The Real Deal New York

City may offer some inflation insulation

November 21, 2007
By Philana Patterson

Even if inflation becomes a problem for the rest of the country, New York City may have some protection against falling real estate values.

As the rate of inflation increases, the value of the payments on longer-term debt erodes. Bonds become less attractive and prices drop, sending yields and the corresponding mortgage rates higher. The fear is that costlier mortgages will lead to a slowdown in home sales and even a contraction in prices. However, New York City property owners, particularly in Manhattan, may have a cushion.

“There’s one difference that gives New York an edge,” said Coldwell Baker Hunt Kennedy CEO David Michonski. “Many co-ops require 100 percent cash and some require 50 percent. Many people are no more than 75 percent financed, which insulates the market against interest rate increases the amount of leverage in the market is less than the average city in the U.S.”

Indeed, in Manhattan, co-ops make up more than 80 percent of the residential for-sale inventory. Still, the city isn’t inflation-proof. Rising inflation could increase co-op and condo common charges such as energy bills and slow the appreciation in apartment prices. The commercial market could also be affected.

“The more common charges go up the less the values go up,” Michonski said. In condos, heating and air conditioning bills in individual units may rise and buyers may factor in those price increases into how much of a mortgage they can afford.

“It’s important to look at whether real wages are rising faster than the rate of homeownership,” said Nick Arnold, senior associate at the Corcoran Group, and an economist by training. In an inflationary environment the value of incomes are eroded by rising prices, and “that would put a strain on people,” Arnold said.

As long as people continue to want to live in New York, the limited space for new housing may also prop up the market.

“Real estate is local in a sense,” Arnold said. “Real estate prices in any market are determined by supply and demand you have to take into account the number of people coming into the market. The supply side is limited by availability and highly developed zoning laws that put limits on new construction. There has been a net inflow of people into the city as opposed to the 1970s and ’80s, when there was a net outflow.

“One could,” he said, “imagine a scenario where there could continue to be an inflow of residents and capital into New York, where inflation would have minimal effect because of tight supply.”

Higher operating costs possible

In the commercial market, rising inflation would likely present a pinch in the form of higher heating and other operating costs which might reduce the rate of return for commercial property owners.

“From an operational standpoint, for owners and investors, the cost to operating and maintaining a building goes up,” said Peter Hennessy, managing principal at the Staubach Co. “They are able to recoup some, but not all, of the expense from the existing tenant base.”

There are other consequences on the commercial side. A lot of landlords have floating rate debt, so they will see mortgages increase, Hennessy said. Also, the commercial rental market could remain stagnant because tenants might not see as much growth in their own businesses, and, if they aren’t expanding, they won’t be out looking to lease larger space, he said.

“If I am a corporation and my cost structure is being squeezed [because of inflationary pressures] that gives me less money to build my business,” Hennessy said. “I’m not taking more office space, not buying more furniture, not increasing headcount I’m not doing the things that have a positive effect on the economy.”

Since the dot-com bust, advertising firms, law firms, not-for-profits, and financial services firms have been some of the types of tenants that have been actively leasing office space in Manhattan, said Robert Sammons, director of research at Colliers ABR.

In October, the Manhattan class A vacancy rate was 8.2 percent, down from 9 percent in September, its lowest level since December 2001, according to a recent Colliers report (see Commercial Market Report on page 6). Asking rent for class A space at the end of October averaged $51.72 per square foot, down slightly from $51.46 in September, but well above the $47.66 per square foot a year ago, according to Colliers. Rents in Midtown have risen about 4 percent this year and could see a similar or greater increase in 2006, Sammons said.

The big problem in the commercial market is that energy prices filter down to more than just construction costs of new buildings, Sammons said. It can also drive up the price of building out space for a tenant moving into a different location.

“You might see tenants renewing where they are instead of looking into moving somewhere else,” Sammons said. “I know it’s on all the brokers’ radar screens. I think what they are telling their clients is, ‘If we can manage to keep it under control we can weather this,’ but it could be touch-and-go in the next few months.”

Sammons said he’s concerned that rents could rise enough in an inflationary environment that it might push some companies to move to Connecticut, New Jersey, and Westchester County in search of less expensive leases.

“The good and bad part of things is that it has always been a little more expensive to build in Manhattan so maybe the sticker shock won’t be as prevalent as it would be in other markets,” Sammons said.

On the positive side, in a higher inflationary environment, real estate values tend to rise, Hennessy said. “People look at real estate as return that is consistent and positive as opposed to the bond and stock markets.”

During the last major inflationary period in the U.S. the late 1970s and the 1980s commercial real estate values dropped dramatically. There were a lot of speculative commercial real estate developments back then, which isn’t an issue today, Hennessy said.

“My personal belief is that we are gong to see inflation persist, but we’re not going to see anything close to what we saw in the late 1970s,” Hennessy said.

Since then, the U.S. has moved to more of a service-driven economy than a manufacturing economy, which has made business in the U.S. less dependent on commodities.

“When commodities become scarce, that drives inflationary pressures,” Hennessy said. “There would need to be cataclysmic inflationary pressures to get us back to where we were in the ’70s.”

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