Forecasting Investment Sales
Dan Duray Oct. 14, 2010, 10:08 a.m.
In many of my Concrete Thoughts columns, and in many of the market reports produced by Massey Knakal, we not only report on what has happened in New York’s investment sales market but forecast what we believe will occur in the future.
In this week’s column, we begin a two-part overview of the indicators that we rely on to make our forecasts. Some of these are very big-picture in nature, but connecting the dots between macroeconomic factors and our local real estate market is what we are constantly attempting to accomplish.
The two main metrics we discuss when talking about the relative health of the investment sales market are the volume of sales and the level of values. These two indicators provide the best snapshot illustrating how the market is currently performing, particularly relative to past performance. The volume of investment sales in the New York City marketplace has clearly been improving steadily since early 2009 (although third-quarter 2010 performance looks like it may have suffered a setback). Additional activity in the distressed-asset market, from both banks and special servicers, has helped with volume increases.
Reaction to tax policy, namely the anticipated increase in the federal capital gains tax, and a return to more normal levels of activity, have helped boost volume in the marketplace.
With regard to value, since hitting what appears to be a bottom in 2009, the trends have been far less clear. After dropping approximately 32 percent on a price-per-square-foot basis on average, we have seen volatility in value as some product types in some submarkets are increasing slightly, and other product types in some submarkets are decreasing slightly. This volatility on the value side is a clear indication of a market that is trying to establish its footing.
The direction and magnitude of volume and value fluctuations are dependent upon many factors. Clearly, fundamentals are a significant component of these factors, and there are several indicators we consistently examine as we try to determine how these underlying real estate fundamentals will be impacted.
Below is a summary of things we keep a close eye on to try to gain insight as to where the market may be headed.
Perhaps the metric that has the most profound effect on real estate fundamentals is the level of employment. The more people who are working, the better for our economy. Simply put, working consumers spend more than nonworking consumers.
As jobs are created and companies grow, the need for more office space is obvious. As more office space is needed, developers must buy land and construct buildings, putting thousands of construction workers to work. This, in turn, puts more consumers in spending mode, thereby further expanding the economy. This is what economists referred to as a positive feedback loop. As the economy grows, people look to upgrade their living conditions, and household formation expands.
For this reason, last Friday’s disappointing jobs report was another setback for those looking for a sustainable recovery in the short term. In September, U.S. payrolls were reduced by 95,000 jobs; private-sector employers added 64,000 workers, but governments and municipalities shed 159,000 workers. As we predicted, state and local governments have been reducing their workforces significantly in reaction to massive deficits that nearly all municipalities are running. Of the 83,000 workers who lost their job from these segments, many were schoolteachers from budget-constrained school districts. This was not surprising given that, for most, the school year begins in September.
Although the economy lost 95,000 jobs, the unemployment rate was unchanged at 9.6 percent. This is due to the fact that the participation rate has decreased as discouraged workers continued to drop out of the search for a job.
A broader measure of the unemployment rate, U-6, rose to 17.1 percent from 16.7 percent. U-6 includes those who have stopped looking for work, and those who are working part-time jobs that desire full-time employment. In another troubling trend, the employment-to-population ratio remained at 58.5 percent. This ratio has been a focus of the Fed and is near its lowest level in more than 30 years.
While an average of approximately 96,000 private-sector jobs have been added each month in 2010, this figure does not even absorb new people entering the job market simply based on population growth. It has done nothing to regain any of the 8.5 million jobs lost during this recession.
In New York, we are much better off than the rest of the nation when it comes to employment. Over 10 percent of the private-sector jobs created in the United States this year have been in New York. This bodes well for our real estate market moving forward. Let’s hope that the City Council uses some common sense when negotiating legislation that could potentially be job-killing, such as the new paid-sick-day initiative that is being discussed.
The magnitude of job growth dictates what is likely to occur with economic activity and, consequently, space demand
As I have often written, we are living at a time when the relationship between politics, economics and real estate has never been closer. For this reason, what government does can have a tangible effect on our marketplace. There has been a tremendous amount of uncertainty caused by government action, which is creating an unsettling feeling for the business community. This pertains to both potential policies that are being discussed as well as the ramifications of policy that has been enacted.
Businesses and individuals have no idea what their tax and cost burdens will be moving forward. It is unclear whether the present tax rates will continue or be raised. A significant component of this, for the real estate industry, is the capital gains tax rate. Some sellers have already acted based upon the anticipated increase in rate, putting properties on the market for sale to take advantage of today’s rates.
Other policies that are creating significant uncertainty include the new national health care program, and the new financial regulation package. It is unclear whether there is a single person in the country who knows exactly what the true costs of Obamacare will be. When pressed, the administration vigorously defended the program’s economic ramifications, indicating that it would reduce the deficit. Within months, the Congressional Budget Office indicated that the costs would be significantly higher than anticipated, and there would be no deficit reduction. Many believe that it is only a matter of time before it is proven that the program will add greatly to the deficit.
Some believe that the program will force private insurers out of business, leaving the government as the sole provider of health care. Skeptics believe this was the veiled intention of the program from the beginning. Others believe that the sheer amount of red tape created by the program will drive health care costs up significantly. They say that providing coverage for an additional 32 million people has to be paid for by somebody.
Regardless of your political stance on this issue, one thing many agree on is that the lack of transparency around its creation and a lack of understanding about its economic impact has created an uncertain environment, which is unfriendly to businesses.
The new financial regulation package also has created a significant amount of regulatory red tape to deal with. When Sarbanes-Oxley was passed by the Congress, corporate America bemoaned the paperwork, procedures and regulations that had to be complied with. There were 12 rules and regulations that companies had to maneuver through. The new financial regulation package has more than 200 of these requirements. Once again, no one can truly quantify the impact of this policy on business.
Companies are currently sitting with trillions of dollars of cash on their balance sheets and are suffering from incredible inertia due to the uncertainties in today’s environment. The best thing government can do for business, and, therefore, the real estate industry, is to provide some certainty with regard to what the rules of the game will be. Once established, businesses will be able to adapt and move forward with confidence. As this occurs, companies will be more confident in making decisions about buying or leasing retail, office and industrial space.
Federal Reserve Bank Policy
During the past couple of years, the Fed has implemented an unprecedented level of intervention. They have doubled their balance sheet by purchasing in excess of $1 trillion worth of mortgage-backed securities and Treasury bills. They have dropped interest rates to near-zero in an attempt to stimulate the economy.
Today, the amount of quantitative easing bullets left in their gun has been greatly reduced. Based upon the disappointing jobs report released by the Department of Labor last Friday, many economists believe that the Fed will resume its asset-buying program, which ceased last March. Economists are referring to this next phase as QE2.
Another tool available to the Fed, which was mentioned as a possibility by Chairman Bernanke, is to stop paying interest on nearly $800 billion worth of excess banking reserves held by the Fed. It is thought that by not paying interest on these reserves, this will create motivation for banks to pump more money into the economy, putting it to work productively. Several bankers I have spoken to indicate that, because the interest paid on reserves is so minimal, this tactic would have little impact on the market.
Figuring out what the Fed is likely to do and what ramifications their actions could have are a significant factor to consider when trying to determine future movements within the marketplace. Much of what the Fed does impacts our interest rate environment, which has obvious implications for the investment sales market. As rates rise, the cost of borrowing increases, exerting downward pressure on value. This is due to the fact that as debt service costs rise, capitalization rates normally increase, and as cap rates increase, values drop.
Given the importance of interest rates, this is the first topic we will discuss in next week’s column. That Part 2 will also look at the impacts of housing, deleveraging and supply and demand on the investment sales marketplace.
Robert Knakal is the chairman and founding partner of Massey Knakal Realty services and in his career has brokered the sale of more than 1,100 properties, having a market value in excess of $6.8 billion.