The investment sales market has been steadily improving over the last few quarters, as fundamentals begin to improve and economic recovery, while sluggish, is upon us. With regard to fundamentals, we have seen rent concessions evaporating and occupancy rates improving. The economy is moving in a generally positive direction but is having difficulty finding momentum as employment growth is well below expectation and last week it was reported that consumer spending experienced a decline of 1.2% in May, the first drop since September of 2009. While the investment sales sector appears healthy, the future of the market, however, is uncertain as market indicators are presently difficult to interpret. These conditions beg the question: Are we in another bubble at the bottom of a cycle?
Today, nothing is impacting the investment sales market more than the supply / demand relationship. Real estate markets are always dependant upon the supply / demand dynamic, however; it appears to be impacting the market more acutely now than we have seen in the past. Presently, there is excessive demand met by a relatively weak supply of available properties for sale.
Demand drivers are active from every segment of the purchasing arena. When we first started to tangibly feel the impact of the credit crisis in the summer of 2007, the institutional capital, which drove up value in the bubble inflating years of 2005 -2007, all but evaporated from the marketplace. The overwhelming majority of investment properties that Massey Knakal closed from mid-2007 until recently have been purchased by with high-net-worth individuals and families that have been investing in the market for decades. Recently, we have seen a reemergence of institutional capital as these investors have formed distressed asset buying funds and opportunity funds to take advantage of perceived opportunities in today’s market. Add to this the significant numbers of foreign investors and we have a demand side of the equation that is overwhelming.
On the supply side, we have seen historically low levels of properties for sale. Typically, the supply of available properties is fed by discretionary sellers who decide it’s time to sell. Typically, when values decrease, as happened beginning in 2008, discretionary sellers withdraw from the market. As this occurs, normally distressed sellers will emerge to fill the void left by the withdraw of discretionary sellers. In this cycle however, this has not occurred. Everything that has happened from a regulatory perspective has provided distressed sellers the ability to avoid dealing with their problems if they choose to.
The result is a very low supply of available properties to satisfy the excessive demand that exist in the marketplace. Due to these conditions, properties are selling for more than fundamental economics would dictate they should be selling for. Consequently, the “great opportunities” and “great deals” that were expected at the onset of this credit crisis have simply not emerged.
The supply of available properties is, however, increasing. We have seen a tangible increase in distressed assets coming to market and these distressed sellers are being joined by discretionary sellers who are, once again, coming back into the market. They have been waiting for a while to implement sell decisions and they simply are not willing to wait any longer to pull the trigger. Some of our clients are selling today because of the looming increases in capital gains taxes next year. Others are selling because of the likelihood that “carried interest taxes” will increase next year from the capital gains rate to the ordinary income rate.
The opinion that discretionary sellers are returning to the market is supported by the fact that we have seen a palpable resurgence of 1031 exchange transactions. We know that these are the result of discretionary sales as distressed transactions rarely have any residual equity which could be reinvested utilizing the 1031 mechanism.
Given this increase supply and the excessive demand that exists, we expect investment sales volume in 2010 to increase by at least 40 percent over 2009 levels. Granted, we are coming off anemic levels last year, but a significant increase in activity will be well received by market participants. In a couple of weeks we will be releasing our first-half 2010 statistics which will be a good indicator of how the year is progressing and should tell us something about what we can expect for the balance of 2010 in terms of volume.
With regard to value, as stated earlier, prices are increasing to levels above what economic fundamentals would dictate. It is almost as if the market is experiencing a mini-bubble at the low point in the cycle. Cap rates have remained at low levels after expanding significantly in 2009 and, remarkably, note sale recoveries have been extraordinarily high relative to collateral value. These conditions seem extremely positive today but, “Where we are headed?” is the bigger question.
Last month’s disappointing employment data has showed that employers are still leery about making commitments to new employees given the uncertainly surrounding the economic recovery and the vast array of tax obligations that are likely to increase substantially in the near term. Consumer spending and consumer confidence remains weak and GDP growth is challenged. Economists are, in increasing numbers, predicting a higher likelihood of a double dip recession.
We anticipate that the investment sales market, for the balance of 2010, will be very healthy as current dynamics continue. However, moving forward there are things to be concerned about. The deleveraging process, which is already in full swing, has a long way to go before all of the properties in negative equity positions are recycled or resuscitated. The 2006 and 2007 vintage loans, which are in the most distressed positions, don’t mature until 2011 and 2012 and are often being kept alive by advantageous loan terms such as interest only periods, interest reserves or are floating over LIBOR which remains at miniscule levels.
The anticipation that interest rates will rise, and rise dramatically, is still looming over the marketplace as well. Interest rate increases will have significant negative implications for the investment sales market and it is only a question of when, not if, these increases will occur.
With regard to supply, a regulatory change impacting the ability of lenders to hold loans on their balance sheets at par, even when they know the collateral is worth significantly less, could lead to significant increases in supply, exerting significant downward pressure on value.
Lastly, the expectations of increases in taxes of all kinds creates significant trepidation on behalf of participants in the marketplace. Capital gains taxes will increase from 15 percent to 20 percent when the Bush tax cuts sunset as they are expected to at the end of the year. Obamacare will add to this capital gains increase and personal taxes on federal state and local levels are sure to rise as politicians across the country demonstrate an inability to effectively cut spending. This is the case in all that but a couple of states which have seen shifts in policy recently.
Therefore, it is easy to understand how bearish participants are using this opportunity to sell and take advantage of the extraordinary supply / demand imbalances, very low interest rates and a, currently, friendly tax environment.
Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,075 properties in his career having a market value in excess of $6.4 billion.