Red flags for real estate
In a Wall Street Journal op-ed last month, Boston Properties Chairman Mort Zuckerman voiced concerns about the economy, and especially the listless growth of the job market.
“The country needs a real recovery, not a phony one,” the mogul wrote.
His viewpoint stands in stark contrast to much of the economic news Americans have heard over the past few months, and especially to the buoyant mood felt in New York City real estate. The Manhattan market has enjoyed a heady year so far, with historically low interest rates and a seemingly limitless influx of international capital sparking a demand for trophy properties. Mammoth trades, such as a $1.4 billion deal at the GM Building and the sale of two penthouses at One57 for more than $90 million each, have set new expectations for the market’s performance.
“There’s a lot of euphoria in the marketplace and a lot of people think that is going to continue,” said Noah Rosenblatt, founder of Manhattan market analytics website UrbanDigs.
Then again, many market-watchers missed or failed to heed the warning signs in the run-up to the 2008 real estate collapse.
And despite the mostly sunny forecasts, a handful of industry observers are warning of dark clouds on the horizon. Experts said they are worried about rising interest rates, and the current disconnect between the New York real estate market and the reality of the economy.
Jonathan Miller, president of the Manhattan appraisal firm Miller Samuel, has said for months that the real estate market is not in a recovery, but a “pre-covery.” The New York City market is being driven by artificial factors, such as the Federal Reserve’s policy of buying bonds to shore up the economy and a severe shortage of homes for sale, he said.
“We are getting good news, but it’s not based on anything fundamental,” Miller said.
See below for a closer look at the red flags in the current real estate market — the warning signs experts say could mean trouble ahead.
Rising interest rates
Chief among economists’ concerns is rising interest rates.
Since November 2008, the Fed has engaged in a policy of “quantitative easing:” buying bonds to keep interest rates at extreme lows and help stimulate the economy. But in May, Federal Reserve Chairman Ben Bernanke announced that the Fed may scale back on bond purchases this year, which would increase interest rates even more than they’ve been inching up already.
Indeed, the average interest rate on a 30-year fixed-rate mortgage jumped from 3.43 percent in May to 4.68 percent in mid-July, according to the Mortgage Bankers Association.
Higher interest rates could impact the real estate market in several ways. First, experts said, it could dampen activity in the residential market by increasing the size of homebuyers’ monthly mortgage payments.
If rates rise too quickly, said Doug Perlson, the CEO of online brokerage RealDirect, that could “slow down the market” and impede the growth of home prices.
Miller said rising interest rates could lead to a “surge and stall” situation, in which activity speeds up — as buyers rush to close sales with rates still low — then fizzles.
Real estate investment trusts, such as Zuckerman’s Boston Properties, are also likely to be hurt by rising interest rates, analysts said. Because of a law that requires REITs to pay most of their taxable earnings out to shareholders, they tend to rely on the capital markets for financing and development costs. Higher interest rates mean that it’s more expensive for them to borrow for those purposes.
In fact, REITs saw their stock prices tumble after Bernanke’s remarks in May, though they’ve since rebounded as the markets adjusted to the Fed’s news.
REITs “have been on a harrowing ride since the Fed’s taper-talk began,” noted Michael Knott, an analyst at Newport Beach, Calif.-based Green Street Advisors.
Higher capital costs are also likely to dampen the hyperactive deal making in the private equity sector, which was responsible for 36 percent of the money flowing into the office market in the second quarter, according to data from commercial brokerage Avison Young.
“The private guys have a lot of money,” said Real Capital Analytics’ Dan Fasulo, “and do push the envelope and prices more than [where] institutional investors and pension fund types think they should be.”
Indeed, investment sales prices are up 17 percent from the 2007 boom-time peak, according to Real Capital Analytics data.
Bob Knakal, chairman of Massey Knakal Realty Services, said he worries that investors are jumping into the market without considering how their ability to refinance these purchases will be affected by rising rates.
“They’re mismatching long-term assets with relatively short-term debt,” Knakal said. “Interest rate risk is not something that is priced into the market the way it should be.”
Private equity investors, in particular, are highly levered, meaning that they tend to use more debt and would therefore take a bigger hit from an interest rate hike.
However, while most industry experts expressed concern about rising interest rates, Miller said he is heartened by the uptick, because it “tempers the market … [and] may keep runaway growth in check.”
Bemoaning what many are calling “a jobless recovery,” Zuckerman’s op-ed called for government policies that would create a tech-savvy workforce and reduce unemployment.
Though the recession is now over, joblessness remains high, which experts said is taking a toll on the housing market.
In June, the unemployment rate in New York City was 8.4 percent, a drop of one percentage point from the same month of last year but still higher than the national 7.6 percent unemployment rate, according to the New York State Department of Labor. By contrast, the city’s unemployment rate in December of 2007, before the financial crisis, was 5.1 percent.
Salaries aren’t increasing either. According to the U.S. Census Bureau, the median household income statewide was $56,033 in 2008. By 2011, that figure had dropped to $55,246.
A drop in unemployment is crucial for the city to move to a full recovery, Miller said.
“The next phase is a recovery based on fundamentals, like employment, being where they need to be and incomes [beginning] to rise,” he said. “All those things will happen, but very gradually over several years.”
In particular, widespread unemployment among young professionals is a major problem facing the housing market nationwide, according to Jed Kolko, the chief economist at San Francisco–based Trulia, a real estate website.
“Young people are at the age where they’re making a lot of housing decisions,” he said, “whether it’s [living with] parents, roommates or on their own, or to rent or buy.”
Young professionals who are unemployed or facing job insecurity, he noted, are far less likely to buy a home than those with steady incomes.
For now, the combination of high unemployment and high prices is unsustainable, Miller said.
Ironically, however, industry experts noted that a strong national employment report could actually harm Manhattan’s commercial investment sales market, illustrating a paradox unique to New York City.
A strong jobs report could prompt the Fed to further scale back bond purchases, causing interest rates to rise and in turn slowing the building sales market, explained Barbara Denham, Eastern Consolidated’s chief economist. “The next really good news will be bad news,” she said.
But even as they hope for lackluster national news, real estate insiders are all for strong job growth in New York, which would create a greater demand for office space and bolster the leasing market.
They may be getting their wish. As of the end of June, 60,700 jobs were created in the city in 2013, the highest rate of growth of any six-month period since 2000, according to the Department of Labor. In comparison, the city lost more than 40,000 jobs per month in early 2009.
A number of political factors are also giving real estate professionals pause. Of particular importance for the New York market is the mayoral election on Nov. 5.
In his 11 years in office, departing Mayor Michael Bloomberg has championed pro-business policies. For example, his administration’s proposal to rezone a large swath of Midtown East — which would allow developers to tear down old buildings and construct taller, modern skyscrapers — was applauded by the real estate industry.
But though the proposal’s enactment was once thought to be a foregone conclusion, the plan has hit a roadblock on the community board level. If it doesn’t pass before Bloomberg leaves office, the next mayor may not have the political muscle (or the desire) to push it through, disappointing developers who hope to revitalize their building stock by adding floors and raising rents.
“If it slows down and doesn’t pass while Bloomberg is in office, that may create uncertainty” for the real estate market, according to Robert Ivanhoe, chair of the global real estate practice at law firm Greenberg Traurig.
The crop of mayoral candidates makes the industry nervous because their views on development are not seen as gung-ho as Bloomberg’s. When it comes to Council President Christine Quinn, one of the front-runners, some industry insiders said they are concerned about what they described as her close ties to unions. Other major industry figures, including CBRE’s Mary Ann Tighe, have endorsed Quinn, however.
Another area where politics is creating uncertainty for the real estate market relates to “carried interest,” also known as a promote, which refers to a common way of compensating the developers of real estate projects and acts as a sweetener for taking the lead on a project.
Currently, carried interest is taxed at capital gains rates, generally at about 20 percent, rather than as ordinary income, which tops out at nearly 40 percent. But several local and national politicians have proposed taxing carried interest at the same rates as earned income.
If such a measure passes, it could deter development, Knakal said.
The way that carried interest is taxed somehow managed to survive Congress’ budget deal at the beginning of the year, despite attempts by Democrats to reform it. The subject, though, more than likely will remain a target for lawmakers in the months ahead. Mayoral candidate Bill de Blasio said he, too, has considered the possibility, if elected, of taxing carried interest as income.
Spiking land prices
The manic demand for luxury residential projects has led to a sharp spike in Manhattan land prices — up to $800 per buildable square foot in some cases, as TRD has reported.
So far, international investors and New Yorkers starved for inventory have been willing to shell out vast sums for these pricey apartments, but if land values keep rising, buyers will eventually balk, analysts warned.
“If land is selling at $800 a foot, then to make sense, the condos would have to sell at $2,200 to $2,300 a foot,” noted Neil Helman, a member of Avison Young’s capital markets group. “There’s going to come some point in time where people can’t afford to spend $2,300, $2,400, $2,500 a square foot for what was once $1,400 or $1,500. So buyers are going to have to say ‘uncle.’ ”
Such high prices may also make it hard for developers to get construction loans. “Developers by nature are extremely optimistic,” Helman said, but at those prices, “lenders may start to pull back.”
The combination of factors could add up to failed condo projects, he said.
“If land prices are pushed too much further … there’s going to be projects that won’t be able to reach the finish line,” he said. “It’s just gotten into very dicey territory right now.”
Moreover, a dramatic land rally such as this one has historically been a harbinger of a downturn, Knakal said. The land market rally is “irrational,” he said, noting “there is no reason” that prices should have climbed so fast.
But this time around, all bets are off because the disconnect between the real estate market and the larger landscape has never been greater.
“There are no models that exist to predict the behavior in this market,” Knakal said. “We are in completely uncharted territory.”
Lack of inventory
New York City’s severe shortage of residential inventory has showed no sign of easing, and experts agree it could be months before there’s any sign of relief for home-seekers.
In the second quarter, listing inventory in Manhattan fell 31.3 percent to 4,795 available units, down from 6,981 in the same period of last year, according to Douglas Elliman’s quarterly market report, compiled by Miller.
With the continued lack of inventory, demand and prices should continue to climb. That sounds like a good thing for the market, but Miller said it is “not a sign of strength.” Rather, because the current shortage was caused by tight credit and an unusually low amount of new building, it actually suggests “imbalance and weakness” in the market.
The inventory squeeze dates back to late 2008, when the recession and accompanying credit crisis halted many under-construction residential projects, and skewered plans for new ones. The pipeline of planned projects had run dry by 2009, Miller said. Meanwhile, with unemployment still high and raises scarce, many New Yorkers cannot afford to trade up to larger apartments, so they’re deciding not to move.
The lack of inventory has since caused bidding wars and driven up prices as buyers compete for the few homes available. That’s caused a bubble that could burst when inventory finally does start to return, sources said.
“I don’t like seeing the market being driven by an artificially low inventory level,” Perlson said. “I’d like to see it being driven by healthy supply and healthy demand. These secondary factors make me less comfortable.”
If inventory stays low for some time, prices could accelerate rapidly, then collapse, Miller noted.
“If we don’t see inventory return to the market, I’m concerned about prices rising too quickly, which would threaten the housing market,” Miller said. “I don’t want to be in a situation where there’s double-digit price appreciation and no relief in inventory.”
As many countries struggle politically and economically, New York real estate has remained a safe haven for foreign wealth.
Many purchases come from countries such as Spain, which is mired in a recession and coping with a corruption scandal involving Prime Minister Mariano Rajoy; Italy, where lenders are now struggling with a flood of bad loans; and Greece, where public finances have been kept afloat since 2010 by a rescue loan program funded by the Eurozone and International Monetary Fund.
Buyers in these and other countries are eager to purchase real estate in the United States and New York specifically, believing that their money is safer here than abroad.
“A lot of what’s driving up prices is coming from foreigners,” said Terrence Oved, a partner at the Manhattan law firm Oved & Oved. “People are making their money in other places in the world that are a lot more dangerous to invest in.”
Because many of these international buyers are more interested in an investment than a place to live, the stratospheric prices they’re willing to pay for homes here essentially amounts to speculation, sources said.
And at some point, that’s likely to catch up with the market, especially when the turbulence settles down and buyers from Europe and elsewhere become less interested in New York real estate. Despite what we may think, Helman said, there isn’t “an infinite amount of foreign buyers.”