The title of this piece makes you wonder what is meant by "they should sell for". What, after all, is value? Many people (particularly appraisers) feel that value is a very different thing than the price someone is willing to pay for a property. There are all types of qualifiers such as "an arms length transaction" between a "willing buyer and willing seller", etc. As a broker who only represents sellers, I see value as the highest price that the most aggressive buyer will pay for a property. Whether the property is "worth it" or not is completely dependent upon the perspective of the buyer.
Arguments about value versus price versus worth can go on for quite a while. This column will not attempt to define the differences between these terms, but will merely look at the relative price levels investment properties are selling for today and try to figure out why.
One of the most evident trends in the investment sales market today is the acute imbalance between supply and demand. While I spend all of my time selling in the New York Metro area, it appears that these imbalances exit nationwide. Whenever I attend conferences across the country or speak with brokers working in major cities in the U.S., the story seems to be the same: Buyers are plentiful, there is a ton of capital on the sidelines and there is not much available for sale. Forget the infamous "bid / ask spread". There is just not enough product on the market to meet existing demand.
In the New York City market, for example, the sales volume in 2009 was abysmal. We always view volume based upon the number of properties sold each year (as opposed to total dollar volume which can be skewed by a few mega-sales in excess of $1 billion). Using the Manhattan submarket as an example, we track a statistical sample of 27,649 properties south of 96th Street on the eastside and south of 110th Street on the Westside (north of these streets is considered the Northern Manhattan submarket).
Over a 25 year history, the average turnover rate within that sample has been 2.6%. The lowest turnover rate we had ever seen was 1.6% observed in 1992 and 2003. These were both years at the end of recessionary periods and were also years in which we hit peaks in cyclical unemployment.
We had always assumed that 1.6% was a baseline for turnover, below which the numbers could not reach. After all, in 1992 and 2003, the only people who were selling did so because they, essentially, had no choice. Death, divorce, taxes, insolvency, partnership disputes, what have you. Our baseline assumption was blown out of the water in 2009 as turnover hit, at least, a 26 year low of 1.17% (our statistics do not go back further than 1984 so we do not know whether this was a historic low or not).
To the causal observer, a lack of buying demand could explain the low activity level. However, if we look carefully at market dynamics, we see that the major contributor to the cobwebs which paralyzed the market was constrained supply.
Typically, the supply of properties for sale is fed by discretionary sellers. As these sellers pull back, as happens when values fall (on average in New York, prices per square foot have fallen in value by 32% from their peak in 2007), distressed sellers will normally step in to fill the void in the supply chain. Thus far in this cycle, those distressed sellers have not appeared in a meaningful way to normalize the available supply. Everything that has happened from a regulatory perspective has allowed the distress, for the most part, to stay camouflaged on lender's balance sheets as a highly accommodative Fed monetary policy provides a recapitalization mechanism for the banking industry.
This has left brokers and buyers in need of magnifying glasses and Basset hounds to locate buildings for sale.
Simultaneously, the demand side has been strengthened and is growing. When we started to tangibly feel the effects of the credit crisis in mid-2007, institutional capital, which was a main inflator of the 2005-2007 bubble, evaporated from the market. From the summer of 2007 through the fall of 2009, the overwhelming majority of our properties were purchased by high-net-worth individuals and the old-line New York families which have been investing in the city for decades. Many of the institutions which were sidelined, had plenty of time to form distressed asset buying funds and began to reenter the market last fall joining the individuals and families in the battle for assets.
Additionally, we saw a substantial increase in the amount of capital emanating from overseas. This was mainly in the form of foreign high-net-worth individuals who, surprisingly, were not real estate investors back home. They had made money in other businesses and decided now was a good time to invest in a market where values have fallen sharply, the political climate was relatively stable and the U.S. dollar was relatively weak. We have not seen this level of foreign demand since the mid-1980s.
This has created a dynamic in which we have many frustrated buyers fighting over relatively few assets. Impatient investors are pressuring fund managers to whom they have given capital, to show some activity and the individuals do not want to miss an opportunity so they have been jumping in. Foreigners are transparently in the market and the confluence of all of this demand is causing bidding to be aggressive. Because of this imbalance, we actually saw prices per square foot increase in the second half of 2009 versus the first half of the year. There is no other explanation for this increase (other than excessive demand versus low supply) as our fundamentals continue to be under stress given continued elevated unemployment levels.
We believe prices are higher than economic fundamentals indicate they should be. This is particularly noticeable in our note sales. We are showing recovery rates of about 95% to 100% of collateral value (as opposed to par, from which discounts can be substantial) meaning that by the time the note buyer goes through the foreclosure process and obtains the deed, they will be into the asset for more than 100% of its value. This dynamic is not sustainable.
No, we do not believe the second half of 2009's increase in values indicate that we have bottomed. We believe they will continue to slide until we have a tangible reversal in unemployment trends and that the upward trend in the second half of 2009 was only an upward bump on a downward trend toward a natural bottom. It is for this reason we have been encouraging sellers to act now to take advantage of these odd circumstances in which demand is extraordinarily greater than supply (this is a difficult thing for a broker to say without sounding completely self-serving). We believe this dynamic could change rapidly if something, probably a modification to bank regulations, changes the inertia in the distressed asset pipeline. Even without a regulatory or legislative change, we have already seen things begin to loosen up. Thus far, it has, unfortunately, only been a drop in the bucket compared to what exists in the market as we embark on the massive de-leveraging process that we must inevitably go through on the way to recovery.
Mr. Knakal is the Chairman of Massey Knakal Realty Services and has brokered the sale of over 1,050 properties in his career