Q & A with Bob Knakal

Posted by urbandigs

Thu Dec 17th, 2009 10:30 AM

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A: I had the pleasure of meeting Mr. Bob Knakal a few weeks ago for an after-work chat to discuss everything markets. It was time very well spent. Mr. Knakal is chairman and founding partner of Massey Knakal Realty Services and publisher of the relatively new StreetWise blog where he discusses thoughts on the macro economy & New York City Investment Markets. I find his content to be unbiased, real time, educational and easy to read. I asked him to delve into some questions that UrbanDigs readers might be interested in, and he quickly agreed. Enjoy!

Question: Where are we in this residential & commercial cycle? What inning might we be in?

Answer: I believe the residential market is further along in the cycle than the commercial market. While it is difficult to predict precisely where the residential market is, I believe that we could be close to approaching a bottom. The tremendous and unprecedented government intervention that we have witnessed has artificially propped up the market in a number of ways. Therefore, I don’t believe that we are presently at a natural bottom and there may be a slight double dip. The first time home buyers credit, artificially low interest rates and the fact that the government (between Fannie Mae, Freddie Mac and FHA) guarantees 92% of all home loans in the country. This is an unsustainable level of support. That being said, I believe that the residential market is somewhere in the 7th or 8th inning and that we could see an upswing in the market sometime in 2010.

With respect to the commercial market, we have seen the volume of sales start to increase from its low point, however, value continues to slide. This slide is based upon the fact that unemployment is continuing to rise and we must always remain cognizant of the fact that there is nothing that more profoundly affects the fundamentals of real estate than employment. As most economists expect unemployment to peak in the first half of 2010, it is very likely that at that peak we will see the weakest status of our fundamentals and, therefore, a low point in value. After hitting this low point, we expect value will bounce along that bottom for an extended period of time until a determination is made as to whether all of the capital on the sidelines will rush into prop the market up or the deleveraging process will be so debilitating that it will keep value at it’s low point.

Question: What are the biggest 3 bearish risks to Manhattan real estate going forward?

Answer: The first bearish risk for the marketplace has to be taxes. We have seen, recently, a substantial increase in real estate tax rates which are further compounded by increasing property assessments. This is a trend that we don’t expect to see reversed any time soon as the city deals with its fiscal problems. We expect increased taxes, not only on the real estate front but, with respect to state and local income taxes and other taxes and fees. These are a significant downside risk to the marketplace.

The second risk is based upon the extraordinarily liberal, if not militant, positions on regulation and oversight of our markets by the New York City Council and our elected officials on Albany. Some of the positions they have taken recently are extremely harmful to the marketplace from a number of perspectives. The pending changes to the residential rent regulation system will, if passed by the Senate, cut jobs and reduce tax collections. Fortunately, the commercial rent control bill seems to be on the back burner for the time being although that would have also cut a significant number of jobs and reduce tax collections.

Particularly distressing is the position that the City Council took relative to Related’s Knightsbridge Armory development in the Bronx. There position was one of not only telling developers what they could build and how they can build it, but, they attempted to place restrictions on the tenants in the property requiring the tenants to pay its employees wages in excess of the minimum wage. This would knock out many of the national big box retailers who would be natural prospects for a development of this nature. This proposal, and its restrictions, makes absolutely no sense for the city nor to Related and the transaction is now stalled leaving a dilapidated eyesore in the middle of the Bronx. This property has been abandoned for over 10 years and will remain so indefinitely. Rather than having economic development, job creation and increased tax collections we are left with stagnation. We have witnessed a project that would have created 1200 construction jobs and 1100 permanent retail jobs go down the drain due to irresponsible policy. The result is that today there are no jobs and no wages being paid at that site.

The third downside risk to the marketplace is that our infrastructure continues to age. Stimulative dollars could be spent upgrading the various infrastructure systems of the city. Particularly if, as the Bloomberg PlanNYC projects, one million additional residents move to the city over the next 20 years, our infrastructure systems need to keep up with the demand that will be created.

Question: What are the biggest 3 bullish factors for Manhattan real estate going forward?

Answer: Perhaps the most pronounced bullish factor is the fact that we went into this down cycle with far less speculative construction than we did going into the recession of the early 90’s. Supply of available property is very low and the amount of new construction is not nearly what it would need to be to meet the demand that is projected for the future. This dynamic alone could lead to an extremely sharp spike in value when the market is in full and tangible recovery mode.

Secondly, New York City seems to be maintaining its domestic and global standing as the financial capital of the world. During this global economic recession, we have seen significant problems emerge in London and Paris and we have seen emerging markets like Dubai show their vulnerabilities. The fact that New York is still the number one destination for investment capital from around the globe is extremely positive and will serve the city well.

The third thing to keep in mind, which is a more long-term benefit for our marketplace, is that the city is literally running out of developable land. There are very few large land parcels that even exist, let alone available to be developed. At some point, particularly in Manhattan, we will see a dynamic similar to what Tokyo has experienced where values will spike considerably simply based on the fact that supply constraint will be very palpable.

Question: Do you see a second wave to this credit crisis, ultimately affecting Wall Street and our markets, or did the fed save the day?

Answer: Well, I believe the Fed’s policies stopped us from entering a catastrophic period that we all feared. If you recall, one year ago, everyone was running around putting money into different banks and were trying to figure out which banks would be solvent and which ones wouldn’t be. There were some major banks that failed and it was really unclear as to whether the system could recover. Policies that were implemented brought us off of the edge of the cliff but we still have a significant way to go before we can have a tangible recovery. Unprecedented government intervention has created a scenario where banks do not have to face the losses that are, so clearly, embedded in their balance sheets. The changes to mark-to-market accounting rules, the fact that bank regulators have been allowing banks to keep loans on their books at par even thought the collateral may be worth half of that, and the modifications to the REMIC guidelines have created an environment in which balance sheet losses can simply be ignored. It is very clear that we have to go through a massive deleveraging process to create stability in our marketplace and until that occurs there is still some downside risk embedded in our marketplace.

Question: Do you see continued concessions by landlords and owners to fill vacancies or have we seen the peak of the deals already being offered?

Answer: We have seen periods of significant concessions on behalf of both residential owners and commercial owners. In the residential sector, we have seen owners offering one or two months of free rent as well as owners paying brokers one month rent as commissions as well. We have seen effective rents down 20-25% causing significant downward pressure on values. In the commercial sector, we have seen inflated free rent periods and work letters for tenants bringing office rents down anywhere from 30-40% depending on the report that you read. I don’t believe we will see concessions grow and, as history tells us, we will see these concessions start to dissipate before we see increases in rent levels.

Question: When do you envision higher interest rates being a significant drag on housing investment in Manhattan? With rates close to all time lows today, is this even a risk worth discussing now?

Answer: Higher interest rates are absolutely a risk but not necessarily in the short-term. All signals coming from the Fed are that they are going to keep interest rates near zero for the foreseeable future. If there was any inkling that rates might be raised, the financial problems in Dubai have cast a spotlight on credit problems that may exist both worldwide and at home. There are other countries that have significant debt problems, such as Greece, where credit ratings of sovereign states are in question. We believe that we will see inflation based upon the massive increases that we have seen in the money supply and that, with this inflation, the Fed will have no choice but to tighten monetary policy. As they tighten, they will increase the Federal funds rate which will put pressure on the spreads that the banking industry is currently enjoying. The Fed’s monetary policy has allowed for a recapitalization of the banking industry and banks have become comfortable with their massive spreads. So the question is: When the Fed starts to tighten monetary policy, how much of that rate increase will the banks absorb, in the form of compressed spreads, before they start to pass increases along to the consumer in form of higher mortgage rates. Most of the bankers I have spoken to have indicated that they would absorb 50-75 basis points of increase but, above that, would start to pass along the increased rates to the consumer. As interest rates increase, it places downward pressure on value.

Question: Please discuss your thoughts on the recent tax hike of 10.3% for NYC co-op and condo owners and the affect it might have on affordability for future sales?

Answer: I am generally opposed to tax increases and believe that the government should exhibit more restraint on the spending side of the equation. However, given that condos, and most particularly coops, are typically taxed at a much lower taxes per square foot than other building classes (due to the low target assessments), increasing tax rates on that type of property is serving to equalize the tax burden and is probably an appropriate move for the city.

Question: Is inflation a threat in your mind, and if so, is real estate a good hedge?

Answer: Inflation is definitely a threat. As I mentioned above, the increase in the money supply over the past nine months has doubled the country’s money supply and the increase is larger than the aggregate increase over the prior 50 years. This has to lead to above-trend inflation and hard assets are the best hedge against inflation. Commercial real estate is a great hard asset. The only caveat is that you would want to buy it before the inflation kicks in and lock in the low interest rates associated with the pre-inflationary period. Owners who lock in fixed-rate debt at today’s rates for the long-term will enjoy significant benefits of owning commercial real estate. Commercial properties are also a better hedge against inflation than residential properties as it is possible to pass along the increase in operating costs to commercial tenants.

A big THANK YOU to Mr. Knakal for taking the time to answer these questions for our readers!! Great stuff!