Next for Investment Sales: Up, Down or Sideways?
The cyclical peak in the New York City investment sales market is now clearly in the rear-view mirror. Volumes peaked in 2014 and 2015, and values peaked earlier this year. Volumes have been dropping for years, and now, property values are moderating on a market wide basis and are down in all major property types in the Manhattan submarket. Simultaneously, for the past two months, contract execution activity is up sharply, and it is becoming fun to be a sales broker again. But where does the market go from here?
I believe that we are about 26 months into an investment sales market correction. There was no event to catalyze this correction. No stock market crash, no Savings & Loan crisis, no housing market imploding, nothing—just the natural cyclicality of the market.
As a backdrop, since 2014’s 5,534 properties trading hands, the number of properties sold dropped for three years running. We are presently on pace to end the year about 33 percent below 2014’s peak. The drop in Manhattan is even sharper as we are currently on pace for a total that is 45 percent below the cyclical peak.
Also, prices have come down dramatically: There was an all-time record of $80.4 billion of sales in 2015, dwarfing the prior record of $62.2 billion achieved in 2007. This year, we are on pace for $32.7 billion, 59 percent below the 2015 peak. In Manhattan, the present pace should get us to $19.2 billion, 70 percent below 2015’s $63.2 billion record.
While these volume trends have been evident for quite a while, values trends are now becoming clearer. The first sign that values would fall occurred at the end of 3Q15 and beginning of 4Q15 when we saw the Manhattan land market essentially shut down within a three-week period. Bids started coming in 20 percent below expectations on most of sites that we were marketing at that time. In 2016, land value in Manhattan counterintuitively rose by 5 percent. However, because the “real value” of land had fallen by about 20 percent, most sellers simply did not sell, sending land sales volume down by a whopping 79 percent. This condition, where volume drops and value appears to be rising, is quintessentially what the market experiences when a correction sets in. The value of land in Manhattan in 2017 is down 19 percent as closings are finally reflecting what bidding activity told us was going to happen back in 2015.
This leads to an important point that must be made. It is bidding and contract execution activity that is much more indicative of market conditions than comparable sales that have closed. The reason for this is twofold. First, a transaction that closes today is a look in the rear-view mirror. Properties are normally under contract for 30 to 120 days prior to closing and a contract typically takes a month or two to negotiate. Second, because of the historically, consistently and relatively low rate of turnover in any neighborhood, most comparable sales studies look at sales over the past year or so. Think about how “old” the market feedback is on a sale that closed 11 months ago. Therefore, today’s bidding activity on properties for sale provides the best indication of true market conditions.
While land was (and is almost always) the first sector to drop, we are now seeing values dropping in Manhattan in all of the major product types. These include elevator and walk-up apartment buildings, mixed-use properties, retail and office buildings. Fortunately, the percentage drops have all been in the single digits. In the outer boroughs, values are also beginning to adjust with some property types seeing reductions in value while others are still appreciating, albeit at a slowing rate of increase.
Much has been made of the wide bid-ask spread that has existed for quite a while now. This began to widen significantly when underlying fundamentals were beginning to experience downward pressure. First, about two years ago, residential rents began to drop—a condition exacerbated by significant new supply being delivered to the market. Second, we saw softness begin in the retail sector about a year ago as technology changed the way brick-and-mortar retail space was being used. And, third, as office space concession packages swelled, downward pressure was being exerted on office rents, and today, we are seeing some face rents below where they were a year ago. The realization of these market conditions is setting in and impacting the sales market. The contract execution activity I referenced has been caused by a narrowing of the bid-ask spread and that narrowing has been caused more so by sellers coming down to meet the market, rather than buyers becoming more aggressive.
So here is each outcome of where we might head from here and the probability associated with each:
A rising market: Based on contract execution activity, we expect to see volume metrics pick up in early 2018 when the contracts that have been executed over the past two months begin to close. Unfortunately, most of this contract activity will not close soon enough to impact 2017 statistics, which we expect to continue to slide through year-end. However, if sellers continue to adjust to market realities, they will continue to come to the market, and volumes will continue to rise. We are beginning to hear that residential rents are stabilizing and concession packages are being reduced. If rents in the major property types solidify and begin to rise, values will also begin to rise again. Interest rates remaining low would bolster the argument for an upswing in the market. (Probability 20 percent).
A falling market: The trends we are seeing are simply early stage correction dynamics. The Manhattan submarket is suffering more than the rest of the market, but changes up or down generally happen in Manhattan before they hit the rest of this city. It would appear that values would continue to experience downward pressure until values drop on a broad basis in the outer boroughs. With regard to the number of properties sold, while market activity is down significantly below peak levels, absolute levels market wide are only at the long-term average of 2.2 percent of the total stock. Given we are at the average, there is plenty of room for the number of sales to slow even further. In Manhattan, the turnover ratio is also 2.2 percent, below the 2.6 percent long-term average. While below the average here, in past cyclical low points, turnover has fallen as low as 1.2 percent to 1.6 percent. Clearly, there is room for this metric to fall as well. Simultaneously, the Fed has projected three rate increases for next year, which would exert downward pressure on value unless we have tangible growth in GDP. (Probability 30 percent).
A relatively stable market: Because there was not a catalytic event that brought about this correction, it should be relatively mild. Corrections in the past have varied in terms of how they impacted the market. During the S&L crisis in the early 1990s, the volume of sales dropped for four years before gaining traction. At the same time, property values dropped by 53 percent. During the recession in the early 2000s, volume also dropped for four years before turning. However, during that recession, there was not one year during which average sales values dropped. During the recent Great Recession, volume dropped for three years, and values dropped by 38 percent on average. Today, we are in the third year of falling sales volume, and while values in Manhattan are down, market-wide values are still increasing, albeit at a very low rate. This correction could mirror the one in the early 2000s when volume dipped but average values never did. Capital is continuing to flow into the market, and with availability growing, this activity should buoy downward pressures. (Probability 50 percent).
Clearly, time will tell, and tax reform could profoundly change the market. We will continue to watch the market and keep you posted on how things play out.