Bubble or recovery?

As investors grow increasingly anxious to deploy the “dry powder” they’ve stockpiled to buy distressed assets, experts say signs of a new real estate bubble are appearing.

That may sound counterintuitive, given the still-recovering state of the market. But investors spent much of 2009 gathering vast sums of capital for distressed assets, only to have it lie fallow in a still-frozen market.

Now that deal velocity is finally starting to increase, experts say investors are feeling pressure to spend their cash. That means prices for desirable assets are rising amid fierce competition for the still-small number of available deals.

While some experts see these purchases as a sign of a recovery, others worry that prices are artificially inflated because investors are not basing the prices they’re paying on current conditions. Instead, they’re agreeing to prices based on the assumption that the market will improve and their properties will start generating more income later.

“On the acquisition side, you have this bubble forming where people are overpaying for assets because they’re swept up in the me-too frenzy,” said appraiser Jonathan Miller, who is also a partner in Condominium Recovery, a venture that looks to convert distressed condo projects to rental apartments. “The math doesn’t work as far as rationalizing the price being paid.”

Since the market crashed in 2008, would-be investors have turned their attention to distressed real estate, hoping to pay rock-bottom prices for apartment buildings, office buildings, development sites and unfinished condos in New York and other urban areas.

But with many lenders unwilling to write down the value of the distressed properties on their books, few deals were done in 2009.

Ken Krasnow, a managing director at Massey Knakal Realty Services, said in 2009 there were only 66 development sites sold in all of New York City. (By comparison, in 2006 Massey Knakal alone sold 217.) He said 2010 is expected to bring a double-digit increase in deals over last year, though volume is still small compared to the mid-2000s boom.

Meanwhile, investors are growing anxious, since many have a finite amount of time in which to invest the capital they raised.

“A lot of these funds that have been raising money are starting to become impatient,” Krasnow said.

Now, “there’s an increased amount of pressure,” he said. “We think the fall’s going to be fairly active, putting some of that capital to work so they don’t have to return it to their investors.”

As a result, when desirable properties come on the market, bidding wars are breaking out, and prices are being driven surprisingly high — sometimes even close to boom-time levels.

“The bubble is a function of the fact that there’s quite a bit of capital, and very little product that is well priced,” said Douglas Hercher, an executive vice president at Cushman & Wakefield Sonnenblick Goldman. “What you’re seeing is an increase in values and a lot of bidding for properties. When you start seeing Class D assets selling for $700, $800 a square foot, that’s not far off the peak numbers we saw.”

St. Vincent’s Hospital in Manhattan, which is in bankruptcy, recently saw a price run-up on one of its building sales. It reportedly received over 20 bids for the Sixth Avenue apartment building it auctioned in June, ultimately selling it for roughly $67 million to Stonehenge Partners, far more than the $48 million Taconic Investment Partners had agreed to pay earlier.

Meanwhile, Krasnow said Massey Knakal has been trading some desirable properties at cap rates — the annual rental income of a building divided by its purchase price — of around 5 and 6 percent, down from around 7 and 8 percent last year.

“Those numbers seem very surprising to people, considering where we were a year ago,” Krasnow said. “There’s a lot of demand, so the pricing was fairly comparable to peak pricing.”

He is now marketing a Manhattan development site at 35-39 Cooper Square, which was originally going to be developed into a hotel but was returned to the lender. Massey Knakal has been marketing the site for only a few weeks, but they’ve received over a dozen offers, he said. He said he’s also seeing similar activity at the Vesta, a 72-unit condo at 19-80 Steinway Street in Astoria, which is only 50 percent complete.

On the one hand, it’s possible to view this activity as a sign of a rapid recovery. But some experts worry that these high prices can’t be justified by the profits these assets can generate for their new owners in today’s still-rocky market. And falling cap rates mean that investors are settling for skimpier returns, experts said, which means they are likely betting on future rent and price increases.

Miller noted that the credit crunch and high unemployment are still making it difficult for consumers to buy homes and businesses to expand, which means that prices for end users will likely stay flat for some time.

But some investors are paying high prices for buildings and development sites anyway, fearing that they’ll miss out on an opportunity.

“If you’re hungry for returns and under pressure from investors, and you see everyone in the room starting to make moves, you don’t want to be left out,” Miller said. As a result, “people are [paying] a price for the project that would mean they have to sell for about the same as they would have … a couple of years prior.”

That means trouble down the line, since condo sale prices have now dropped around 21 percent from the boom-time highs. Meanwhile, the current frenzy has “delayed the resolution of getting the assets priced correctly,” Miller said.

But others noted that while some investors may be overpaying for today’s market, they’ve learned their lesson from the boom, and are no longer looking for a quick flip.

“The people who are buying those assets are taking a long-term view,” Hercher said. “You can debate whether it’s a little overpriced, but when they look at New York City and the long-term potential of the market, they’re probably making a pretty good bet.”