Knakal: Resurgence of Institutional Capital

Posted by urbandigs

Tue Oct 20th, 2009 01:52 PM

A: I need to plug Robert Knakal's Streetwise blog because the content has been a breath of fresh air for the past nine months or so. In his latest piece, he discusses the "resurgence" of institutional capital interested in buying distressed Manhattan property, to which their is limited supply (office, multi-family, mixed-use, etc..). With transactional volume down "60% from 2008 and 75% from 2007", average property values fell about 32% from peak levels. Sounds about right with office properties seeing the most pressure. But with sales volume down so sharply, why the limited supply?

There are three main pressures on commercial properties:

a) rising unemployment
b) declining rents
c) tight financing in the mid to high end

Strange to see inventory levels so tight given the plunge in sales volume. To hear Knakal describe it, "...discretionary sellers are seeing these pricing trends as a tangible reason not to place properties on the market at the present time". According to "Low Volume of Investment Sales Caused by Supply Constraint; Demand Still Strong":

The volume of investment sales recently has been extraordinarily weak whether you look at aggregate sales price or number of transactions. In fact, we are on pace to see sales volume hit the lowest level we have seen in the 26 years we have been tracking these statistics.

Average property value has fallen in New York by 32% from its peak levels. Multi-family properties have been performing best, having lost only 16% of value while office buildings with significant exposure to the marketplace have been the most negatively affected, seeing a reduction in value of about 70%.

These reduced values have peaked the interest from the buying community as investors are looking for core assets at greatly reduced prices. Conversely, discretionary sellers are seeing these pricing trends as a tangible reason not to place properties on the market at the present time. At the height of the market in the first half of 2007, we had, at one point, 836 exclusive listings. Today, we have just 513 and have been below 600 for the entire year.

We remain hopeful that the supply side of the equation will get better as distressed assets appear to be coming to the market in slightly better numbers than we have seen thus far in the cycle.
Mr. Knakal goes on to discuss..."on the demand side, we have seen resurgence, within the past month or two, of institutional capital. As I mentioned earlier, this capital all but evaporated from the marketplace in the summer of 2007 and many of these institutional real estate players have formed distressed asset funds looking to buy properties. These funds are now in the market actively bidding on opportunities."

I too know of a few funds that were recently set up to take advantage of distress opportunities in that sector. Leads me to believe that a disconnect may exist in the most distressed commercial sectors as bids, while out there, just are not at levels that non pressured sellers would consider trading at - but then again, what the heck is non pressured sellers anyway. How do we quantify who needs to raise cash fast and close within a few months or else default? And how do you add in to that the human reaction to dealing with a financially stressed situation? Maybe a seller is in denial and ignores what in hindsight turns out to be a solid bid?

With declining rents, rising unemployment, and a tight financing market, the price has to be right; as the new owner will ultimately have a much better environment with which to operate the property. This is a highly deflationary phenomenon and tends to have a ripple effect on competing properties. This also may be one reason why bids have improved in the sense that Armageddon is now off the table, but not to a level that would jive with the current reflation trade mentality. The numbers still have to work!

For now, it's likely a good time to get into some distressed properties in office and mixed use marketplace if you have the cash and the numbers work! The chances of a natural overshoot to downside are high with such a fierce move; especially in office markets. For residential, the fear trades window was about 2-3 months (Feb, March, into early April) before the market saw a re-emergence of buyers and bids started to price out systemic risk. We found out later which months ultimately saw the sharpest deals.

Last check saw Manhattan office vacancy rates at 11.1%, a five year high, with rents falling 5.2% from the 2nd quarter and down 22% from the year ago period; via Bloomberg.

Calculated Risk adds some thoughts from NY Fed President William Dudley:
"First, the capitalization rate—the ratio of income to valuation—has climbed sharply. At the peak, capitalization rates for prime properties were in the range of 5 percent. That means that investors were willing to pay $20 for a $1 of income. Today, the capitalization rate appears to have risen to about 8 percent. That means that the same dollar of income is now capitalized as worth only $12.50. In other words, if income were stable, the value of the properties would have fallen by 37.5 percent. Second, the income generated by commercial real estate has generally been falling."
Not sure where cap rates are today, as my business is entirely focused on the residential sector. But it is clear that we are experiencing a deflationary adjustment, no matter what reflation trade seems to be going on in more liquid markets. Its healthy, it has to happen, it is happening, and markets will continue to purge the excesses from a credit fueled housing boom.

Net effective rents are more clearly showing the furious adjustment; these are rents after deductions and landlord concessions are factored in. Crain's reports net effective rents for commercial sector "hit levels that are 45% below their pre-recession peaks".

While I just renewed my residential lease 2 weeks ago, I'll share the outcome:
I rent a 891 sft, JR4, with 1 bathroom in full service upper east side building. E 80s location, west of 3rd avenue. My starting rent in 2006 was $2,900. It was raised to $3,100 in 2007 and raised again to $3,300 in 2008 (they asked for $3,450, but only offered $3,300) as there was no inventory in building even though markets seemed to be trending down this time last year already.

Landlord offered me $3,150 + 1 month free rent for a 13 month lease renewal. I asked for $2,900 plus the same concession. They came to $3,000/mth + 1 month free on a 13 month lease. I took it. So, that brings the net effective rent to about $2,750/month, or a 17% reduction from last year's levels.
Anyone out there care to share what they are seeing in the commercial or rental leasing markets?


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