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.

19 Responses to “The Bulls Versus the Bears (Part 2)”

  1. 1 matt in philadelphia March 28, 2010 at 11:11 am


    In your opinion, what will be the catalyst (i.e. government intervention, etc.) for lenders to start disposing of distressed commercial properties? In the last significant property downturn during the early ’90s, the RTC led the way towards recovery. What does the recovery future look like for this cycle?

    It’s great reading your posts. Keep up the good work!


  2. 2 Brooke March 28, 2010 at 11:24 am

    Bob, this blog provides the most comprehensive overview of the commercial real estate market and the issues that we are facing. Could you please address the economic recovery and how the bulls and the bears differ on the progress of the recovery. The statistics may say there is a recovery going on but people are still hurting and tenants in my buildings are all singing the blues. I know some may just be looking for rent relief but some have not asked and are still crying.

    Thanks so much for sharing your wisdom with us.

  3. 3 Jason Burk March 28, 2010 at 11:33 am

    Speaking of distressed assets. Will the timing of dispositions all be caused by the FDIC’s influence on banks. Or is the delay a fear and denial issue of the bank’s? I seemd to fall more on the side of the bears on this. And the more time passes the bear is winning.

  4. 4 Nathan Isikoff March 29, 2010 at 8:50 am

    Great series!..You must read “The Great Short” by Michael Lewis. Look forward to seeing you soon.

  5. 5 Tejas March 29, 2010 at 11:29 am


    In your next article can you discuss further about ‘capital on the sidelines’. I agree with you the ‘fear’ for underwriters has been, will my yields be weaker than the future risk free rate in the US? Leaving many US investors WAITING for RTC 2.0, Fed to move to treasuries ONLY, stabilization of rents, and an appreciating dollar. Waiting is the hardest part…

    Can you touch on international investing? Not from the perspective of German/Australian investors buying in America but rather American’s buying in China/India/Brazil? With a focus on foreign tax and deal structuring? Foreign investments will provide some solid returns while investors wait in the doldrums.


  6. 6 Kent March 29, 2010 at 3:34 pm

    In Part 1 I agree with the Bulls. In Part II I generally agree with the Bears. Overall, I guess I think we will end up somewhere in-between. That means some opportunities, but it will not be easy. Patience will be rewarded.

  7. 7 David Bahr March 31, 2010 at 4:48 am


    Inspected an industrial building in Freeport yesterday. The buyer stated he was locked in on a 5.75%, fixed rate, 20-year amortization, no balloon payment loan. The lender was JPMC. He said JPMC wouldn’t agree to it (where the buyer banks) until he shopped at Citi and they offered the same thing except 25-year amortization. (40% LTV on $1M loan)

    I’ve never heard of such a thing in the commercial market. Have you? As an appraiser, I don’t like this. No refi work in 5-years when the loan resets. Could this be a new “fad” going forward? Banks exist to lend so they gotta lend. Perhaps going forward, they’ll have to more attractively price their product for their customers, if they want any.

  8. 8 rknakal April 1, 2010 at 6:33 am

    Hi Matt, thanks for your post and your kind words. I believe mortgage maturity will lead to many distressed assets coming on the market. Advantageous mortgage terms such as interest only periods, interest reserves and floaters over LIBOR are not likely to be continued with the extend/pretend, delay/pray extension strategy. This is particularly the case if a property is not cash-flowing to the extent that it can carry its debt at a reasonabley close to market rate of interest.

    If the government changed mark-to-market or bank regulators no longer allowed lenders to hold assets on their balance sheets at par even though they know the collateral is worth far less, we would see a wave of distressed assets come to the market overnight. However, this would also lead to hundreds,if not thousands, of bank failures so I dont anticipate this type of intervention.

    The recovery’s future will be dependent upon whether the bulls or the bears are correct. I believe that when the market does gain sufficient traction, it is going to take off like a rocket, but it could be quite a while before that happens.

  9. 9 rknakal April 1, 2010 at 6:36 am

    Hi Brooke, thanks for your post and your kind words. I will address the general economy and the perspectives of the bulls and the bears in either next week’s column or the final installment in two weeks.

  10. 10 rknakal April 1, 2010 at 6:45 am

    Hi Jason, thanks for your post. The FDIC could impact distressed asset flow by changing policy. There are presently 720 banks on the FDIC’s watch list and it is predicted that several hundred will fail this year. How the institutions are dealt with will have an impact on distressed asset flow as well.

  11. 11 rknakal April 1, 2010 at 6:47 am

    Hi Nathan, thanks for the post. I have the book you mentioned in my library at home and will move it up the list so I can get to it a bit sooner.

  12. 12 rknakal April 1, 2010 at 6:58 am

    Hi Tejas, thanks for your post. Capital on the sidelines will be addressed next week. In terms of investing overseas, I am far from an expert on that subject as I have never sold any properties outside of the U.S. I think the situation with Google and China illustrates the potential difficulties doing business overseas. I have had a few clints who have purchased properties in Russia and the results were disasterous. I believe in diversification but I also think investors in real estate should only invest in areas that they know very well. One of the reasons many foreign investors like the U.S. is due to the relative political stability and laws that (until recently) were very transparent and can be relied upon. The government’s and bankruptcy courts’ ability to displace senior secured creditors as was done with the auto makers and in the Yellowstone case, make you scratch your head but, out system is still better than anything else that exists.

  13. 13 rknakal April 1, 2010 at 6:59 am

    Hi Kent, thanks for your post. As I always say, time will tell…

  14. 14 rknakal April 1, 2010 at 7:01 am

    Hi David, thanks for your post. I am not sure I understand the loan being offered to your client. Are you suggesting that JPMC is offering a commercial loan with a 20 year term or just 20 year amortization with a 5 or 10 year term (5 and 5)?

  15. 15 David Bahr April 6, 2010 at 8:33 am


    Sorry for the delay and confusion. The loans being offered by both JPMChase (20 years) and Citibank (25 years) are fixed rate, no balloons, no resets.


  16. 16 John April 8, 2010 at 5:48 pm

    David, I believe you are referring to what is known as a “fully amortizing” loan. It is commonplace in the portfolio life company sector where 15/15 or 10/10s are offered (sometimes 20/20). Most borrowers opt not to take it given it carries with it higer debt service given shorter amortization. In your example it appears that Citi is “buying the business” probably given their cost of funds are so low (thank you Mr. Taxpayer). I’ve never heard of this from a bank, much less a 25/25.

  1. 1 Interest Rates » The Bulls Versus the Bears (Part 2) « StreetWise Trackback on March 28, 2010 at 8:27 am
  2. 2 The Bulls Versus the Bears (Part 2) « StreetWise Equity on me Trackback on March 28, 2010 at 8:58 am
  3. 3 Streetwise: The Bulls Vs. The Bears of Commercial Real Estate « Robert S. "Bob" Lowery Trackback on April 15, 2010 at 7:09 am

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