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.

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6 Responses to “10 Things to Watch in 2010 (Part 3)”


  1. 1 Carl Todd January 10, 2010 at 11:32 am

    rk
    Good analysis. We must be very careful in the use of the budget scalpel and heed the Mohawk caution of “look how today’s decisions will affect the next seven generations”. We must be very careful not to cut programs to the point that put us behind the competitive development such as education and research and that the resulting cuts cost us more in the end than the money saved such as in health care, infrastructure and energy.

    Also, we can stop the phony sound bite “reduced RE taxes” by substituting non-income tax deductible fees for required municipal services by “privatizing” them. Who’s fooling who when the cost to provide those service has an added profit factor? If the contractor’s production cost (with tax paying legal labor) is lower than the municipality’s the head of that department providing the service should roll. The security of a government job, with medical and pension benefits should have a lower total cost than private industry with a profit factor therein.

    On the latter point – When I was a Sr. Appraiser in NYC’s Dep’t. of RE I was captain of for our wage negotiation team for our contract negotiations. We research salaries, benefits and pensions industry wide. We also valued the City’s package and found it to be 20% below the average private industry’s package. We agreed to settle for a package that at the time was 10% below the industrial average for the benefit of the job security, local 5 – 8 hour day week. Yes we even included the extra value of the length of service added vacation time.

    Why did I finally have to leave my City job? The annual direct salary left me too short and my immediate cash needs at the time were more pressing and needed than my deferred benefits. I traded my 5 – 8 hour work week for a 6 1/2 – 10 hour work week and today at 85 (next month) pension vs IRA I’m way short than if I was able to keep my City job. R.E. moon-lighting was a department ethical no that I was not going to violate and tarnish my professional reputation and standing. In the appraisal field you’re as good as your reputation and your handling of your last case. The R.E. trade has the shortest memory of any industry.

    Again in municipal budget cuts – use the carpenter’s rule -“Measure three times and cut once”

  2. 2 Jeff Green January 11, 2010 at 9:15 pm

    Affirmative for the housing market at number 5.
    It must go up.

  3. 3 rknakal January 14, 2010 at 10:06 am

    Hi Carl, thanks for your post. It is always interesting to hear your perspective.

  4. 4 rknakal January 14, 2010 at 10:07 am

    Hi Jeff, thanks for your post. The question that is most interesting is, When?

  5. 5 Dave Collins January 14, 2010 at 5:05 pm

    Mr. Knakal,

    Having been in the industry since the mid-80’s, what strikes me the most about this cycle is that there is such a belief this time in the opportunity in distressed real estate/debt. What it really says is that we all willingly drank the kool-aid and knew that the underlying valuations were bunk. It was a colossal exercise in group think or wink, wink, nudge, nudge. Given your comments on the amount of bids on recent distressed deals, I wonder if we are going to have a “bounce back” effect on pricing. After all, as an industry, we certainly have proven to be a poster child for irrational exuberance.

    A final comment: I am in the process of raising a small fund to buy assisted living senior properties that are NNN leased to long-term operators. The net return to investors is 10-12% virtually risk free–think of clipping a bond coupon.I have had numerous prospective investors say they want mid-20% returns–at a minimum–and they are pursuing distressed real estate. Good luck with that.

    Thanks for your always in-depth and insightful comments.

  6. 6 rknakal January 17, 2010 at 12:22 pm

    Hi Dave, thanks for your post. Although there is tremendous demand in the market, there are several forces exerting downward pressure on pricing. This upward pressure versus downward pressure scenario will likely play out over an extended period before a winner is crowned. As for those investors looking for mid-20s returns, they should look somewhere else. That is not even close to the market today.


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