Running Off The Cliff

Posted by jeff

Fri Oct 17th, 2008 04:03 PM

Wiley%20Coyote.jpgThankfully, housing starts fell 6.3% nationally in September to a seasonally adjusted rate of 817,000 units, according to the Commerce Department. This was the lowest national rate since January 1991, according to CBS Marketwatch. They were also revised down for July and August. No surprises here, quite rational in fact. The market is reacting to the horrible housing oversupply and moribund demand conditions by decreasing supply. Let's hope it goes to zero; in fact, if they could turn the minions of idle bulldozers to knocking down some of the vacant and half-built surplus housing, it would probably do us all a favor, and hell... it would be fun to watch on YouTube. Building permits, which are considered to be less volatile than housing starts, reportedly fell 8.2% to 786,000, a 27-year low, also very rational. So one might ask what is happening closer to home in our beloved Gotham City. The chart below of housing permits for Manhattan, Queens, Brooklyn and the Bronx, is quite eye catching (September numbers aren't out yet).


New York City real estate aficionados will easily identify the absurd spike in building permits back in June as a result of the re-vamping of the 421a tax abatement program. For those novices out there, see Noah's prior pieces on this program here and here. The bottom line is that the city made the 421a program, which was originally meant to incentivize the building of affordable housing, harder to get, while restricting the locations it was available in to much less popular neighborhoods and lowering the overall subsidy. For those of us who don't believe in government subsidies (although we all have learned that regulation is another story), it is not surprising that contrary to its initial intent, this program ended up "incentivizing" builders to build luxury condos in prime locations.

The removal of the subsidy for many prime areas around the city was a very strong impetus for developers holding land to "get in the ground" and get grandfathered for the subsidy. In fact, in the 421a FAQs bulletin on the HPD web site it states that "Any project that commences construction prior to December 28, 2007 or July 1, 2008, respectively, will not be subject to these new provisions and will still be eligible to receive 421-a tax benefits pursuant to the prior law. Any project that commences construction after the relevant date will be subject to the new provisions." Later it reads "Construction must commence on or before the effective date of the specific provision. It will be considered the later date of a building or alteration permit and the installation of a metal or concrete load bearing structure, footing or caisson." As to when the construction must be completed, the regulations say "without undue delay" and "We would deem completion within 36 months from commencement as a guideline for construction being completed without undue delay."

So there you have it, not only do the permits have to be filed, but actual construction has to take place this decade in order to qualify for the tax abatement. Heavy incentive for a land owner to build a building and oh, by the way, developers don't usually build buildings until they have a construction loan or at least a bridge to construction loan in place. Even financial institutions are likely committed to delivering the 16,774 units of new housing product indicated by the permits taken in June.

As many of you understand, land is the underpinning of all real estate value, being the key piece of equity onto which leverage is applied. Land values, particularly in a buoyant market, begin to reflect the future profit potential of full utilization of airspace at its "highest and best use." In fact, near the end of a real estate cycle many times the "developer's profit" is largely eaten up by the high cost of the land. Meaning that if you build the full airspace available at its highest and best use and sell it out, after paying for design costs, construction costs, marketing etc., there may be very little profit left above the initial cost of the land - although this only becomes obvious in retrospect. In an efficient market environment this would be a gaiting factor on land prices. Once developers began to foresee that the sell out values they could get from building were declining or even just flattening, they would refuse to buy increasingly high priced land that became available. In fact, well before all hell broke loose in the financial markets, land prices in some areas of New York City were starting to slip back from their bubble-like run-up.

Sorry for digressing, but as you also know the real estate development market isn't truly efficient and is as subject to emotion as any other. However, it does still have a discounting mechanism. In the case of New York City new housing permits, developers were further blinded to the realities of what is likely to unfold, due to their desire to capture the 421a benefit. In fact, they had to try and capture the 421a benefit because to some extent it was already factored into the price of the land when they acquired it. Read that again, because this is how markets work: they anticipate future benefits and detriments and build them into prices (though sometimes better than at other times).

As Mike Stoler noted at the Yale Club gathering, we will be at peak supply of housing inventory in New York City in no time due to all the construction activity. Now you know why developers are still running off the cliff. Even when the banks eventually take over these projects, they will likely make sure that construction is finished without undue delay to preserve the value of the 421a tax abatements, even if the building is eventually going to go rental. Today the 421a legislation does have some exemptions to the completion without undue delay clause. "Such factors may include fires or other casualties that cause damage to completed construction work or severe, prolonged, and unavoidable labor stoppages or industry-wide material shortage." Maybe they could add industry-wide insanity to the list.