The Bulls Versus the Bears (Part 3)

For the past two weeks, we have taken a close look at several factors which impact commercial real estate values and how optimist’s (the Bulls) perspectives differ from those of pessimists (the Bears). We continue this discussion below:

8 ) Corporate earnings: Corporate earnings are important as the more profitable companies are; the more likely it is that they will hire employees to grow their businesses. Growing business need more office space and growing retailers absorb vacant storefronts. The more employees that are hired, the better for our economy as output will grow and, most importantly, consumers will have more disposable income and, presumably, they will spend most of it. The recent stock market rally portents a more positive perspective on future earnings. Why the rally has been so strong is due to different factors depending upon whom you ask; the bulls or the bears.  

The Bulls: The bulls believe that corporate earnings have performed well above expectations at this point in the cycle and that this is reflected in a rallying stock market. They believe that these earnings are sustainable and will lead to new hiring initiatives. These earnings will lead to corporate growth which will enhance real estate fundamentals, leading to a substantial and sustainable  recovery.   

The Bears: The bears believe that much of the corporate earnings which have exceeded expectations were due, mainly, to massive cost cutting and that top-line revenue growth has not resumed to levels which are needed to promote substantial new hiring. The bears want to see top-line revenue growth continue for a quarter or two before they believe corporate earnings are solid. The rallying stock market, they claim, is based simply on future expectations, not solid earnings today which would precipitate job creation.

9) Capital on the sidelines: We have heard, and continue to hear, about the massive amount of capital that is sitting on the sidelines seeking opportunities to purchase distressed assets and core commercial real estate properties which need to be sold. Each day we hear about another fund or another investor that has entered the market and is looking to buy. At this point in the cycle, it appears the demand drivers are substantial, but, is this perception reality?  

The Bulls: The bulls believe that everyone who says they have $5 million, or $50 million, or $500 million to invest in real estate, have it. And they believe it is mostly from unique  sources indicating that there really are billions and billions of dollars sitting on the sidelines waiting for an opportunity to buy. Clearly, the demand is out there in the marketplace as we see a significant number of bidders on each of the properties being sold today. On our income producing properties dozens of offers are obtained and on the notes we have sold, which were collateralized by New York City properties, we have received over 50 offers on every one. A combination of high net worth individuals, families, institutional capital and foreign investors have created demand unlike anything we have seen in recent times. The bulls believe that this overwhelming demand, which exerts upward pressure on value, will dominate the factors in the market which exert downward pressure on value.

The Bears: The bears believe that, of the people claiming to have capital waiting to invest in commercial real estate, many are representing the same pools of equity. Many of the funds have not been raised with cash sitting in accounts. They merely have verbal representations that money is available “for the right deal”. It is very likely that equity sources have many “scouts” in the market claiming to represent the same pools of equity. If this is the case, the bears believe that the amounts of capital claimed to be looking for opportunities is grossly overstated.  They also believe that, while there may be a lot of capital available for “good deals”,  the expectations of what a good deal is, is unrealistic and, therefore, this demand is artificial.

10) Financing: Clearly, debt availability is a significant driver in our investment sales marketplace. Community and regional banks across the country have invested much of their risk based capital in construction and development projects and the result of this is that 124 banks failed in 2009 and is why today there are 720 banks on the FDIC’s watch list of potentially troubled institutions. Fortunately, for those of us in New York, our community and regional banks have invested primarily in cash-flowing properties and they have maintained very healthy portfolios. Because of this, they have continued to lend throughout this crisis. The commercial and money center banks have, however, for the most part, withdrawn from the real estate lending scene. Moreover, construction financing is extraordinarily challenging to find today. This is true particularly for any asset class other than residential rental properties. Even for residential rental construction financing, low loan-to-value ratios exist and recourse is generally included for, at least, part of the indebtedness.

The Bulls: The bulls believe the financing picture is thawing significantly and expectations are that the commercial and money center banks will be back in the game shortly, if they have not already begun to make loans. The bulls say that the CMBS market is on the road to recovery as evidenced by the recent transactions which began late last year. They believe that, although loan-to-values are low and recourse is required, construction financing is available and that there are lenders which are looking for strategic opportunities. If this level of availability existed, it would be extremely positive for the commercial real estate market.

The Bears: The bears see the lending environment as still very limited. Capital availability is low and most real estate loans are being made on only the most conservative terms. The bears also view the CMBS market as still in a relative state of inertia.  They point out that CMBS transactions which have occurred thus far in the cycle have helped only a very narrow slice of the marketplace as loan-to-values are around 50 percent ( one transaction was closed at 75% LTV) and loans that are being made are more in the form of personal loans based on the strength of the borrower as opposed to the viability of the real estate project. This is not only true for CMBS loans but also for traditional loans made by portfolio lenders. The bears believe it will be many years before construction financing comes back anywhere close to what its normal trend has been.

Next week, we conclude this discussion of the divergence of perspectives between the bulls and the bears. We will conclude with the topics of cap rates, supply / demand dynamics and the economic recovery.  Until then……

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.

3 Responses to “The Bulls Versus the Bears (Part 3)”

  1. 1 mark April 7, 2010 at 9:30 am

    i don’t think it’s bull v bear. it’s more about reality v perception (which often can become reality). the reality is the economy still sucks, and is not getting much better, but the fed/treasury have flooded the markets with liquidity. thus, the reality is the fundamentals will likely continue to soften but the perception, prompted by unprecedented money printing and government intervention, is that we’ve already bottomed. in an economy where total credit market debt : US GDP ratio is in excess of 375% we are now 1.5x more leveraged than we were in 1931 (260%). this is the unfortunate reality. they’re trying to reignite the same credit bubble they did post tech wreck with ZIRP, only this time on a foundation of 10% unemployment, obvious structural insolvencies (TBTF banks etc) and mass consumer bankruptcies/foreclosures. we must not forget that going into this consumer spending was 70% of GDP. the government has stopped the bleeding, but they’ve solved nothing. ultimately, we must go through the deleveraging process no matter how painful (opportunistic?) it will be. long term i am bullish on the US (china is the biggest bubble in history of mankind) but near term there are many pitfalls and headwinds. then again, what the hell do I know. happy hunting.

  2. 2 John April 8, 2010 at 5:43 pm

    Very well said Mark! I completely agree about your statement of perception turning into reality. What’s the old saying, 50% of reality is perception or something like that.

  1. 1 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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