Last week, we began discussing the divergence of perspectivesamong many participants in the marketplace, some of whom areviewing the future very optimistically and some of whom remainpessimistic. The bulls believe the market has bottomed and a real,sustainable, recovery is upon us. The bears believe that presentmarket conditions represent the eye of the storm and that we are infor even rougher times ahead as we get further into 2010, 2011 and2012. This week we will continue to look at factors which areaffecting the marketplace and how the bulls and the bears areinterpreting them.4) Deleveraging: During thebubble inflating years of 2005 to 2007, there were massive amountsof debt placed on investment properties. As values have fallensignificantly from the peaks, there is far too much leverage in thesystem and most participants agree that deleveraging must takeplace. The opposing perspectives of the bulls and the bears relatesto the extent to which this deleveraging will actually takeplace.Using the New York City market as an example, we believethere are presently 15,000 properties (out of a total of 165,000)that currently have negative equity positions. On these assets,there is approximately $165 billion in leverage. If we take intoconsideration the reduction in value that we have seen in variousproduct types and use today's more conservative loan-to-valueratios, we believe there should only be $65 billion in leverage onthese assets if the market were appropriately leveraged.This meansthere is $100 billion too much leverage in the system. Of course,this will not all come out of the market in the form of losses.Some properties can still cash flow at 90, or 100, or even 110percent loan-to-value ratios (thanks in large part to low interestrates). Other properties want to be held for the long-term byowners who have alternative sources of revenue to feed propertiesthat are under water and others will be worked-out between theborrower and the lender. However, we believe that $30 to $40billion will be absorbed, in the form of losses, before the dustsettles in this cycle.The Bulls: The bulls believethat interest rates will stay low for an extended period of timewhich will make the strategy of simply waiting, beneficial and willsave many of the properties that are in negative equity positionsThey believe that the extent to which deleveraging will occur willbe far less than anticipated (ie, many fewer distressed assets thanmost participants expected). They believe that fundamentals arebecoming enhanced and the deleveraging projected in 2011 and 2012,based on the maturity of 2006 and 2007 vintage loans, will not beas significant as expected.The Bears: Thebears believe that there will be massive deleveraging, particularlyduring 2011 and 2012, as the 2006 and 2007 loans mature. Theysuggest that the 06 and 07 loans are the ones that are the mostunderwater as they were originated at a time when value was at itspeak and loan-to-value ratios were at their maximum. They also haveindicated that they feel ten-year CMBS loans, which will createsignificant maturities in 2016 and 2017, will cause a second waveof deleveraging. This would add more stress to the marketplace andindicates the "lost decade" conditions similar to those that Japanrecently suffered.5) Unemployment: If you are afrequent reader of StreetWise, you know that I view unemployment asthe indicator which has the most profound affect on real estatefundamentals. During the recent recession, the U.S. has lost 8.5million jobs. The importance of job losses to real estatefundamentals can be illustrated as follows: if someone has lost ajob, or fears they may lose a job, they wont move out of mom anddad's home to set up their own household, they don't move from asmaller rental apartment to a larger one, they wont move from arental unit to buy an apartment or a single family residence andcompanies that are letting people go, don't take more office space,they want less office space. In order for our real estatefundamentals to tangibly recover we need substantial jobgrowth.The Bulls: The bulls currently point to thefact that we are losing only tens of thousands of jobs permonth today while we were losing 600,000 and 700,000 jobs per monthin the first quarter of 2009. They believe this losing-jobs trendwill soon reverse and that we will have positive job growthbeginning within the next few months. The Department of Labor hasprojected that in 2010 our economy will grow by an average of90,000 jobs per month. The bulls view this as very positivenews.The Bears: The bears point out that, simplybased on population growth, we need 100,000 jobs created per month.They claim that if we had 100,000 jobs created per month throughoutthe year we would still not gain back any of the 8.5 million jobsthat were lost to the recession. The bears claim that, in order tohave a sustainable recovery, we need 300,000 to 400,000 jobscreated per month and that, even at this rate, it would takeseveral years to regain the 8.5 million jobs that werelost.6) Interest rates: The Federal Reserve Bank'sinterest rate policy has been keeping rates at historical lowlevels. The direction of these rates and the timing of rateincreases will have a significant impact on our marketplace movingforward. Rate increases could cause many transactions which arehanging on by a fingernail to crater. Interestingly, floating rateborrowers turned out to be smart (as opposed to fixed-rateborrowers who are paying higher rates) as low rates are saving someoperating statements. An increase in interest rates could changethis dynamic significantly. How much they increase, and when,should be on the minds of every floating rate borrower in themarket (and also on the minds of anyone with mortgages maturing inthe short-term).The Bulls: The bulls believe thatthe Fed will keep interest rates artificially low for theforeseeable future. They do not believe that the likelihood ofinflation is real in the short- to medium-term and they believethat the Fed's exit from the marketplace will not be impactful onour interest rate environment. While it is expected the FederalFunds Rate will increase by year's end into the range of 1.25% to1.5%, the bulls believe that lenders will allow the spreads tocompress to absorb this increase, which will not increase mortgagerates to any significant degree. If commercial mortgage ratesremain steady, values will not be negatively impacted. The Bears: The bears believe that inflationis indeed on the horizon which will exert upward pressure oninterest rates and that the Fed's exit from the marketplace willcause rates to climb. To the extent that the Federal Funds Rate isincreased (and most economists believe that it will be in the 1.25% to 1.5% range by year's end), mortgage rates will be drivenup significantly. Increasing interest rates will have a dampeningimpact on commercial real estate values.7) Gross DomesticProduct (GDP) Growth: During this crisis we have gonethrough an unprecedented reduction in GDP growth. 70% of U.S.output is consumer driven and we have seen consumer confidence andconsumer spending at near-record lows during the past couple ofyears. With housing values down significantly from the peak (homesare the major asset for an overwhelming majority of U.S. citizens),Americans are feeling less wealthy and are, therefore, spendingmuch less. They are also unable to use home equity lines of creditto gain access to whatever equity they may have had. Mortgageequity withdrawal was a major contributing factor to a -4% U.S.savings rate a few years ago. Consumer spending drives our economyand provides the fuel for GDP growth.The Bulls:The bulls believe that we will see GDP growth in the 5 to 6 percentrange which, while still below typical GDP growth coming out of arecession, is significantly above what the consensus is among U.S.economists. They believe that consumer confidence (and thereforespending) will rebound and, moreover, the stimulus will startto tangibly take hold and that the output of the U.S. will grow ona healthy path out of our current position.TheBears: The bears believe that fourth quarter GDP growth,at 5.9%, was created mainly by government intervention and that theeconomy does not have the wherewithal to sustain growth levels atthese rates without government support. The bears believe thatconsumers are uncertain about their economic futures, particularlygiven the uncertainty of the U.S. tax outlook moving forward, givenall of the government spending and massive deficits being observedon federal, state and local levels. With an apparent unwillingnessfor politicians to cut spending (except in New Jersey andVirginia), Americans see the only possible outcome as increasedtaxes across the board. The bears expect GDP growth to be asluggish 2 to 3 percent for the balance of 2010 and into 2011.Nextweek we will continue our look at the divergence between theperspectives of the bulls and the bears by addressing corporateearnings, capital on the sidelines, financing, capitalization ratesand supply and demand. If there are other topics you would like tosee addresses, just let me know. Until then.....Mr. Knakal isthe Chairman of Massey Knakal Realty Services in New York City andhas brokered the sale of over 1,050 properties in his career havingan aggregate value in excess of $6.2 billion.