensus of economic forecasters expect 2010 will be a year with growth better than the past two years but  at only a modest 3% to 3.5% level (much lower than typical post recession growth). Unfortunately, this level would not be high enough to bring unemployment down significantly.  

Will GDP growth be sustainable without government intervention which is scheduled to phase out by mid-year? Outside of the labor market, this is the biggest question mark hanging over the economy: How will consumers and businesses respond when government support fades?

The two components of growth that we will be monitoring closely moving forward will be the net change in private inventories and business investment (non-residential  fixed investment).

Inventories have been drawing down rapidly as we have seen nearly $300 billion liquidated in the second and third quarters of 2009. The continuation of this trend is an important step towards recovery. Thin private inventories will allow production to spike quickly when demand returns, resulting in positive economic output.

During this recession, the pullback by consumers was outdone by an even sharper withdrawal by businesses. Capital spending tumbled more during this cycle than at any time since the Great Depression. This segment provides, potentially, the greatest upside surprise in 2010. 

Business balance sheets, for the most part, look promising. Profits are up, the cost of capital is down and productivity is strong. According to the Fed, the corporate financing gap, reflective of how much companies must raise externally, hit a negative $189 billion in the third quarter from a negative $153 billion in the second quarter. A negative financing gap means companies have the funds in-house to support potential capital expenditures. However, a sustained rebound in capital spending is likely not to occur without improvement in consumer spending.

5) The Housing Market. To a great extent, the performance of the housing market will impact consumer confidence and consumer spending (key to GDP growth). This market has been hammered as current house prices are at, roughly,  fall of 2003 levels, 29% below the peak achieved in the second quarter of 2006 according to the S & P/ Case-Shiller Index. Today, nearly one out of every four homes has a mortgage balance greater than its market value (or one-third of all homes with a mortgage). This leave approximately 15 million homeowners “underwater”.

Trouble throughout the housing sector is clearly abating, however, homeowners, lenders and builders have a long way to go before they are out of the woods. Home sales data is difficult to interpret as existing home sales look positive but the extent of the impact of government stimulus in this sector is significant. New-home sales data is extremely volatile as it makes up only about 15% of all home sales, thus, the upward and downward readings are taken from a much smaller statistical sample. Four month averages here are a more clear indication of trends.

Much of the recent improvement in sales is due to artificially low mortgage rates, created by the Fed’s purchases of mortgage backed securities and the first time home buyer’s credit. Both of these initiatives are set to expire by the middle of this year. When they do, sales activity will likely take a hit similar to the evaporation of auto sales after the expiration of the Cash for Clunkers program.

We believe there is greater downside risk in this sector than upside risk based upon the fact that the spike in foreclosures is nowhere near its end. At the end of the third quarter, 4.5% of loans were in the foreclosure process, up from 3% a year earlier. In 2008, more than 1.7 million homes were relinquished via the foreclosure process, short sales or deeds in-lieu of foreclosure. In 2009, this number grew to 2.0 million and projections for this year expect the number to swell to about 2.4 million.

The Making Home Affordable program was rolled out by the White House in February of 2009 with the intention of providing relief to struggling homeowners. While it has lowered mortgage payments on a trial basis for hundreds of thousands of people, it has largely failed to provide permanent relief. As of mid-December, 759,000 homeowners had received loan modifications on a trial basis, typically lasting three to five months. Only about 31,000 of these people had received permanent modifications.

This program has had two distinct impacts on the sector. The first is that has raised false hopes among people who simply cannot afford their homes. The second is that by trying to modify-out of this crisis, the crisis will be lengthened. Additionally, banks have been using temporary loan modifications as justification to avoid an honest accounting of the mortgage losses still embedded in their balance sheets.

One area of the housing sector could show some hope in 2010. Residential investment (new home construction) fell so sharply during this recession that it has little room to decline further. In fact, starts were at a level of less than 400,000 on an annual basis at various points during 2009 compared to a trend-level of about 1.25 million (It is interesting to remember that about 500,000 homes are taken out of the stock each year by natural disasters or intentional demolition).

Sales of new homes peaked in July of 2005 and in November of 2009 stood at 74% below this peak. However, inventories have been reduced to their lowest levels since 1971, so construction is likely to rise providing a contribution to overall economic growth. Home construction, particularly given its depressed level starting point, could be a positive surprise for 2010.

6) The Political Landscape. What I mean here is the type and extent of regulation which will be implemented and the impact it will have on our economy.

Politicians have been beating the drum of regulation of financial firms and this could have a dramatic impact on our credit markets. A growing concern is the limited availability of credit to fund companies whose growth could help abate the country’s persistent high unemployment. Will regulation stifle credit availability?

What will be the perspective of those making policy on regulation? Will they embrace the capitalist system of the U.S. in which we have a dynamic, volatile economy with painful episodes (like the recent one) to get faster long-run growth in living standards or will they look at it from a more European perspective, consisting of a more stable economy with fewer crises but also slower growth over time? These are interesting and thought-provoking questions.

The European model seems to prize stability over risk even at the cost of less innovation. Some argue that overemphasizing stability in the wake of the crisis will mean less wealth for the next generation. Some argue that the boom was a mirage consisting of false prosperity driven by excessive leverage. Others argue that capitalism is simply not stable and we should just deal with that fact while others promote a system of ups and downs incorporating trying to avoid the very highest peaks and the very deepest troughs.

Important for commercial real estate is that any new regulation of the financial industry should distinguish between firms engaged primarily in speculative trading and the lenders linked to the real economy of Main Street. A real danger is that regulation of the former might inadvertently strangle the latter. This issue would become acute if Congress passes measures that force all banks to bear the costs of protecting those institutions whose activities pose systemic risks. Among the unintended consequences of such an approach would be that consumers and small businesses, starving for credit, would indirectly bear the cost of such fixes.

New regulation should be implemented only after Congress requires financial institutions to account separately for their trading and traditional banking activities. If history has taught us anything  it is that, unfortunately, the regulation we are going to get will be much more a matter of politics than economics. Clumsy, ill-conceived and hot-headed efforts advertised as promoting the ability to avoid a repeat of the current crisis could yield neither more stability nor more growth. It could also result in less credit availability, something the administration claims is something they want to promote.

For the conclusion of 10 Things to Watch in 2010, please come back to StreetWise next week …….

Mr. Knakal is the Chairman of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career.