Archive Page 2

Note Sales are Taking Off!


As we have discussed in several previous StreetWise columns, the distressed asset pipeline, which has been clogged for nearly two years, is beginning to loosen up. Lenders and special servicers are faced with thousands of distressed assets on their balance sheets and in their portfolios, yet until recently, only a small number of these assets have made their way to the market.

Everything that has happened from a regulatory perspective has provided these entities with the ability to avoid having to make decisions relative to these distressed assets. These regulatory changes have included changes in the FASB market-to-market accounting rules, modifications to REMIC guidelines and bank regulators letting banks hold notes on their books at par even though they know the collateral is worth substantially less.

The Federal Reserve’s highly accommodative monetary policy is allowing for the recapitalization of the banking industry which is relieving pressure on lenders to deal with distressed assets quickly.

Additionally, the foreclosure process can be particularly long, cumbersome and complicated (particularly in states other than Texas and Georgia). Many holders of distressed assets are choosing to sell notes rather than wait for the foreclosure process to be completed which would allow them to sell the assets rather than the paper.

Note sales can take two forms. The first is simply a financial transaction in which a bank or special servicer will pool many disparate loans with disparate collateral spread throughout a state, region or the entire country. These loans will typically be sold to what we call a “financial engineer” which will look at each loan, determine where it is in the foreclosure process, what can be done to enhance the note’s value and how to maximize the value of the individual loans for resale. These buyers are simply buying on a percentage-of-par basis and are looking to make a profit on the slicing and dicing of these pools.

The other approach to note sales is to simply sell a single note, collateralized by a property or a portfolio of properties. The typical buyer here will be a real estate investor who is buying the paper to get to the title of the property and own the assets on a long-term basis. These buyers typically pay much more for the note than a financial engineer will because they don’t have to build a profit into the process of administrating the foreclosure process. This is the type of note sale transaction that Massey Knakal has focused on in our Special Assets Group.

If we look at the distressed assets that we have sold recently and are currently working on, 78 percent of them have been note sales as opposed to REO (“Real Estate Owned” is  a typical term used by lenders for properties they take title to after a foreclosure) sales.  We expect this percentage to decline as time goes on and the foreclosure process is allowed to finish. Our large percentage of note sales versus REO sales is not surprising when consideration is given to the percentage of recovery sellers are achieving on note sales relative to collateral value.

Collateral value is the key measuring stick by which we determine how effective a note sale recovery can be. I am often called by investors who claim that they want to buy distressed notes, however as soon as they tell me that they wish to buy paper at 50 cents on the dollar, meaning 50 percent of par value, I immediately know that they are not serious note buyers and let them know that they will be unsuccessful in this endeavor.

The reason I say this is because if the collateral value is only 40 percent of par, they will be overpaying at 50 percent and will lose money. If, however, the collateral is worth 90 percent of par, and they are only offering 50 percent, they are not going to be able to buy anything as savvy investors will certainly outbid them. Therefore, we see that par value is really irrelevant relative to what a recovery will be.

A much more important indicator is collateral value or what the asset is worth if the deed were to be delivered. When we are retained by an institution to sell a note, the first thing we do is calculate the value of the collateral. This amount is then discounted by a percentage which is derived based upon taking the entire scenario into consideration. The variables include how far along the institution is in the foreclosure process, whether the borrower is being cooperative and the quality of the documentation.

Clearly, if a foreclosure process is nearing its conclusion, it is a very different situation than if the foreclosure process has not even begun but the note is in default. Similarly, if a borrower is cooperative, it adds value to the recovery. We have done transactions in which the borrower had a completely adversarial relationship with the lender, such that we could not even gain access to the property. In cases like that, we may not even be aware of the the tenancy in the property. In a scenario like that, the discount for the note would be much more significant than if the borrower is cooperative and we have a sense of how the real estate is performing.

Additionally, it is important to do significant due diligence on the quality of the documentation that exists. All documents must be reviewed including the note, the mortgage and the intercreditor agreements (to the extent that there is subordinate debt on the property). A summary of all interaction between the borrower and the lender can also be helpful.

When marketing a note, we move down two parallel paths simultaneously in that we must not only perform due diligence on the real estate asset, we must perform due diligence on the documentation to fully understand what exactly it is we are selling. This takes tremendous amount of time and effort but is important to make sure that all participants in the transaction fully understand what they are stepping into.

Another factor which greatly affects the recovery on a note sale is the extent to which the seller of the note is prepared to make representations. Some lenders have very complete files and are willing to make substantial representations about what they have and what they have done. Here , recovery is enhanced.  

There are, however, some lenders that will only represent that they own the note and have authorization to sell the note. They will not make any representations beyond this. I am often asked by a lender or a special servicer if a note can be sold under those circumstances. My answer is always that everything can be sold and everything has a price; it is only a question of what the highest price will be. Understandably, the more definitive the representations a lender is willing to make, the higher the final price and, therefore, the recovery.

Note sales have been dominating the distressed asset market recently and are becoming more and more popular. This is particularly true as distressed asset holders attempt to take advantage of the supply / demand imbalance that I often refer to in this column which provides the seller the ability to achieve pricing higher than what current economic fundamentals would dictate. There is significantly more demand than there is supply which is resulting in dozens of investors competing for each availability.

Under these circumstances, there is no wonder why distressed asset holders are eagerly entering the note sale market.                

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.


1031 Exchanges Come Roaring Back to the Market


Welcome back old friend! Yes, we have seen a re-emergence of the blessed 1031 tax-deferred exchange in recent weeks, and what a welcome sight it is.

The opportunity to protect hard earned equity in the sale of an investment has been available to investors since 1921. However, this part of the tax code was so complex that only a small segment of the investment community took advantage of this mechanism.

In 1990, the Omnibus Budget Act provided more widespread access to a broader set of investors as this option was clarified and simplified. Section 1031 exchanges are often mischaracterized as “tax free” when they are actually “tax deferred”.

The theory behind this mechanism is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay taxes. Only the form of investment has changed, therefore, it would be unfair to collect a tax on a “paper” gain.

When an investor utilizes this mechanism, the deferred gain is payable when the replacement property is sold and is not part of yet another exchange. At that point, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

1031 exchanges in the investment property market have been growing in popularity since the mid-90s and fueled a majority of transactions in the mid to late 2000s. With falling property values and transaction volumes beginning in late 2007, we saw a significant reduction in 1031 transactions.

In previous StreetWise columns, I have gone into detail about the supply / demand imbalance and the fact that the volume of sales was so low due, mainly, to lack of supply as opposed to waning demand. The supply of available properties for sale is generally fed by discretionary sellers. When value falls, as it has done since 2007, discretionary sellers withdraw from the market and the supply is then fed by distressed sellers. Distressed sellers have not fed the supply in numbers which were expected because everything that has occurred from a regulatory perspective has allowed these sellers to avoid dealing with their distressed assets.

Recently, we have seen the flow of distressed assets begin to loosen as banks and special servicers are beginning to clean up their balance sheets and portfolios. Simultaneously, we have seen discretionary sellers returning to the market. The tangible evidence that this is actually happening can be seen in the 1031 activity we have seen recently. Distressed sellers are rarely left with any equity to reinvest in the form of a 1031 exchange. Discretionary sellers, on the other hand, often have significant equity to redeploy via this tax-deferred vehicle. We are, once again, seeing sellers ask for flexibility in closing periods to provide them with better chances of being able to effectuate an exchange.

During the past 4 weeks alone, we have signed 12 contracts with purchasers who are investing 1031 funds. Moreover, we are receiving multiple calls each day from investors who are looking for properties to complete exchange transactions. This is certainly reminiscent of 2006 and 2007 when so many transactions were motivated by tax-deferment. The demand side has been very strong for quite a while as institutional capital has returned to the market, joining the high-net-worth individuals and families which have dominated the horizon for the past couple of years. Foreign high-net-worth investors are present in rapidly growing numbers and the re-emergence of 1031 capital adds more pressure to already overwhelming demand for investment properties.

Don’t mistake my perspective as I am not suggesting that market conditions are back to the go-go, bubble inflating, years of 2005 to 2007. I am, merely, passing along a trend that we are seeing which has, for the most part, been absent for quite a while. It is yet another sign that the recovery is upon us.

From an intermediary’s point of view, or anyone’s, who is reliant upon transaction volume for their livelihood, it is positive to see this type of activity returning to the market. To the extent that distressed sellers continue to dispose of assets and discretionary sellers return to the market, transaction volume has no choice but to increase. As sellers with real equity sell, each transaction is likely to stimulate another transaction as a 1031 is contemplated.

This trend certainly bodes well for our projection that transaction volume will increase by about 40% this year over last year. Welcome back old friend, indeed!

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 a market value in excess of $6.2 billion.

Can the Building Sales Market be Good and Bad at the Same Time?

In recent weeks, Streetwise has looked at the divergence of opinions and perspectives present in the marketplace. There is significant optimism and pessimism present at the same time so the question becomes, Can market conditions actually be positive and negative at the same time? I believe the answer is yes but it is dependent upon individual circumstances.

There are many indicators in the market which lead us to be optimistic. Unemployment, the metric which most profoundly impacts the fundamentals of real estate, appears to have bottomed and we are starting to see job growth. Inflation appears to be in check and even the most bearish economists don’t see inflation as a short-term problem. Interest rates, while edging up, have not caused any significant increase in borrowing rates. When the Fed ceased its asset buying program at the end of March, we saw upward pressure on interest rates, particularly at the long end of the curve as the 10-year T-bill, which had consistently hovered around 3.5%, rose to over 4% for a brief period. Last Friday it closed at 3.625%, a surprising result after the Fed announced 10 days ago that it would begin a program to sell a trillion dollars worth of assets over time.

Rental rates appear to have bottomed as well. In both the commercial and residential sectors, concessions are being reduced and, in a few cases rents are rising. I actually spoke to two bankers last week who told me that they were dropping commercial lending rates due to the competition with other banks to put money on the street. This, to me, was a remarkable and eye opening occurrence.

In our building sales business, the positive signs are abundant. The supply of available properties for sale is growing. This supply is increasing as lenders and specdial servicers are coming to terms with assets that are underwater and have little hope of being turned around. We have seen a tangible increase in notes and REO that these entities are coming to market with. Additionally, discretionary sellers are beginning to place assets on the market as they feel the palpable optimism that exists in the market.

While supply has increased, this additional supply has been met step-for-step by increasing demand. Activity on all of our listings continues to be excellent as all three of the demand “food groups” are in full swing. These include high-net-worth individuals and families, institutional capital and foreign buyers. Due to this overwhelming demand, we saw, for the first time in many quarters, prices rise in the first quarter of 2010 in some segments of the market. In other segments, prices continued to slide. This dynamic, however, is certainly indicative of a bottoming in pricing.

This all sounds very positive, but you may ask, What about all of the properties with negative equity in them? The fact is that, even with fundamentals becoming healthier, they will not revive at a pace quick enough to bail out most of the distressed assets that are in the market. Therefore, it is entirely likely that we will have improving positive conditions in the market while simultaneously seeing an active distressed asset component. Based upon the substantial number of distressed assets that exist, it would not be at all surprising to see distressed assets come to market over an extended period of time, two or three years perhaps.

One investor I spoke to last week told me that he believed distressed assets would be present in the market as far out as 2016 and 2017 when the 10-year CMBS loans that were originated in 2006 and 2007 mature. His belief was that growth will exist but will be too slow to recoup all of the losses experienced in this market downturn. I certainly hope he is not correct.

Presently, we see many positive signals in the market indicating that we are emerging from the malaise we have been living with.  Things are certainly looking up for our market; however, distressed assets will be part of our playing field for years to come. So the answer appears to be, “Yes”, things can actually be good and bad at the same time. It all depends upon which side of the fence you are sitting on.

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 a market value in excess of $6.2 billion.

First Quarter NYC Sales Activity Flat but Horizon is Sunny

Normally, the content in StreetWise is very macro in nature as I try to make the topics of interest and germane to a national audience. This week, I will divert from this practice to share with you what we are seeing in the New York City building sales market and, perhaps, those of you operating in other markets across the country can chime in with what you are seeing in your markets.

In the first quarter of 2010 (1Q10), we did not see the increase in sales activity that we had anticipated based upon the positive psychology many participants in the market are exhibiting. In terms of dollar volume of sales citywide, there were $2.03 billion of closed transactions, a 0.7% reduction from the $2.05 billion transacted in 1Q09. Interestingly, we saw better results in Manhattan than in the outer boroughs where activity levels continue to drop from the remarkably low 2009 levels.

On the island of Manhattan, we segment the market into two distinct regions: “Manhattan” which is the market south of 96th Street on the Eastside and south of 110th Street on the Westside and “Northern Manhattan”, which is north of those boundaries. In 1Q10, Manhattan sales activity remained relatively unchanged from 1Q09 as we had $1.539 billion in closed transactions versus $1.536 a year earlier. While this total represented an increase of just 0.2% from 1Q09, the 1Q10 activity was up 51% from the $1.01 billion in 4Q09. Northern Manhattan performed much better as sales activity hit $116.9 billion, up 197 percent from the $39.3 billion in 1Q10. It is not surprising to see Northern Manhattan performing as well as it was the submarket most adversely affected during this downturn.

Surprisingly, sales activity in the boroughs continued to drop. In the Bronx, sales volume was down 13% from the $79.7 million in 1Q09. In Queens, volume dropped to $143.4 million in 1Q10, a 20.9% drop from a year earlier. Brooklyn was the weakest performer with $161.9 million in sales, a 23% drop from 1Q09.

1Q10 performance versus 1Q09 performance was relative unchanged on the whole; however, 1Q09 was not the low point in activity last year. In fact, activity levels dropped from 1Q09 showing that the low point in activity was in 2Q09 or 3Q09 depending on market segment. Therefore, if we annualize 1Q10 activity, the yearly total for 2010 would exceed 2009 by about 30%, something that bodes well for this year.

Manhattan is always the last submarket to fall and the first to rebound so the 1Q10 activity is a clear indication that the market is bottoming out and recovery is on the way.

While the dollar volume of sales tells us something about market activity, at Massey Knakal we focus much more on the number of buildings sold as a few large transactions can skew the dollar volume total significantly. In fact, in 1Q10 to top 6 sales represented nearly half (48%) of the total dollar volume of sales.

In New York City, we track a statistical sample of approximately 165,000 properties. In 1Q10, there were 373 properties sold. This represents a 2.8% increase over the 363 sales in 1Q09. If we annualize the 373 sales, we are on pace to see 1,492 buildings sold in New York City in 2010. This represents a turnover rate of 0.9 percent of the total stock of properties and is up slightly from the 0.87 percent turnover in 2009. To provide some perspective on this projection, in 2006 and 2007, we saw turnover ratios of 2.96 and 3.04 respectively.

With regard to the number of properties sold, once again, Manhattan and Northern Manhattan showed positive gains in 1Q10 while the boroughs continued to drop.

1Q10 sales activity was nothing to write home about, however, there are clearly reasons to be optimistic. We have seen a significant increase in the supply of distressed assets coming to market as banks and special servicers are either close to completing foreclosures or are growing tired of the protracted foreclosure process here and are deciding to sell paper as opposed to waiting to obtain title. The discounts necessary to sell notes is not large enough to dissuade sellers from moving this paper. We are also seeing a substantial increase in supply from discretionary sellers as they see more opportunities coming to market and want to either reposition their portfolios or have some extra dry powder to take advantage of new opportunities as they present themselves.

Even more positive is the fact that these new offerings are being met with tremendous demand. The activity on almost all of our exclusive listings (502 as of today) is very strong as we are seeing buyers move off the sidelines and onto the playing field. Based upon the number of contracts we have signed in 1Q10 (an increase of 87% over 1Q09), we expect activity to pick up significantly in the balance of 2010.

We are projecting a citywide volume of sales turnover to exceed 1.2% this year, about a 40% increase over last year. In Manhattan, we expect turnover to climb to 1.6% to 1.7%, a 40% to 45% increase over last year. While these projections would still result in historical lows (not counting 2009 levels), this level of activity would be a welcomed increase for those of us who rely on transaction volume for our livelihood.

Just as Manhattan is leading New York City out of this cycle, we expect New York and Washington (which has already seen positive shifts in fundamentals) to lead the U.S. out of this downturn. We remain firm in our conviction that the worst of this cycle is over and, while there are still some landmines out there, better times lie ahead of us.

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.

Distressed Asset Update – Here They Come

We have all been surprised by the relative lack of distressed assets in the marketplace thus far in this cycle. Two years ago, we were anticipating a significant amount of distressed assets coming to market. This was described in many ways, most notably as a potential tsunami or an avalanche of properties and notes that could be scooped up for pennies on the dollar. However, this condition has yet to occur.

The reasons for this are numerous. Essentially, everything that has happened from a regulatory perspective is allowing lenders and special servicers to not have to deal with their problem assets. Whether it is mark-to-market accounting rule changes, modifications to the REMIC guidelines or bank regulators leniency, distressed assets have not been coming to market in the numbers that we all know exist.

Bank regulators, for instance have essentially said to banks that if they have bad loans on their books at par and they know the collateral is only worth 60 percent of par, they can leave asset values as they are without incurring any write-downs.

The Fed’s highly accommodative monetary policy is allowing banks to borrow at close to zero and, if they are lending, they are making whopping spreads of 500 to 700 basis points depending upon the loan type. To the extent they don’t even lend, they can simply buy Treasuries and make nearly 400 basis points today. Just a couple of short years ago, spreads were as narrow as 30 or 40 basis points on some loans as the competition to put debt on the street was fierce.

Today’s massive spreads are allowing the banking industry to recapitalize itself, which was, after all, the Fed’s intention. Tremendous profits are being generated which can be used to write down bad loans incrementally. From the bank’s perspective, they are able to wait, make large quarterly profits, write-down bad loans and wait until the write-downs reduce book value close to market value. Once this occurs, distressed assets can be disposed of without incurring losses. For this reason the distressed asset flow has not been nearly what was anticipated.

Notwithstanding this fact, we have seen a significant increase in the amount of distressed assets that have been coming to market recently. During this cycle, Massey Knakal’s Special Assets Group has completed over 1,100 valuations for lenders and special servicers, giving them valuations for the underlying collateral of their loans. From September of 2008 through September of 2009, these efforts resulted in only12 exclusive listings. From October 1 of 2009 through the present, we have received 66 exclusive listings from banks and special servicers and we anticipate this flow of distressed assets to continue.

Although the flow has increased, it remains a drop in the, proverbial, bucket compared to what actually exists in the market. But the flow has tangibly increased which is a welcome occurrence for the brokerage community. A major reason for this is the cumbersome foreclosure process that exists in New York. Foreclosure can take two, or three, or even four years to complete in this state. Many holders of distressed notes do not want to go through that protracted process. This is particularly true given the relatively high recovery rates on note sales relative to collateral value. Therefore,  selling distressed paper has become a much more viable option.

As interest rates start to increase, as evidenced by the recent rise in the 10-year T-Bill based up on the Fed’s halting their asset buying program, these increases will put additional stress on distressed assets and could be a motivating factor for potential sellers to act quickly. If interest rates continue to rise, it will create more pressure on holders of distressed assets to sell as the opportunity cost of not doing so becomes greater and greater.

Adding to the increase flow of distressed assets is the fact that advantageous mortgage terms are beginning to expire. On an increasing basis, we have seen interest-only periods provided on 2006 and 2007 vintage loans start to evaporate. Interest reserves, which have carried many properties which have been fundamentally under water for quite a while, begin to burn off and floating rate loans originated in 2005 and 2006 are either at or nearing maturity. If these loans were floating over LIBOR, debt service rates may only be 2 or 3 percent today and, clearly, there are no lenders that will renew or extend a loan at these extraordinarily low interest rates.

We, therefore, expect the flow of distressed assets to continue to increase as we move farther into 2010 and into 2011 and, perhaps, 2012. Time will tell, but this recent trend is a very encouraging sign for those of us in the transaction business.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty 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.

The Bulls Versus the Bears (Part 4)

This week, we conclude our discussion of the divergent perspectives of the optimists and the pessimists.

11) Cap Rates: Going into this down-cycle, it was expected that cap rates would rise significantly as significant levels of distress were evident in the marketplace. Cap rates had risen anywhere from a low on some product types of 50 to 75 basis points, up to as much as 250 to 300 basis points on others. It appears that, given the constrained supply of available assets and the significant demand chasing those assets, there is presently downward pressure on cap rates as they have not risen nearly as much as had been expected. Is this a temporary phenomenon or does this mark the beginning of a recovery? As usual, it depends upon your perspective.

The Bulls: The bulls believe that we have passed the bottom in terms of a high cap rate environment and that cap rates will continue to stay, essentially, where they are or go down slightly as the significant amounts of capital on the sidelines rush in to create significant demand for properties. They believe that the recovery is upon us and that value is rising. They point to the lack of suitable alternative investments and the low yields available on cash and cash like assets which provides motivation to own real estate yielding modest (by historical standards) returns.

The Bears: The bears believe that, while they have appeared to have plateaued, cap rates have only done so because of the acute supply / demand imbalance that the market is currently experiencing. They believe that when distressed assets come to the marketplace in the numbers that actually exist, the supply will be increased significantly, placing significant upward pressure on cap rates. The bears believe that with interest rates rising, cap rates will rise accordingly and that, if history repeats itself, a period of positive leverage will return to the market.

12) Supply and Demand: We have frequently referenced the significant imbalance between supply and demand in today’s investment sales market. The supply of available properties for sale is normally fed by discretionary sellers who decide that, for whatever reason, now is the time to sell their property. As value falls, as we have seen during this downturn, discretionary sellers withdraw from the market. The supply of available properties then typical gets fed by distressed sellers.

Everything that has happened from a regulatory perspective has allowed many distressed sellers the ability to not have to address their problems. Changes in mark-to-market accounting rules, bank regulators allowing loans to be held on balance sheets at par even though the lenders know the collateral is worth less and modifications to the REMIC guidelines, which address how CMBS loans are dealt with, have allowed lenders and servicers to kick, the proverbial, can down the street.

This has led to a sharply constrained supply and, with significant demand in the marketplace, there are far more buyers than there are properties available for sale. Demand has been seen from many sectors. These include: 1) high net worth individuals, 2) families that have been investing in various markets for decades, 3) institutional capital which was sidelined after the credit crisis started to be felt in the summer in 2007 is now back with distressed asset buying funds and opportunity funds and, 4) foreign investors have come into the marketplace in numbers not seen since the mid 1980’s.

The Bulls: The bulls believe that demand is so significant that it has the ability to absorb even a significant increase in the supply of available properties for sale. They believe that we are past the bottom and that upward pressure on pricing significantly exceeds downward pressure. They feel that the downward pressure on cap rates and the resulting upward pressure on values is not based simply on a supply / demand imbalance at a relatively short period in time, but a fundamental shift in investor perspective. While they believe this imbalance has exacerbated market conditions, they believe the imbalance is given too much credit for present conditions.

The Bears: The bears believe that the supply of distressed assets will eventually create an abundance of properties for sale which will drive prices lower as investors have significantly more options and competition for existing availabilities gets diffused.  They believe the supply / demand imbalance is the primary cause of today’s value levels and that supply can only rise from here. They point to tremendous pent-up demand on the sell side as many discretionary sellers who may have wanted to sell have delayed these decisions based upon soft market conditions. As time goes on, these sellers will decide they no longer will delay their action and many of these properties will come to market. Additionally, the number of distressed assets hitting the market have been minuscule compared to those that exist in the market and this condition will change. As supply increases, downward pressure will be exerted on value.       

 13) The Recovery:  The question here is whether the economic recovery is tangible and sustainable or has unprecedented levels of government intervention propped up the market resulting in seemingly unnatural bottoms being achieved.

The Bulls:  The bulls believe that the worst is behind us, inflation is not a concern, employment will begin to pick up and bank balance sheets are not in as much trouble as everyone thought. The bulls see fundamentals getting healthier. They believe that the stock market is a proxy for this recovery and that there is nothing but blue skies ahead.

The Bears: The bears believe that we are sitting in the eye of a hurricane. They believe all is calm which is providing a false sense of security about our being out of the tough times. They are quick to point out the massive need for refinancing and the still nowhere-to-be-found CMBS market. The bears are very concerned about rising interest rates and what they may do to the market moving forward.

Many of you have sent me emails stating that the issue is not really about the bulls and the bears but rather about the realists and those who cannot see things clearly. While I agree that realism is important, interpretation of statistics is based upon one’s psychology and one’s perspective. Whether a glass is half-full or half-empty is dependent upon perspective and interpretation.

As far as the bulls versus the bears go, time will tell who is correct. Until then, all we can do is take things one day at a time and do the best we can.

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 a market value in excess of $6.2 billion.

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.