Is the Investment Sales Market in a Mini-Bubble?
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The investment sales market has been steadily improving over the last few quarters, as fundamentals begin to improve and economic recovery, while sluggish, is upon us. With regard to fundamentals, we have seen rent concessions evaporating and occupancy rates improving. The economy is moving in a generally positive direction but is having difficulty finding momentum as employment growth is well below expectation and last week it was reported that consumer spending experienced a decline of 1.2% in May, the first drop since September of 2009. While the investment sales sector appears healthy, the future of the market, however, is uncertain as market indicators are presently difficult to interpret. These conditions beg the question: Are we in another bubble at the bottom of a cycle?
Today, nothing is impacting the investment sales market more than the supply / demand relationship. Real estate markets are always dependant upon the supply / demand dynamic, however; it appears to be impacting the market more acutely now than we have seen in the past. Presently, there is excessive demand met by a relatively weak supply of available properties for sale.
Demand drivers are active from every segment of the purchasing arena. When we first started to tangibly feel the impact of the credit crisis in the summer of 2007, the institutional capital, which drove up value in the bubble inflating years of 2005 -2007, all but evaporated from the marketplace. The overwhelming majority of investment properties that Massey Knakal closed from mid-2007 until recently have been purchased by with high-net-worth individuals and families that have been investing in the market for decades. Recently, we have seen a reemergence of institutional capital as these investors have formed distressed asset buying funds and opportunity funds to take advantage of perceived opportunities in today’s market. Add to this the significant numbers of foreign investors and we have a demand side of the equation that is overwhelming.
On the supply side, we have seen historically low levels of properties for sale. Typically, the supply of available properties is fed by discretionary sellers who decide it’s time to sell. Typically, when values decrease, as happened beginning in 2008, discretionary sellers withdraw from the market. As this occurs, normally distressed sellers will emerge to fill the void left by the withdraw of discretionary sellers. In this cycle however, this has not occurred. Everything that has happened from a regulatory perspective has provided distressed sellers the ability to avoid dealing with their problems if they choose to.
The result is a very low supply of available properties to satisfy the excessive demand that exist in the marketplace. Due to these conditions, properties are selling for more than fundamental economics would dictate they should be selling for. Consequently, the “great opportunities” and “great deals” that were expected at the onset of this credit crisis have simply not emerged.
The supply of available properties is, however, increasing. We have seen a tangible increase in distressed assets coming to market and these distressed sellers are being joined by discretionary sellers who are, once again, coming back into the market. They have been waiting for a while to implement sell decisions and they simply are not willing to wait any longer to pull the trigger. Some of our clients are selling today because of the looming increases in capital gains taxes next year. Others are selling because of the likelihood that “carried interest taxes” will increase next year from the capital gains rate to the ordinary income rate.
The opinion that discretionary sellers are returning to the market is supported by the fact that we have seen a palpable resurgence of 1031 exchange transactions. We know that these are the result of discretionary sales as distressed transactions rarely have any residual equity which could be reinvested utilizing the 1031 mechanism.
Given this increase supply and the excessive demand that exists, we expect investment sales volume in 2010 to increase by at least 40 percent over 2009 levels. Granted, we are coming off anemic levels last year, but a significant increase in activity will be well received by market participants. In a couple of weeks we will be releasing our first-half 2010 statistics which will be a good indicator of how the year is progressing and should tell us something about what we can expect for the balance of 2010 in terms of volume.
With regard to value, as stated earlier, prices are increasing to levels above what economic fundamentals would dictate. It is almost as if the market is experiencing a mini-bubble at the low point in the cycle. Cap rates have remained at low levels after expanding significantly in 2009 and, remarkably, note sale recoveries have been extraordinarily high relative to collateral value. These conditions seem extremely positive today but, “Where we are headed?” is the bigger question.
Last month’s disappointing employment data has showed that employers are still leery about making commitments to new employees given the uncertainly surrounding the economic recovery and the vast array of tax obligations that are likely to increase substantially in the near term. Consumer spending and consumer confidence remains weak and GDP growth is challenged. Economists are, in increasing numbers, predicting a higher likelihood of a double dip recession.
We anticipate that the investment sales market, for the balance of 2010, will be very healthy as current dynamics continue. However, moving forward there are things to be concerned about. The deleveraging process, which is already in full swing, has a long way to go before all of the properties in negative equity positions are recycled or resuscitated. The 2006 and 2007 vintage loans, which are in the most distressed positions, don’t mature until 2011 and 2012 and are often being kept alive by advantageous loan terms such as interest only periods, interest reserves or are floating over LIBOR which remains at miniscule levels.
The anticipation that interest rates will rise, and rise dramatically, is still looming over the marketplace as well. Interest rate increases will have significant negative implications for the investment sales market and it is only a question of when, not if, these increases will occur.
With regard to supply, a regulatory change impacting the ability of lenders to hold loans on their balance sheets at par, even when they know the collateral is worth significantly less, could lead to significant increases in supply, exerting significant downward pressure on value.
Lastly, the expectations of increases in taxes of all kinds creates significant trepidation on behalf of participants in the marketplace. Capital gains taxes will increase from 15 percent to 20 percent when the Bush tax cuts sunset as they are expected to at the end of the year. Obamacare will add to this capital gains increase and personal taxes on federal state and local levels are sure to rise as politicians across the country demonstrate an inability to effectively cut spending. This is the case in all that but a couple of states which have seen shifts in policy recently.
Therefore, it is easy to understand how bearish participants are using this opportunity to sell and take advantage of the extraordinary supply / demand imbalances, very low interest rates and a, currently, friendly tax environment.
Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,075 properties in his career having a market value in excess of $6.4 billion.
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Bob,
Great analaysis. The past 10 years were bullish for real estate the next 10 not so much. We are experiencing cap rate compression because interest rates are being kept low by the Fed monetization of the debt. Investors cannot get bond yields over 4%. When rates rise ( and they certainly will) this phenenom will end. Keep writing enjoy reading.
Bob:
As always; valuable market-based insights. All of the recent "scarcity premium" language in the net lease sector has, in fact, been documented on a case-by-case basis for the "best-of-breed' candidates.
We still do verify, on a daily basis, secondary credits and secondary locations that Sellers and Listing Brokers assert should be transacted in this "scarcity environment".
We do see "a scarcity".....a scarcity of reasonably and appropriately priced NNN assets for our seasoned Net Lease Investors around the country.
On the debt side, the Fed, in the last 48 hours, has been suggesting 'a wish' to keep rates down; while acknowledging inflationary concerns; but a suggestion that rates may stay lower through 2012. (Any politics playing a role here?) We'll see.
Clearly, the debt piece is critical going forward.
While there is good debt available with modest leverage; the bid/ask spreads are still very challenging when trying to craft a win/win deal. We have had three 1031 deals with savvy buyers 'go South' this past week; when the parties could not come to terms and as Buyers opted to pay capital gains under current rate structure.
There are more opportunities as you indicate; but we can verify a continuing resistance to fully execute unless compelled by tax or estate planning issues.
Hi Stephen S. Thanks for your post. Interest rate increases are among the biggest downside risks to the market today. Increased rates will increase the required yield investors will require and will increase borrowing rates for purchasers. Both of these things have negative implications for value. Additionally, as you correctly point out, distressed assets will come to the market in greater volume as floating rate debt will be less serviceable and the opportunity cost for banks keeping good money in bad deals will escallate. Many more properties will not be able to service debt if rates increase substantially.
Hi Greg, Thanks for the post. Yes, actually real estate values have been on an upcycle since 1993 and only began to fall in 2008. That is much longer than the typical upturn in the market. Over the past 60 years, the average upturn has only been about 7 years between downturns. It may take a while for the market to revive fully as tax increases next year will be a big drag on GDP growth, our economy and our commercial real estate market. Our rates have been kept low by all of the turmoil in Europe and, as you say, will certainly go up in the future.
Hi Sean, thanks for your post. You make many great points. Scarcity is driving the market today and supply is short while demand is overwhelming. That being said, I believe that tax impacts will play an increasingly important role in a seller's decision making process. Cap gains will skyrocket as will all taxes (federal, state and local) as municipalities deal with growing budget deficits from out of control entitlement programs which are unsustainable. We need policy makers with some intestinal fortitute to get the ship back on track. We have many clients today selling to take advantage of today's low capital gains rates and many sellers who are trying to beat the tax increases on carried interests.
Bob, I very much appreciate your insight. What do you see in the way of treatment from bank regulations towards impaired loans as we approach the large wave of maturing debt ? I would have to think that the govt does not want to see another RTC situation. What are your thoughts ?
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Mr. Knakal, great work as usual. Please expand on your comment concerning the negative implications of the pending interest rate increases. This will obviously make returns on acquisitions less attractive, but it will also force the banks hand in renegotiating loan terms, thus stopping the 'kicking of the can' and increase the supply of assets in the market to fill the void. Not sure if the good outweighs the bad but it's not all bad, agreed?