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.

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22 Responses to “Real Estate Bulls Versus Bears Battle Intensifies (part 1)”


  1. 1 Tony J. March 21, 2010 at 1:22 pm

    Hi Bob, this is a very interesting piece and I am looking forward to the follow up. I think I am mainly a bull as I think things are getting better. I don’t know if I feel that way because of the amount of time we have been in the new reality or because I see more action. Even though I am optimistic, the deficits scare me. Our interest payments are greater than some countries GDPs.

    Thanks for the insights. Tony

  2. 2 John March 21, 2010 at 10:57 pm

    Bob,
    Greatly enjoy reading your articles. Very well writen, cogent, powerful! As somebody raising money for “vulture funds” I’m definitely on the pessimistic side of real estate fundamentals and values.

    While Obama and his minions socialize our lives and our healthcare, not a single new job has been created. Every “bailout” type program has failed to create anything like the long-term stability this country needs to get out of this recession. Bring on the double dip, we’ll be waiting to buy when prices hit RTC 2.0 levels.

    John

  3. 3 Rob Mathes March 22, 2010 at 9:46 am

    Based on the analysis presented to date, it appears that the bulls have a short to medium term outlook with their optimism based on the lack of new supply and few closed transactions over the past two years leading to significant pent up demand; especially given the “deep pockets sitting on the sidelines.” The Bears seem to believe that none of that matters as long term structural macro weaknesses will overwhelm any positive short term demand. As such, one could walk a very thin line being both bullish and bearish depending upon one’s time line perspective. The key, as always is people’s willingness to transact, whether residential or commercial. However, transactions in any significant number depend entirely upon credit availability and a narrowing of the bid ask spreads. The longer the banks can make the relatively risk free spreads you’ve identified, the more likely that they will be able to 1) 1end additional funds and 2) dispose of now sufficiently written down problem assets whether loans or OREO).

  4. 4 Hooman March 22, 2010 at 2:07 pm

    Bob – another excellent update. I am pleased that you are outlining the views of both bulls and bears, as you hear it from the street.

    While 2010 has, so far, gotten off to a much better start than I anticipated, I still think I am in the bear camp. I think back to the high-flying days of the late 1990’s, pre-tech bubble, and remember hearing about a “new paradigm” of investing where the fundamentals did not matter. I think the same message is being said again about real estate, and the overall economy.
    In Los Angeles, the newspapers cover massive layoffs from city and county agencies, the school district, and other bureaucracies, and on the same page promote the rosy real estate market and rising home prices.

    I would like to see your updated thoughts on the “mark to market” issue, and how that has affected the real estate markets.

  5. 5 JM March 22, 2010 at 2:08 pm

    How about Realism?

    Optimisim/pessimism is not a point of view; these are opinions of psychological thought processes.

    Realism is based on empirical data. It is fact, not opinion.

    Optimists will often confuse realism with pessimism.
    ie. Physicists are viewed as the pessimists while the Pope is the optimist. In reality, the physicists are the realists only describing what they see, not hoping for what they see or measure.

    Economics is more an art than a science b/c it is so inter-related with a society which has a primitive DNA expressing emotions. This makes the future very unpredictable. This clouded feeling makes reading data very difficult for some and they rely on their brain’s evolved center to hope and be optimistic. Optimists live longer and happier. Evolutionary biologists will attest to that.

    Rose-colored glasses, however, are a terrible mistake for individuals. Houses and families break apart from this as it leads to greed and/or gambling. What’s worse? When the government forces us to view through those rose-colored glasses b/c it has run out of other options to further competitive productivity.
    Everyone must read the data (govt and private) and make their own informed decisions. Will a 1-2 family house whose rent:buy ratio (aka PE) today of 18:1 move higher in the coming decade? Will it stay the same? Will it drop to historical average closer to 15:1? How about 12:1 as it was in the 1970’s? Will GRM’s of 12X for say a Queens apartment building rise, fall or stay the same in the coming decade? Take all you know about the economy, historical data, the GRM of 4xRR for a 50 family in 1998, etc… and individuals must make their own conclusions. I learned my lesson from the late 80’s, early 90’s the hard way, though I was only a child. I am a REALIST. The streets are not bloddy enough for me.

  6. 6 Charlie P. March 23, 2010 at 7:43 am

    Folks, we just got into this mess. the multi-family buildings market has not even begun to correct yet. these things take a very long time. we are years away from the bloody streets the pervious poster mentioned.

  7. 7 rknakal March 23, 2010 at 7:53 pm

    Hi Tony, thanks for your post. I can see how the deficits scare you. Interest payments on borrowing is crazily high. In New York, for instance, we pay $5.5 billion per year in debt service out of a $132 billion budget. This figure is expected to reach $7.7 billion in 2014 without any additional borrowing. The federal government’s position is much worse.

  8. 8 rknakal March 23, 2010 at 8:11 pm

    Hi John, thanks for your post. Many folks feel the way you do. Regardless of whether you agree with the present administrations policys or not, you must admit that job creation, the most important part of our recovery, has been completely abandoned by them in favor of pushing healthcare. Because of this, the mid-term elections will be very interesting as a proxy for how the entire nation feels about the government’s priorities.

  9. 9 rknakal March 23, 2010 at 8:15 pm

    Hi Rob, thanks for your post. You make some great points about lending and what might create an incentive to lend today. Clearly, with banks enjoying very wide spreads, deals will have to be compelling for them to lend. Their recapitalization, based upon the Fed’s highly accomodative policy, will provide the fuel for them to lend when they feel the time is right. Until then, debt availability will drive certain transactions.

  10. 10 rknakal March 23, 2010 at 8:20 pm

    Hi Hooman, thanks for your post. The “new paradigm” is never new, just a modification of the old paradigm. You are correct that people said that in the late 1990’s and they said it again in 2007. The fact is that economic cycles are a natural part of business cycles and will always be with us. My friend, Dr. Peter Linneman from the Wharton School, says that the cycle always consists of Hubris, Greed then Fear and that throughout history you see this pattern continue to cycle and cycle. He is absolutely correct. More to come next week so stay tuned.

  11. 11 rknakal March 23, 2010 at 8:32 pm

    Hi JM, thanks for your post. If you are a regular reader of StreetWise, you know that I rarely disagree with those posting on this site (not out of any motivation other than I really agree with the viewpoints expressed here). In this case, however, I must let you know that I think “realism” is different to different people. Statistics are subject to interpretation. You tell someone that we lost 20,00 jobs last month and the optimist says, “well, we were losing 700,000 jobs per month a year ago”. The pessimist says, “we need 100,000 jobs created per month to keep up with population growth so I wont be happy until we are creating over 100,000 jobs per month”. Date points can be agreed on but the interpretation of the data is what psychological perspective is all about. Markets are psychological and greed, fear and panic (all psychological perspectives) are what makes markets. If everyone simply looked at numbers and everyone had the same numbers, there would be no market other than a commodity-like exchange where perspective didn’t matter much. But even in a commodity driven market, perspective, or psychology, is what determines buyers and sellers. Realism is realism but psychological persuasion is what makes people do what they do. Everyone’s interpretation of the empirical facts differs and that is what makes markets. JM, Thanks for sharing your thoughtful insights.

  12. 12 rknakal March 23, 2010 at 8:34 pm

    Hi Charlie, thanks for your post. Bloody streets are coming is your message. A bear you are my friend. Many people agree with you. Multi-family properties in NY are holding up better than anything else due to the restrictive rent regulation we have here. I take it you are not operating in thte NY market.

  13. 13 jnelms March 25, 2010 at 9:09 am

    About all I have learned over the years is that in economics there are no experts and no one really has a clue as to what will happen next.

  14. 14 Greg March 26, 2010 at 6:11 pm

    Great article.

    Most investors buy real estate for cash flow or appreciation (both if possible). If one agrees that interest rates will increase in the case of inflation and/or any type of economic recovery (or removal of government suppression) it would seem real estate values must decline further to maintain cash flow (assuming leverage is used) thus eliminating the appreciation buyer.

    Improving operations is a possibility, but this equates to a gamble that operational growth will outpace interest rate risk in the long term. The winning gambler likely breaks even in terms of value. Not a very good bet in my mind.

  15. 15 Chris March 26, 2010 at 9:52 pm

    Robert, who is going to buy these assets when the baby-boomers begin selling them off and their lazy kids don’t want to manage them? I doubt Gen-x and millenials have the cash. Prices have no-where to go but down over the next two decades. Faxtor in what Obama does with death tax and we are in for a real loss as sellers.

  16. 16 rknakal March 28, 2010 at 7:46 am

    Hi Jnelms, Thanks for your post. Clearly, economists are much better at explaining why what happened, happened, as opposed to predicting the future. The point here, however, is not so much about who is right and who is wrong but how people are feeling and why they are feeling that way. Psychology impacts decision making and decision making impacts our markets.

  17. 17 rknakal March 28, 2010 at 7:51 am

    Hi Greg, thanks for your post. Inflation if a double-edged sword for commercial real estate. Hard asset values increase in an inflationary environment as rents will grow with inflation (so will expenses). This will increase the “value” of properties, however, with interest rates increasing, borrowing costs go up and cap rates will have to rise to return the same relative value. The key is to put long-term fixed-rate financing on the assets prior to inflation taking off. Timing this is an art which is very challenging to get just right.

  18. 18 rknakal March 28, 2010 at 7:55 am

    Hi Chris, thanks for your post. Yes, death taxes, and all taxes, are likely to rise over the next few years, at least, to make up for all of the irresponsible spending our politicians are addicted to. I do, however, believe that there will always be capital looking for real estate investments and that, at the peak of the next cycle, values will be much higher than they were at the peak of the last cycle. History has shown us that this will happen. However, due to the massive and unprecedented amount of government intervention, it could be a VERY long time before the next peak is reached.

  19. 19 lighthouseas March 29, 2010 at 2:11 pm

    Great post. Unfortunately I’m more bearish. Ignoring residential real estate, the commercial side presents some big issues for the next few years. With billions of commercial real estate loans now in default and another $1.4 trillion coming up for maturity in the next three to four years with declining RE valuations, I don’t see how we get out of this mess anytime soon. Not sure how the equity gap, loan value vs real estate value, get’s solved without forcing the banks to take more major write-downs in their portfolios.


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