Water and Diamonds and …
Do you remember college? Do you remember Economics 101? In Econ 101, we studied Adam Smith’s famous Paradox of Diamonds and Water. Even though life cannot exist without water and can easily exist without diamonds, diamonds are pound for pound vastly more valuable than water. While marginal-utility theory of value resolves this paradox, scarcity of goods is what causes humans to attribute value. If we had an unending abundance of both water and diamonds, we probably wouldn’t value either very much.
The diamonds and water analogy is representative of quintessential supply-and-demand fundamentals. An acute supply-and-demand imbalance in New York’s building sales market is creating dynamics that are perplexing to many of us active in the building-sales sector, as properties are currently selling for more than they probably should be.
In 2009, the volume of investment sales in New York City had fallen to $6.3 billion from $62.2 billion in 2007, a 90 percent contraction. The number of properties sold fell to 1,439 from 5,018, a 71 percent drop. Many people who track the market felt that the reason volume was so low was because investors did not have interest in purchasing properties given the stresses that were obvious to all of us. Nothing could be further from the truth. We believe the overwhelming reason why volume was so low was because of a severely supply-constrained environment. Dollars were water and buildings for sale were diamonds. This dynamic continues into 2010, as significant stockpiles of capital sitting on the sidelines continue to fight over a very scarce supply of available properties for sale.
To fully appreciate the extent of our supply-constrained environment, we must consider that there is rarely a plentiful supply of available properties for sale in New York. Going back 26 years, the average turnover rate, within the statistical sample of approximately 165,000 buildings, has been only 2.6 percent. This is a remarkable statistic that indicates that, when a property is purchased, the average holding period of that asset is approximately 40 years. The 2009 turnover rate fell to 0.87 percent, representing an average holding period of about 115 years.
The supply of available properties is typically fed by discretionary sellers-i.e., those who are not forced to sell for any reason. When value falls, as we witnessed in 2008 and 2009, discretionary sellers withdraw from the marketplace and, as when this has happened in the past, the supply of available properties is fed by distressed sellers. Thus far in this cycle, this dynamic has not occurred.
Everything that has happened from a regulatory perspective has allowed distressed sellers to avoid acting. These regulations consist of modifications to the FASB mark-to-market accounting rules; bank regulators allowing banks to hold loans on their balance sheets at par even if they know the collateral is worth much less; and modifications to the REMIC guidelines providing some leeway in how servicers and special servicers deal with securitized loans.
These reasons, coupled with the fact that highly accommodative monetary policy from the Fed is allowing for a substantial recapitalization of the banking system, has created a disincentive for distressed sellers to place assets on the market, thus constraining the available supply.
WHILE SUPPLY HAS BEEN constrained, the demand side has been booming. During the bubble-inflating years of 2005 to 2007, much of the run-up in prices was caused by the massive amount of institutional capital that was seeking real estate investments. When we started to tangibly feel the credit crisis in the summer of 2007, this institutional capital all but evaporated from the market.
In fact, more than 95 percent of the transactions we have closed, since the summer of 2007, have been purchased by high-net-worth individuals and the old-line New York families that have been investing in New York City properties for decades. After a noticeable hiatus from the landscape, institutional capital has seen a resurgence, as many of these investors have formed distressed-asset-buying funds or opportunity funds to acquire real estate at our new, lower price levels.
We have seen this institutional capital actively participating in the bidding process on a majority of the more than 500 assets that we currently represent exclusively for sale on the market. At the same time, the high-net-worth individuals and families continue to actively pursue purchasing opportunities.
Additionally, we have seen high-net-worth foreign investors come into the marketplace in numbers not seen since the mid-1980s. Demand from this sector has been stimulated by the perception that everything in New York is cheap, relative to where the values have been, and the fact that the U.S. dollar is low relative to many foreign currencies.