NYC Commercial Meltdown: Listen to Residential's Message

by: Jeffrey Bernstein

According to a recent New York Times article, as we have been expecting, New York City's office market has hit the skids, big time. In my mind, the message here with regard to residential real estate is very noteworthy. Eventually, in a poor demand environment, prices will fall, despite a previously tight supply environment and positive long-term outlook. The New York City commercial market is sending a strong signal not just about the New York residential condominium market, but even the multi-family rental market.

Way back in January of 2008, I penned "Commercial Real Estate - The Next Train Wreck?" In that piece I touched on the Three Cardinal Sins of Real Estate: 1) Overpaying, 2) Over-Leveraging 3) Over-Building. In my opinion at the time, it was obvious that many had broken the first two rules, but that in some markets, particularly New York, the third rule had not been totally violated.

In June I did a follow-up piece on the commercial market and focused on the NYC Office Market. I noted:

The Manhattan office market is and has been for several years, purely a demand-driven market, supply just isn't a big factor. Further, I will aver that as a result of the tight supply situation, which, under normal circumstances looked likely to persist for at least a couple more years, few employers in New York want to risk running out of space and/or having to find new space at substantially higher rents. For these reasons it is particularly notable that the commercial market in New York is softening fast. It argues that space reductions are being made despite the fact that space might be quite tight in the next upturn, indicating that those cutting back expect their employment levels in Manhattan to remain lower for several years to come.

I also included some interesting figures to back this up, saying:

According to Scott Latham, Executive Vice President of Cushman & Wakefield, as quoted earlier this year on The Stoler Report, during the 1960s, 1970s and 1980s builders delivered an average of 56.5 million square feet of new commercial office space per decade, plus or minus. In the 1990s and 2000s 15.5 million feet of new space was delivered while 25 million feet of commercial space was converted to other uses. The city has been experiencing demand growth of about 3.5 million square feet per year typically.

The Manhattan office market constitutes an estimated 350 million square feet of space. So the typical annual addition of space recently has been 1% of the total. As you can tell, it would take several years of space additions with no increase in demand to cause vacancy rates to move up 3 percentage points. Another way to look at it is that as the economy recovered from 9/11, between 2004 to 2006 vacancy rates fell from 10.9% to 5% and 30 million square feet of space was absorbed. Voila! demand-driven market.

So now some figures from Colliers AB as reported in the New York Times. There are nearly 16 million square feet of office space in 68 office buildings as large blocks listed today. This is a doubling of large office blocks, which had previously been incredibly tight, due to the very reasonable growth of new supply (which always has lots of contiguous space). The large block space that is available constitutes about 5% of the total NYC office market in and of itself. Importantly, at least 16 large office blocks are being marketed for sublease, up from 3 last year.

Let's focus on this last point for a minute. In many cases, when commercial real estate owners lose tenants, if they are at all optimistic about the long term, particularly in a great market like New York City, they decide, that if they can afford to, they will let the space stay empty for a while rather than entering into long-term leases at low prices. In fact, Michael Calacino, the president of brokerage firm Studley, is quoted in the New York Times article as saying "A lot of landlords are still in denial."

However, sublettors can't play that game. If you are on the hook for real estate you can no longer afford, you hit bids. The old Wall Street maxim "Your first loss is your best loss" comes into play. In fact, according to Studley, as a result of aggressive sublet deals, actual rents on deals that have been signed in the last quarter fell by as much as 20-30%. Now most people in commercial real estate know this phenomenon of sublets by heart. But it is instructive to think about indirect price transmission mechanisms like this that come into play in downturns across various asset classes.

Let's take another example. I had a client in Florida that was a very successful, family-run real estate operation. This client was looking for broken deals to buy cheap and finish rehabbing. I spoke with several large banks I knew had portfolios of loans in the markets my client was interested in. I had a discussion with the chief lending officer of National City Bank (NCC) one day and he told me that they had learned from the early 90s not to blow out real estate at 30 cents on the dollar BLAH BLAH BLAH. You know, National City never did blow out its impaired assets. They are gone now and management is likely being blown out instead, having been acquired by PNC as a result of pressure from regulators.

My bet, is that the bank will now finally start selling problem assets at whatever price it takes to clear them out. On the other hand, maybe PNC can afford to hold out for higher prices. Maybe it will be another bank that sets the new low price floor because the FDIC liquidates them directly. My point is there is no way to stop the price adjustment; eventually someone will have to sell and it will only take one transaction to establish a new, lower price plane. This is what we are seeing in the commercial market with sublets.

Let's talk about another market that people still believe is somewhat impervious to the pain we are seeing in commercial. As Urban Digs readers know, I love the New York City multi-family rental market as an asset class longer term, but I think people overpaid for properties and over-levered them. You can read about it in my September 2008 piece NY City Rental Property-As Good As T-Bills - NOT! This is another market that is in no way over-supplied, but I am convinced will see pressure on rents due to demand issues.

But wait, you say, if people become afraid to buy condos, won't they continue to rent and won't that boost the rental market? Here's the rub - some more non-obvious transmission mechanisms for lower prices are at work. As noted in another recent piece, Toll Bros. (NYSE:TOL) is doing rent-to-own in one of its buildings and it is competing with sublet listings by current owners. Separately, young people are increasingly sharing apartments. According to New York Habitats roommate share accommodations are up nearly 50% from 2006 through the first half of 2008. According to an article in the Queens Gazette, the New York Foundation for Senior Citizens' Home Sharing program has received the largest increase in home sharing applicants at any time since it started 27 years ago.

Tishman, which bought Peter Cooper Village and Stuyvesant Town to take these apartment complexes upscale, is reportedly packing the place with college students who will each pay a premium amount to jam into apartments together. Why is the firm doing this? It needs to support the huge leverage it put on the project. What do you think converting these apartments to dorms will do to rents longer term? Won't the huge absorption of college students into these gigantic apartment complexes hurt rents at the other East Village buildings that used to serve as accommodations for students?

The cat is now very much out of the bag with regard to over-levered multi-family housing and the attempts to get rent-regulated apartments to turn over to free market rates (Schumer Seeks protection for Apartment Buildings Facing Default). Not only will officials be watching the landlords closely, but tenants are starting to realize that they are in no position to try and push rents up on the apartments that have been deregulated.

Now I don't have to tell you that with mergers, acquisitions and liquidations of financial firms still ongoing, pressure on office property rents will continue to increase. I think you may see now how even the heretofore bullet proof multi-family rental market which dominates New York City residential space (about 70% renters and 30% owners), could see rents and/or occupancy pinched.

I hope, therefore, that the point is not lost on you that despite the tight supply of owner-occupied residential space, a large percentage of existing owner-occupied buildings being co-ops where owners are traditionally less leveraged and carrying strong cash reserves, demand still rules. Transmission mechanisms we may not even be able to visualize now will pressure prices down, and weak-handed owners, no matter how small the number, will ultimately set pricing when the merde hits the oscillating respirateur. Which should be happening right about now.

FCE.A, AVB, AKR, VNO, SLG, NYB, MTB, and BFSB all have significant exposure to New York City commercial real estate.

Disclosure: The author has no positions in these securities.