After the Shellacking: What D.C., Albany Power Shifts Could Mean for Commercial Real Estate Market
Dan Duray Nov. 11, 2010, 11 a.m.
Last week’s midterm elections produced dramatic but not entirely unexpected results. In President Obama’s own words, Democrats got shellacked. Republicans gained control of the House; they lost several seats, but Democrats managed to hold on to the Senate. In New York State, it appears that the Republicans will have a majority in the State Senate, taking back control after two years of a Democratic majority. So, what are the ramifications of these results on our commercial real estate market? Let’s take a look.
A note first: It is important for me to state that I’m not making any political endorsements here. I mention politics occasionally in my writing, but I am merely trying to express opinions regarding the impact policy is likely to have on our real estate market. I am a registered independent who has equal dissatisfaction for politicians from both parties when bad policy is endorsed and, conversely, I have financially supported, and voted for, independents as well as Democrats and Republicans. More appropriately, I like to think of myself as a “Realestatetarian,” always considering the implications of government policy on what I do every day: selling buildings.
At press time, Republicans had gained 61 seats in the House and six in the Senate. Democrats also lost, on a net basis, at least seven governorships and 24 legislative majorities. The potential margin of victory was underestimated by most, as even the most right-leaning political pundits assumed that the Republicans would gain 50 to 55 House seats.
The cause of this significant swing was a colossal shift among independent voters. The percentage of U.S. voters registered as Republicans, Democrats and independents has remained fairly consistent over the past decade or so. Independents make up approximately 28 percent of the voting population. In the 2006 midterm elections, independents favored Democrats by an 18-point margin. In the last presidential election, independents voted for President Obama over John McCain by a margin of 16 percent. Last week, independents favored Republicans by 8 percent. This massive 24 percent swing in just two years was unprecedented.
Given the powerful message delivered to the White House by these results, it’ll be interesting to watch if the administration will now see things more pragmatically or continue on an ideological track. The implications for our economy and, therefore, our real estate market are significant.
For the first time, toward the end of last week, the administration started to indicate that they may consider coming off their position of strongly supporting tax increases for all Americans making over $250,000 per year. While never directly addressed, the implication is that capital-gains-tax increases and dividend-rate increases would go hand-in-hand with those proposed tax increases.
From an economic perspective, the more expensive a certain activity becomes, the less that activity occurs. Therefore, we would expect that if capital-gains taxes were to rise (scheduled to increase from 15 percent to 20 percent), thereby increasing the cost of selling a property, sales volume would decrease. Based upon the anticipation that capital-gains rates were going to increase, many discretionary sellers placed properties on the market beginning this past summer with the objective of closing prior to end of the year to take advantage of this year’s lower rates. Other issues impacting the real estate market include what will happen with taxes on “carried interests” and taxes on dividends rising from 15 percent to 39.6. The latter of these could have profound implications for REITs, which have been among the most active market participants of late.
It will be interesting to see if anything gets settled in the lame-duck Congressional session. The looming uncertainty over tax rates has been a contributor to stymied growth in gross domestic product and job creation. Fortunately, this tax rate issue is something that can be resolved very early in 2011, if not addressed before the end of this year. The uncertainty created by the health care bill and the new financial regulation package is something that is likely to remain for years as the true implications of each of these far-reaching programs is determined.
On a federal level, there is once again a balance of power in Washington. Some believe this may lead to gridlock, others not so much. Regardless, markets will view this balance favorably, as radical legislation is unlikely to be passed given a split Congress. The biggest fears exist when one party, be it Republicans or Democrats, hold a super-majority in both houses. It is under these circumstances when radical legislation is likely to pass.
IN NEW YORK State, Andrew Cuomo won the governor’s race handily over Carl Paladino. The governor-elect will certainly have his plate full when he takes office. He has vowed to clean up Albany and even indicated that, if his initial attempts are unsuccessful, he may resort to using the Moreland Act, a 103-year-old tool available to the governor. This would provide him with unfettered power to dig into any aspect of state government. Rather than using this tactic as a backup plan, perhaps it should be upgraded to Plan A. While it might ruffle a few feathers, something must be done to end the pay-to-play culture that our Albany lawmakers seem to be addicted to. Correcting the dysfunction within Albany will be no easy task.
Neither will be solving the state’s financial woes. Mr. Cuomo faces significant financial hurdles in dealing with the state’s $135.3 billion budget. In fiscal year 2011-2012 (beginning on April 1), the projected state budget deficit is $9 billion. This is exacerbated by the fact that a large revenue drop-off is anticipated by the evaporation of federal stimulus funds and the expiration of last year’s income tax hike on our wealthiest residents. Things get only worse as the projections are extended. In the 2012-2013 fiscal year, the deficit swells to $14.6 billion. In 2013-2014, the deficit increases again, to a projected $17.2 billion.
These massive deficits are the result of currently enacted spending requirements of 6.9 percent annually through 2013-2014. At the same time, receipts are only expected to grow by 4.3 percent.
Mr. Cuomo’s first budget is due on Feb. 1. In an age where campaign promises are forgotten at the speed of light, it’ll be interesting to see if he keeps to his campaign pledge of holding the line on spending. He also promised “no new taxes” and a 2 percent annual cap on property tax increases. It would appear that the only possible way he can stay true to those promises would be to go head-to-head with the powerful public-sector unions. Health care costs and education spending make up approximately 50 percent of our state budget. The teachers’ union and the health care workers’ union will undoubtedly spend millions on TV commercials in opposition to any attempts to reduce spending in these areas.
Without the intestinal fortitude and political will to withstand this barrage, meaningful spending cuts will be impossible and our tax burden, which on a per-capita basis is the highest in the nation, will likely increase even further. It would be unfortunate to see New York State income taxes rise significantly, only to be told that the New York State income tax is an “old tax” that is being increased, not a “new tax.” And even if the 2 percent annual cap on property taxes is implemented, it is important to realize that residential and commercial real estate tax bills will still increase by more than 2 percent per year, as the calculation of taxes consist of the tax rate and the property’s assessment. Even if the rate was capped at 2 percent, due to annual assessment increases, taxes will rise higher than the capped percentage.
Property tax caps should be the governor’s priority. Needless to say, Sheldon Silver will have something to say about that. Notwithstanding, tax caps should be enacted and must be coupled with changes in collective bargaining agreements so that local governments and school districts can control labor costs. Fundamental reforms of public pensions, which are about to skyrocket to levels never seen before in New York State, are also essential.
FOR OUR MULTIFAMILY sector, the elections produced some pros and cons. On the pro side, at press time, Republicans were sure of at least even 31/31 control of the State Senate. With Republican control of the Senate, the bills routinely passed by the New York State Assembly, which are extraordinarily pro-tenant, are not likely to gain much traction. These bills include raising the threshold for high-rent deregulation from $2,000 per month to $2,700 per month, and re-regulating any units that had been deregulated and now rent for $5,000 per month or less. These provisions would hamper the condo conversion market and would lead to even larger subsidies provided to every regulated tenant by every non-regulated resident.
While these pro-tenant bills are proposed and passed by Democratic legislators playing up to their constituencies, it is interesting that for the past two years, the Democratic-controlled Senate did not calendar these bills for a vote. Could it be that they knew the deleterious impact they would have on the marketplace so they just left them collecting dust? Proposing a bill that voters would like, but that legislators know has very little chance of actually passing, can be an effective vote-getting mechanism. Were some of these legislators fearful that their bills might actually become law? If they understand economics, they just might have been.
On the con side for the multifamily industry, Eric Schneiderman won his bid to become attorney general. One of his stated top priorities was addressing the tenant harassment issue. I certainly would never advocate that harassing tenants is acceptable. However, our rent-regulation system is dysfunctional, and leaves owners with little choice but to start litigation to determine a tenant’s income level or whether his or her regulated apartment is the primary residence. The day tenants start marching into managing agents’ offices, announcing that they really live outside the city and only use their regulated apartment as a pied-à-terre, or that they are illegally subletting their apartments to make a profit, and turn their keys in will be the day that owners can stop litigating with tenants to find out the truth.
Last week, some things became clearer, and some things remain fuzzy. One thing is, however, certain, and that is that we have a long way to go before the economy is growing at an extent to which meaningful job creation is possible (by meaningful, I mean 350,000 to 450,000 jobs per month). It will take that type of job creation to tangibly enhance the underlying fundamentals of real estate. Let’s hope our new legislators are able to implement policy that will make that happen sooner rather than later.
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.