Archive for March, 2010

The Bulls Versus the Bears (Part 2)

Last week, we began discussing the divergence of perspectives among many participants in the marketplace, some of whom are viewing the future very optimistically and some of whom remain pessimistic. The bulls believe the market has bottomed and a real, sustainable, recovery is upon us. The bears believe that present market conditions represent the eye of the storm and that we are in for even rougher times ahead as we get further into 2010, 2011 and 2012. This week we will continue to look at factors which are affecting the marketplace and how the bulls and the bears are interpreting them.

4) Deleveraging: During the bubble inflating years of 2005 to 2007, there were massive amounts of debt placed on investment properties. As values have fallen significantly from the peaks, there is far too much leverage in the system and most participants agree that deleveraging must take place. The opposing perspectives of the bulls and the bears relates to the extent to which this deleveraging will actually take place.

Using the New York City market as an example, we believe there are presently 15,000 properties (out of a total of 165,000) that currently have negative equity positions. On these assets, there is approximately $165 billion in leverage. If we take into consideration the reduction in value that we have seen in various product types and use today’s more conservative loan-to-value ratios, we believe there should only be $65 billion in leverage on these assets if the market were appropriately leveraged.

This means there is $100 billion too much leverage in the system. Of course, this will not all come out of the market in the form of losses. Some properties can still cash flow at 90, or 100, or even 110 percent loan-to-value ratios (thanks in large part to low interest rates). Other properties want to be held for the long-term by owners who have alternative sources of revenue to feed properties that are under water and others will be worked-out between the borrower and the lender. However, we believe that $30 to $40 billion will be absorbed, in the form of losses, before the dust settles in this cycle.

The Bulls: The bulls believe that interest rates will stay low for an extended period of time which will make the strategy of simply waiting, beneficial and will save many of the properties that are in negative equity positions They believe that the extent to which deleveraging will occur will be far less than anticipated (ie, many fewer distressed assets than most participants expected). They believe that fundamentals are becoming enhanced and the deleveraging projected in 2011 and 2012, based on the maturity of 2006 and 2007 vintage loans, will not be as significant as expected.

The Bears:  The bears believe that there will be massive deleveraging, particularly during 2011 and 2012, as the 2006 and 2007 loans mature. They suggest that the 06 and 07 loans are the ones that are the most underwater as they were originated at a time when value was at its peak and loan-to-value ratios were at their maximum. They also have indicated that they feel ten-year CMBS loans, which will create significant maturities in 2016 and 2017, will cause a second wave of deleveraging. This would add more stress to the marketplace and indicates the “lost decade” conditions similar to those that Japan recently suffered.

5) Unemployment: If you are a frequent reader of StreetWise, you know that I view unemployment as the indicator which has the most profound affect on real estate fundamentals. During the recent recession, the U.S. has lost 8.5 million jobs. The importance of job losses to real estate fundamentals can be illustrated as follows: if someone has lost a job, or fears they may lose a job, they wont move out of mom and dad’s home to set up their own household, they don’t move from a smaller rental apartment to a larger one, they wont move from a rental unit to buy an apartment or a single family residence and companies that are letting people go, don’t take more office space, they want less office space. In order for our real estate fundamentals to tangibly recover we need substantial job growth.

The Bulls: The bulls currently point to the fact that we are losing only tens of thousands of jobs per month today while we were losing 600,000 and 700,000 jobs per month in the first quarter of 2009. They believe this losing-jobs trend will soon reverse and that we will have positive job growth beginning within the next few months. The Department of Labor has projected that in 2010 our economy will grow by an average of 90,000 jobs per month. The bulls view this as very positive news.

The Bears: The bears point out that, simply based on population growth, we need 100,000 jobs created per month. They claim that if we had 100,000 jobs created per month throughout the year we would still not gain back any of the 8.5 million jobs that were lost to the recession. The bears claim that, in order to have a sustainable recovery, we need 300,000 to 400,000 jobs created per month and that, even at this rate, it would take several years to regain the 8.5 million jobs that were lost.

6) Interest rates: The Federal Reserve Bank’s interest rate policy has been keeping rates at historical low levels. The direction of these rates and the timing of rate increases will have a significant impact on our marketplace moving forward. Rate increases could cause many transactions which are hanging on by a fingernail to crater. Interestingly, floating rate borrowers turned out to be smart (as opposed to fixed-rate borrowers who are paying higher rates) as low rates are saving some operating statements. An increase in interest rates could change this dynamic significantly. How much they increase, and when, should be on the minds of every floating rate borrower in the market (and also on the minds of anyone with mortgages maturing in the short-term).

The Bulls: The bulls believe that the Fed will keep interest rates artificially low for the foreseeable future. They do not believe that the likelihood of inflation is real in the short- to medium-term and they believe that the Fed’s exit from the marketplace will not be impactful on our interest rate environment. While it is expected the Federal Funds Rate will increase by year’s end into the range of 1.25% to 1.5%, the bulls believe that lenders will allow the spreads to compress to absorb this increase, which will not increase mortgage rates to any significant degree. If commercial mortgage rates remain steady, values will not be negatively impacted.  

The Bears: The bears believe that inflation is indeed on the horizon which will exert upward pressure on interest rates and that the Fed’s exit from the marketplace will cause rates to climb. To the extent that the Federal Funds Rate is increased (and most economists believe that it will be in the 1.25%  to 1.5% range by year’s end), mortgage rates will be driven up significantly. Increasing interest rates will have a dampening impact on commercial real estate values.

7) Gross Domestic Product (GDP) Growth: During this crisis we have gone through an unprecedented reduction in GDP growth. 70% of U.S. output is consumer driven and we have seen consumer confidence and consumer spending at near-record lows during the past couple of years. With housing values down significantly from the peak (homes are the major asset for an overwhelming majority of U.S. citizens), Americans are feeling less wealthy and are, therefore, spending much less. They are also unable to use home equity lines of credit to gain access to whatever equity they may have had. Mortgage equity withdrawal was a major contributing factor to a -4% U.S. savings rate a few years ago. Consumer spending drives our economy and provides the fuel for GDP growth.

The Bulls: The bulls believe that we will see GDP growth in the 5 to 6 percent range which, while still below typical GDP growth coming out of a recession, is significantly above what the consensus is among U.S. economists. They believe that consumer confidence (and therefore spending) will rebound and, moreover,  the stimulus will start to tangibly take hold and that the output of the U.S. will grow on a healthy path out of our current position.

The Bears: The bears believe that fourth quarter GDP growth, at 5.9%, was created mainly by government intervention and that the economy does not have the wherewithal to sustain growth levels at these rates without government support. The bears believe that consumers are uncertain about their economic futures, particularly given the uncertainty of the U.S. tax outlook moving forward, given all of the government spending and massive deficits being observed on federal, state and local levels. With an apparent unwillingness for politicians to cut spending (except in New Jersey and Virginia), Americans see the only possible outcome as increased taxes across the board. The bears expect GDP growth to be a sluggish 2 to 3 percent for the balance of 2010 and into 2011.

Next week we will continue our look at the divergence between the perspectives of the bulls and the bears by addressing corporate earnings, capital on the sidelines, financing, capitalization rates and supply and demand. If there are other topics you would like to see addresses, just let me know. Until then…..

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 having an aggregate value in excess of $6.2 billion.


Real Estate Bulls Versus Bears Battle Intensifies (part 1)


As we have progressed through the recent recession and entered recovery mode, I have observed an interesting change in participant’s perspectives on where we are headed from here. Up until a couple of months ago, it seemed like there was consensus within the commercial real estate sector regarding the direction of things to come. We felt the effects of high unemployment and a degrading of our fundamentals. From late 2007 through the beginning of 2009, we knew things were going to be difficult with transparent downward pressure on rental rates and property values. The health and direction of these metrics have always been, and remain, linked to aspects of the broader economy.

Lately, it appears those who are optimistic (the Bulls) are becoming much more optimistic and those who are pessimistic (the Bears) are becoming much more pessimistic.  Generally, participants in the market are relatively more optimistic than they were one year ago as evidenced by the many “investor surveys” that have been published since the beginning of the year. However, some optimists are seeing nothing but blue skies and some pessimists are now nearly guaranteeing that things will get much worse as our economy and our real estate market double-dip.

This week, I want to begin looking at various aspects of our economy and discuss what I am hearing from both the bulls and the bears. There are about a dozen aspects I will address so this will be a multi-part column which will continue for another week or two. More importantly, I would appreciate hearing from StreetWise readers about your perspectives on our current market how you see things evolving over the next two to three years.  Are you a bull or a bear? Let’s see what others are saying:

1) Inflation:  The level of inflation in the economy is important to watch because, if inflation rises above the Fed’s comfort level of 1% to 2%, Chairman Bernanke will likely raise interest rates in response. This increase in interest rates would likely translate into higher lending rates at banks which would exert downward pressure on commercial real estate values.

The Bulls: The bulls see inflation as being in-check with far too much deflationary pressure in the system for inflation to be a concern in the short to medium term. Unemployment remains high, consumer spending is moderate and demand for consumer credit is very low. The bulls are not concerned about inflation at all.

The Bears: The bears are concerned about inflation, not in the short-term, but definitely in the medium and long-term. With the U.S. government doubling our money supply in 2009 (which was higher in dollar amount than the aggregate of money supply increases over the prior 50 years!), the bears believe there is no way that inflation will not creep into the economy. If the bears are correct, rates will be increased which will exert downward pressure on values.

2) Housing:  The U.S. housing market is important to watch because, for most Americans, homes represent their largest asset. As property values increase, there is a wealth effect which greatly impacts consumer spending which still represents about 70% of our Gross Domestic Product. As equity levels rise, homeowners can tap into this “savings” through mortgage equity withdrawal (MEW). MEW was a major reason (along with credit card usage) why the savings rate in this country dropped to -4% (yes, negative 4 percent) a few years ago. Even if MEW was not used, the wealth effect of large amounts of perceived equity encouraged consumers to spend more than they would have otherwise. Given the influence of the consumer on our economy, the performance of the housing market must not be overlooked.

The Bulls: The bulls believe that the housing market has bottomed and a recovery has begun. And I am not referring to the National Association of Realtors who have been publishing optimistic press releases consistently over the past 15 months (many based upon just one month’s worth of a statistically insignificant data) insinuating that the market had bottomed even as values continued to drop like a stone.  Chip Case, of Case-Shiller fame, recently stated that he believed the housing market had bottomed and that he expected values to rise throughout 2010. Others in the market, while having a self-interest to portray a recovering housing sector, have presented compelling data that foreclosures are down and values are rebounding. The bulls also point to the fact that we have been in a sustained environment of low housing starts for an unusually long period of time. For nearly two years, housing starts averaged about 450,000 on an annual basis, well below the stabilized long-term average of about 1.3 million. The interesting thing about the 450,000 number is that the U.S. market looses 300,000 to 500,000 homes each year due to natural disaster or obsolescence. This housing start data will bode well for supply / demand dynamics moving forward, the bulls say.

The Bears: The bears see a double-dip in housing on the horizon. They say foreclosure activity has been artificially curtailed by various government programs and pressure the government has placed on lenders to “go easy” on homeowners who are under water. This has kept foreclosure numbers well below their natural level and, without unemployment reversing and income levels rising, defaulting homeowners have little hope of reversing their fates. The loan-modification programs have been a disaster for the government as less than 200,000 mortgages have been permanently modified (as opposed to the 4 million target) and more than 70% of the loan temporarily modified fall back into default within 6 months. The bears also see a market completely propped up by the government. The first-time homebuyers tax credit (now expanded to include some non-first time homebuyers) gave an $8,000 credit to buyers when the 3.5% FHA downpayment on the average U.S. home ($178,000 last month) is only $6,230. Here the government is handing the buyer a deed and a check for $1,770. The bears say this is what precipitated the problem in the first place. Between Fannie Mae, Freddie Mac and FHA, the government guarantees 92% of all home loans in the nation. As unemployment remains elevated, which most economists are predicting through 2011, the likelihood of further housing value declines seems inevitable to the bears.

3) The Fed’s Exit: The Federal Reserve Bank has doubled its balance sheet in the past 18 months. At some point the Fed must withdraw its support and the implications of this on our commercial real estate market could be significant. The Fed’s exit can occur in only four ways. 1) They can stop buying assets. Last year the Fed pledged to purchase $1.3 trillion of assets which were mostly in the form of mortgage backed securities and treasuries. The intent here was to exert downward pressure on interest rates. Most of the $1.3 trillion has been spent and this program is scheduled to cease at the end of this month.  2) They can sell the assets that they have purchased. Again, these were mostly mortgage backed securities and treasuries. 3) The Fed can raise the federal funds rate. 4) The Fed can drain excess bank reserves from the system. Numbers 1, 2 and 3 will exert upward pressure on interest rates while number 4 will reduce the pool of available capital that could be used to make commercial real estate loans. Whether the Fed will exit or not is not disputed. What is remains the timing of the withdrawal and its impact. This is where the bulls and the bears differ.

The Bulls: The bulls acknowledge that the Fed will exit and that it will cause upward pressure on interest rates. They believe that the increases in rates, however, will have minimal impact on commercial real estate values as the banking industry will be willing to compress spreads more quickly than they will be willing to pass along higher lending rates to borrowers. They also believe that the draining of excess bank reserves, which presently stand at about $800 billion, will have little impact as banks are not lending these reserves now anyway. “So what if they drain from a pool which is untouched” the bulls claim. They see this as tactical and not impactful on commercial real estate.

The Bears: The bears see the Fed’s exit as putting significant pressure on interest rates to rise and they believe these increases will have a significant impact on mortgage rates. The Fed’s highly accommodative monetary has allowed the banking industry to recapitalize itself as they are borrowing at close to zero and, if they are lending, spreads can be 600 or 700 basis points depending on the product. If banks choose not to lend, they can simply purchase risk-free treasuries and make 250 to 350 basis points depending upon term. Many bankers indicate that they will compress these spreads to absorb interest rate increases of 50 to 75 basis points but, above that, the increases will be passed along to borrowers. Higher commercial mortgage rates mean downward pressure on value. The bears also see the draining of excess reserves as a negative as lending volume will return at some point. When it does, commercial real estate will be competing with other asset classes for this debt and to the extent there is less capacity in the system, there will be less available for office buildings, retail properties and apartment complexes.

In subsequent parts of this topic, we will look at deleveraging, unemployment, interest rates, GDP growth, corporate earnings, capital “on the sidelines”, financing, cap rates, supply and demand, and rent levels. If there are other topics you would like me to address here, just let me know.

More to come next week on StreetWise………

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

Why Buyers Should Buy Today

Two weeks ago, the title of my Streetwise column was, “Why Would a Seller Sell Today if They Didn’t Have to?” This prompted several emails from readers asking me to address the flip side of that coin which is why buyers should buy today.

The general perception is that prices have either hit bottom or may only slide further by another 5 or 10%. As we’ve discussed in several other columns, the timing of the market approaching bottom will likely coincide with the time that unemployment peaks and reverses its trend. Job creation will have a positive impact on our fundamentals and will exert upward pressure on pricing.

There are several reasons why buyers should want to be active today.

Low Supply: The supply of available for sale, particularly in New York City, is never very high. The average holding period here is about 40 years as the average turnover rate, over 26 years, has been only 2.6% of our building stock. This average declined to 0.87% citywide in 2009.

As supply is always low, there is never an abundance of properties to look at. So, if a property is available for sale today, a buyer may want to take the opportunity to act if it is an asset that they consider “core” (for them which differs from investor to investor) as that asset is not likely to be available in the future when the buyer has perceived the market to have bottomed out.

It is Nearly Impossible to Call the Bottom: After all, we only know that we have hit bottom after we are past the bottom. Some investors feel optimistic about the market moving forward, and believe we have already hit bottom. Fearing that they may miss the buying opportunity, they are deciding to jump in today to take advantage of market conditions.

Inflation: With the U.S. Government having doubled the money supply of the country in 2009 (the increase was greater than the aggregate increases over the last 50 years), many investors feel that inflation is likely to follow. During an inflationary period, hard assets are assets of choice as their value will rise in conjunction with inflation. Commercial real estate is a particularly attractive hard asset under these circumstances. The key would be to buy the hard asset before inflation kicks in, locking in long-term, low-interest, fixed-rate debt. As inflation kicks in, it would drive up the value of the asset and the advantageous debt terms create an even better performing investment.

If we are not at the Bottom, we are Very Close: Another reason to buy today is because if we are not at the bottom, we are certainly close to the bottom. Nationally, investment property prices are down 30% to 40% depending upon the marketplace. In New York City, average prices are down 31% from the peak. Whether prices go down another 5% or up another 5%, will it really matter to the long-term investor whether we are slightly above the bottom or not?

It is impossible to accurately time the bottom of the marketplace. If we use an equity market analogy, when Citigroup stock hit $1 per share, if an investor was only willing to pay 95 cents and decided not to purchase because they thought the stock would fall farther, would that investor really care if they had purchased at a $1 with today’s price of $3.92?

One of my very good clients, who has been investing in commercial real estate for over 20 years, told me that his biggest regret is that he did not buy more aggressively. He said he should have offered more for the properties he bid on because, as a long-term investor, it really didn’t matter if he paid a little more.

Values are Likely to Hit Record Highs in a New Peak:  A secret to success in commercial real estate investing is to simply be able to hold-on until the next cycle kicks in. In every new cycle we have seen a new peak in value significantly in excess of the prior peak. The overwhelming majority of participants in the marketplace believe it will be no different this time, particularly in the real estate sector.

The Savings & Loan Crisis in the early 90’s was precipitated mainly by over-speculation and over-building in commercial real estate. When the market rebounded, it rebounded significantly higher than the value levels we saw in the mid to late 80’s.

We entered this cycle without the massive speculative construction that we had before the S&L crisis. Our present crisis was not caused by the real estate industry although commercial real estate has been a casualty of this crisis. Therefore, our fundamentals were in much better shape going into this crisis than it was as we entered previous downturns and it is expected that, when the market does recover, it is going to skyrocket to new heights not seen in the past.

There is still uncertainty in the marketplace, but, after all, that is what makes a market. If everyone knew everything and everyone agreed on everything, the market would be a fairly boring place. Commercial real estate investing has risks associated with it, but, for those who want to be in the game, buying today should prove to be very lucrative over the long-term.

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.

Could Government Policy Impact Commercial Real Estate More than Changes in Fundamentals?


There is no doubt that we are living in a time when there has never been a more closely tied relationship between politics, economics and real estate. In fact, the unprecedented level of government intervention has had profound implications for our real estate fundamentals. This has been true for both the residential and commercial markets.

In the residential market, the impact of government intervention could not be clearer. The government’s initiative to increase the homeownership rate in the U.S. from, the almost-equilibrium level of, 62% into the high 60s has been front and center. This one initiative, which created a platform to put people into homeownership who could not afford to own homes, provided the shove off the cliff for Fannie Mae and Freddie Mac, leading them into insolvency. The mandate to put people into houses that the could not afford to own them forced the GSEs to loosen their standards. They would buy almost anything in sight which encouraged banks to originate mortgages to anyone with a heartbeat. How could they possibly substantiate making those infamous “ninja” loans? You know, no income, no job, no assets……no problem. A strong case can be made that this one initiative was the tipping point for our current financial crisis, setting the stage for participants in the marketplace to do what they do best when opportunities present themselves. .

Today, the government is the most important influencer of the residential market. Between Fannie, Freddie and FHA, the government now guarantees approximately 92% of all single family mortgages in the country. Moreover, the government purchases most of those mortgages and keeps interest rates low by having the Fed purchase most of the mortgage backed securities and treasuries that are offered for sale.

The first time homebuyers tax credit (which has been expanded to include some non-first time buyers) has created a very unusual dynamic. The average home price in the U.S. is presently about $178,000. Most buyers are getting FHA loans today which require only a 3.5% downpayment. This amounts to $6,200. The tax credit is $8.000. So essentially, the government is handing buyers a deed and a check for $1,800 and saying “Go for it”. Haven’t we seen this movie already? If housing double-dips, it will not be a surprise.

In the commercial sector, government intervention has, again, played a leading roll. In order to get the credit markets unfrozen, TALF was expanded to apply to commercial real estate in the hope that it would stimulate the secondary market. The PPIP was created to essentially achieve the same objective. While neither program produced nearly the direct results that were expected, they served a useful purpose in that their sheer existence brought credit spreads in, helping to thaw the frozen markets.

However, the best thing that can be done for commercial real estate is for the government to focus on job creation. The relentless pursuit of other unpopular agenda items does little for CRE and, in fact, hurts our market. Job creation will help fundamentals get back to the point where we will see occupancy rates rise and rent levels increase. When I mentioned this at a conference I was speaking at recently, one audience member stated that when it comes to job creation, “We can’t expect the president to be a miracle worker”. Miracles we don’t need; just a little focus and some strong leadership.

A tax policy that can be relied upon would be a good start. Within the past two months, for instance, we have heard that the Bush tax cuts will be extended, that they will sunset and that they will be extended for some Americans but not for others. Is your head spinning too? Without anyone in Washington (on either side of the aisle) being able to show political will to substantively cut spending, how can we be lead to believe anything other than the fact that our taxes will rise significantly? Uncertain tax policy has been one of the major reasons employers give for not hiring, even when a current need exists.

Another job creator would be consumer stimulation. Why does the government increase taxes, process those dollars through an inefficient machine that removes some of the money in the form of waste, fraud and abuse, and then doles out what’s left in the form of entitlements and bailouts? Why not just cut taxes and have 100% of the money go directly to the consumer? Tax cuts have worked effectively in the past and both parties have used this tool. Not only did Ronald Regan use tax cuts to stimulate the economy but so did JFK. Few people remember that.

The president claims that doubling our exports would create over 2 million jobs, yet three trade agreements have been sitting on his desk since he took office with no attention given to them. It is unlikely this will change until after the mid-term elections (if ever) as union support is critical for this administration and organized labor does not favor free-trade. This is unfortunate as free trade agreements help open markets and expand opportunities for American workers and businesses as they can enter and compete more easily in the global marketplace.

Spending on infrastructure would seem to be another area in which job creation could be attained. Only 11% of the $787 billion stimulus was targeted towards infrastructure and much of that money has not been deployed yet. The idea of forming an Infrastructure Bank has been discussed which would create a public/private initiative to build, augment and upgrade the core infrastructure in the U.S. which is greatly needed.  

People point to “green jobs” as a possible answer. Thus far, the results have been disappointing. $5 billion of government money was allocated to weatherization programs with the intention of putting as many as 87,000 workers back to work “right away”. Many of these workers would presumably be in the construction industry, a sector in dire need of assistance. Thus far, only 2 of the 10 highest funded states have completed over 2% of planned units. In New York for example, we finished a whopping 280 homes out of the planned 45,400. California competed 12 out of 43,400 and Texas was unable to get anything done out of the 33,908 they had planned. Those three states have a total population of about 80 million and only 292 homes have been weatherized, hardly making a dent in that 87,000 jobs number.  

The biggest concern participants in the commercial real estate market should have is that we are now so closely tied to government intervention and policy. This is scary. The track record of Washington’s policy making and initiatives (created, implemented and overseen by both Republicans and Democrats) has been far from stellar. The U.S. post office was established in 1775 and is now insolvent. Social security was created in 1935 and it is insolvent. Fannie Mae was established in 1938 and it is insolvent. Medicare and Medicaid – insolvent. Freddie Mac – insolvent. The Department of Energy was formed in 1977 to lessen U.S. dependence on foreign oil. Since then, the department has grown to 16,000 employees with an annual budget of $24 billion. The result is that we import more oil than ever before. Is it any wonder that only 35% of Americans want the government running a business which represents 1/6th of our economy?

Simply put, Americans are concerned today. Concerned about government spending, taxes, deficits and where we will be in 5 years or 10 years. These concerns impact hiring decisions and consumer spending. And those things greatly impact the fundamentals of commercial real estate. Clear direction and sound policy would go a long way towards normalizing things. We all want our market to recover as quickly as possible. Let’s hope it happens more quickly than we expect.

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.