Commercial bubble trouble?

NYC investment sales brokers say talk of a market peak is exaggerated, but concede investors are exercising more caution

From left: William Silverman, Shimon Shkury and Michael Cohen
From left: William Silverman, Shimon Shkury and Michael Cohen

Predicting a market bubble is almost always a losing pastime. But that hasn’t stopped brokers, market analysts and economists from talking about whether the New York commercial market is peaking — and what the global economic slowdown will mean on the ground here.

This month, The Real Deal talked to investment sales executives who said that while investors and lenders are exercising more caution these days, the bubble theory is being overblown. That’s even as prices have soared since 2010, prompting comparisons to the boom and bust of the mid-2000s.

“I don’t see any short-term disaster right now, despite what is going on in the rest of the world,” said Jim Gross, co-head of operations at Douglas Elliman Commercial, speaking of sinking stock prices, flat inflation and increasingly jittery investors. “What always seems to happen in a downturn is there is a sudden event that no one can foresee. You just have to play safe.”

Investors are, indeed, playing it a bit safer. That involves scrutinizing properties more closely and generally being pickier about deals. For example, sources predicted that Chinese investors, facing economic turmoil in their homeland, would take on more low-key investments rather than making trophy plays.

Nobody was overly concerned about the amount of new office supply coming Downtown and on the Far West Side. But the companies relocating to those new spaces are leaving behind older Class B blocks that may be harder to fill, sources said.

For more on how startup firms play into the commercial mix, which neighborhoods are attracting the most (and least) investment and how the market is responding to increased interest rates, we turn to our panel of experts.

William Silverman
Managing director, Hodges Ward Elliot

There’s been a lot of handwringing by economists lately about a possible commercial bubble. What do you think based on the deals you’re seeing in today’s market?

The answer is not cut and dry. The gap between premier and mediocre assets
this year appears to be duly widening. The warts that were overlooked in 2014 and 2015 are receiving more scrutiny in 2016. But best-in-class assets will still attract demand.

What kind of properties are attracting the most investment in NYC and which properties are investors avoiding?

The shift in the market is away from “momentum” investing to “thesis-based” investing. For the last several years it was not about what you were buying because it was just a good idea to get as much exposure as you could. But now people cannot rely on mere bull-market momentum. While some investors think there’s room to grow in the luxury multifamily sector, others say Long Island City and Bushwick will be the next office markets. The Downtown Class B office market is also seeing more demand as a result of a high rate of residential conversion and increased demand from commercial tenants seeking refuge from Midtown South rents.

Is NYC’s economy strong enough to handle all the space coming to the market Downtown and on the West Side?

The issue is not whether NYC has enough demand to fill Hudson Yards, it’s whether we have enough demand to backfill the spaces left behind by the tenants who are moving there, like KKR, L’Oreal, Time Warner and Coach. Old-school corporate tenants seem to be choosing these newer spaces, so maybe the new-school TAMI — technology, advertising, media and information technology — tenants will be the ones to take the spaces they vacate. The buildings that succeed will be those that offer the adult playground experience favored by those tenants.

Are there new markets emerging as tenants change their investing strategies?

Smaller tenants, requiring under 25,000 square feet on a floor, have long been relegated to secondary buildings in Midtown East. Perhaps now we will see them moving to areas like south Broadway and the Garment Center. When you see astute players such as Westbrook buying at 1375 Broadway or Vanbarton at 31 Penn Plaza, one has to imagine that part of the thesis is this western migration.

How has Chinese investment in NYC been impacted by the country’s economic slowdown, stock market turmoil and currency devaluation?

The second wave of Chinese investment is going to be a lot more choosy and specific. Many of these investors have planted their flag on the far right side of the bell curve with trophy purchases like the Waldorf Astoria
and One Chase Manhattan Plaza. Now they’re walking their way back as they develop a more traditional exposure to the market. 

Michael Cohen
President, Tri-State, Colliers International

Do you think there’s a commercial bubble on the horizon and how do interest rates play into the current climate?

The likelihood of a bubble is vastly exaggerated. The market has long anticipated this first interest rate increase by the Fed and basically shrugged it off. The real question is: How much will the Fed increase rates by over the next few years? I don’t think the market is ready to shrug off three to four increases. And in a funny way, the lack of inflation, volatility in the stock market and global slowdown in growth all seem to argue against more increases in the near term, which is a net positive for commercial real estate values.

Which Manhattan neighborhoods are seeing the strongest leasing activity and which are struggling?

Midtown South will continue to be an undersupplied market until job growth in the TAMI grinds to a halt, which is highly unlikely to occur in 2016. On the other hand, the Downtown market has plenty of supply, albeit at rents 20 to 30 percent higher than a few years ago. Even factoring in those rent increases, Downtown is still attracting cost-conscious tenants, refugees from Midtown South, and offers some of the best values in Manhattan. In Midtown, supply seems likely to increase because of defections to the Far West Side and Lower Manhattan, but availability is already well into single digits, creating a challenging environment for tenants.

Do you think NYC’s commercial market has peaked or is nearing a peak?

There’s been so much talk about the market peaking in 2015 that it does seem likely to be self-fulfilling. The big question is whether foreign capital will really be affected by the global slowdown. There still seems to be an inexhaustible supply of buyers for every property on the market. [In terms of foreign investors] we may see less investment activity from Chinese and Russian oligarchs this year, but other sources will rise to replace them. We’ve seen activity from both Canada and Germany of late.

Is NYC’s economy strong enough to fill all the commercial space coming online?

The Far West Side is already a proven success with no shortage of demand. Downtown has been less successful in attracting tenants but should fill its space, albeit more slowly.

What do you predict on the commercial development front in Manhattan? Are developers and lenders going to be willing to tackle new commercial projects given the uncertain market?

New development will be highly site specific. Midtown South, which already has insufficient supply, will remain attractive to developers. The proliferation of boutique, speculative office buildings in the Meatpacking District is a perfect example of that. Developers will be more cautious in Midtown and Downtown.

What do you see as the biggest challenges to the market in the coming year?

Certain markets and submarkets are already oversupplied, and others will remain undersupplied throughout 2016. That said, there is clearly going to be a lot of space vacated by tenants that migrated to Lower Manhattan and the Far West Side.

Shimon Shkury
President, Ariel Property Advisors

How much is Manhattan investment sales activity up or down by, and are you seeing a slowdown?

We find all this talk of a slowdown premature. Dollar volume in the second half of 2015 was up 23 percent compared to the second half of 2014. People are expressing caution about the global economic climate, but NYC’s characteristic as a safe haven remains true amidst this turmoil.

What kind of properties are attracting the most investment in NYC and which are investors steering clear of?

Investors are acting with more caution for development sites, but the market is still healthy overall. We are marketing an assemblage at 86th Street and York Avenue right now, and we’ve received several dozen bids in six weeks. Pricing remains at elevated values.

Are developers and lenders going to be willing to tackle new commercial projects given the uncertain market?

Every market has the occasional pullback but the city’s long-term trajectory is great. We expect to see more work-life projects like Hudson Yards and Essex Crossing. The city’s economic growth is diversifying through the development of new or converted buildings to accommodate the growing TAMI industry.

Sign Up for the undefined Newsletter

Which new areas are developers and investors showing interest in?

While we’ve seen coverage of expanding areas such as the South Bronx or Prospect-Lefferts Gardens, we’re paying very close attention to East Harlem. The anticipated rezoning there will include a mix of market-rate, moderate-income and affordable housing. We’re also keeping an eye on Jamaica and Ridgewood in Queens. Both are increasingly on investors’ radars and have projects in the pipeline that may serve as a catalyst for broader change.

Jon Caplan
Vice chairman, JLL

How do commercial property values compare to the recent past? Do you think there’s a bubble forming?

Over the past six to 12 months, there’s been some leveling in pricing, which is not surprising — or of major concern. … New York is not facing significant overbuilding or overleveraging, and the underlying fundamentals have been strong. Lower-risk capital stacks with increased equity in deals is being driven by more conservative underwriting and lending standards, as well as by investors, particularly for larger and more institutional-type assets. In times of global uncertainty, NY real estate benefits.

How much is Manhattan sales activity up or down by compared to the recent past?

Manhattan set a new record in 2015 with $60.3 billion in investment sales. That represents approximately a 50 percent increase over 2014 and close to a 25 percent increase over Manhattan’s prior record of $48.5 billion in 2007. Several trends have contributed to record sales activity last year, including greater foreign participation, more recapitalizations — partial interest transactions — and the increased number of larger deals, those above $500 million.

What types of properties/areas are attracting the most investment in NYC?

Institutional, foreign and private capital players have been expanding the submarkets they’re pursuing, driving investment to Downtown, Brooklyn and Queens, as well as Northern Manhattan and the Bronx. Class B office has seen a rebirth, partly because of its appeal to TAMI tenants. Development, particularly in residential, has attracted greater institutional and foreign participation. There are signs of more caution, particularly in the hotel and development sectors, but there hasn’t been a major shift away from certain product types. In 2015, office transactions generated the largest dollar volume, with $24 billion, and the residential sector saw the greatest number of deals, with 232 deals valued at $13.5 billion.

Have you seen interest wane from foreign investors amid global uncertainty?

Foreign participation in the New York investment market soared to 45 percent of Manhattan sales [dollar volume] in 2015 versus 19 percent in 2014. … Foreign capital will continue to be active at a higher level than prior to 2015. There is great diversity among the foreign sources as well. Last year, the three largest participants were Canada at 35 percent, China at 27 percent and Norway at 7 percent of foreign capital investment.

Jeff Blau at Related has said that Chinese investors were notably absent among bidders to recapitalize the first Hudson Yards tower. How has Chinese investment been impacted by the country’s economic slowdown?

Globally, investors face incredibly low — sometimes negative — yields on low-risk sovereign bonds.  While Manhattan real estate yields are low by historical standards, real estate yields appear quite attractive relative to global “risk-free” rates. That should continue to attract foreign investment to New York, including Chinese capital. In addition to political and economic stability, the combination of significant Chinese money held outside of China, and the continued strengthening of the dollar vs. the yuan, adds support to Chinese investment in U.S. real estate.

Peter Hauspurg
Chairman/CEO, Eastern Consolidated

What are your biggest concerns about the sales market in NYC?

The dark clouds that people are writing about really aren’t there yet. The expiration of 421a has dominated the conversation in recent weeks, but that only affects one segment of the industry. It’s really a “tale of two markets.” We are seeing an oversupply of high-end condos and, as a result, developers are cutting their floor plans, and we expect the expiration of 421a to lead to a slowdown of affordable housing development. However, at the same time, there isn’t any indication that land prices are falling. For example, we currently have a Manhattan development site in contract at well over $1,000 per square foot. On the other side of the market, income-producing properties such as existing multifamily buildings, retail condos and office buildings are performing very well and there is far more money chasing these assets than there is product available.

Are developers and lenders going to tackle new commercial projects going forward given the uncertain market?

New York City has been adding jobs at a rapid clip; 2015 alone saw a net gain of 87,100 jobs, a 2.1 percent year-over-year increase. In December, NYC’s unemployment rate was 5 percent — down from 6.5 percent the previous December. …So as long as the city continues to create jobs, we expect to see office buildings occupied.

What do you see as the biggest challenges to the commercial market in the coming year?

We’re expecting a lot of residential units to come online in Brooklyn and Queens, but as long as the city continues to add jobs, the market should be able to absorb them.

Jim Gross
Co-head of operations, Douglas Elliman Commercial

What are your biggest concerns about the NYC investment sales market? Do you think the market has peaked or is nearing a peak?

I don’t see [a bubble forming]. The stock market has taken an enormous hit but I don’t see anybody panicking.

Have you seen interest waning from foreign investors amid global economic uncertainty?

We’ve seen a lot of interest but you still have to find the right deal and a lot of foreign groups don’t want to be in a bidding situation. … If you look at the price of oil, investors may want to be here, but no matter what, they still want to see the numbers [on their deals]. They’re not just going to throw their money down at anything just to be here.

Are there any interesting pricing trends you’re seeing in Manhattan?

In general, rents have risen 10 percent to 15 percent Downtown. The cheapest area in the city now is [around] Grand Central. The area that has increased dramatically is around 14th Street, where landlords are asking for over $100 a foot. Years ago you’d never think about that.

Are there any new trends in the office market that you’re seeing?

We’ve never had this level of young people moving to the city getting jobs with startup and Internet-based companies. With certain types of companies from the tech industry, landlords have wanted a lot of security, but if they can pay at least six months of security and take spaces of $80-to-$100 a foot that range from just 5,000 to 50,000 square feet, landlords are not afraid to fix them up. That is where the market is really popping.

Gil Robinov
Executive managing director, International Advisory Group

How has the Manhattan office market changed in the last 12 months?

People are not using as much space as they used to. They used to have corner executive offices, with couches and conference rooms, but you don’t have that anymore. If you have a company on a lease that is expiring and they’re occupying 25,000 feet, they’ll bring in a space designer and look at renting 17,000 feet — 20 percent less space. That’s more efficient for them. Even if they have to pay a higher rent, they’re not renting as much space as they used to because they don’t need large offices.

Where has this happened?

Startups and tech companies moving into the Flatiron and Meatpacking districts that have been in the business for just a few years do not want to commit to long-term leases. They will be happy with a lease for three to five years. Their primary concern is space that is open and flexible because they don’t know what the future holds. You have a whole new short-term market now as a result, but landlords are still trying to secure longer leases for stability. And in general, as people use less space, rents have gone up between 10 and 15 percent across Manhattan.

In January, Silverstein Properties was dealt a blow after 21st Century Fox and News Corp. nixed its plans to be the anchor tenant at 2 WTC. How difficult do you think it will be to find another anchor tenant to fill such a high-profile space?

Who knows why they lost the deal. People lose deals all the time, but I’m sure that somebody else is going to come along. Silverstein is smart, a dealmaker, and he’ll find someone else.

Where are the best investments and relative bargains for commercial real estate in NYC?

There are no bargains. If anything, you have to overpay.