By Robert A. Knakal, Chairman, Massey Knakal Realty Services

Given the current state of both the building sales and credit markets, the most commonly asked question I’ve been getting recently has been, “Bob, how did we get in this position?” My answer to this question has simply been that 2007 will be remembered as the year we started to pay for the Fed keeping interest rates too low for too long. Here is why and how we got here:

The market can be broken down into three distinct segments: the pre-August 2007 market; August and September of 2007; and October 2007 through today. To fully understand where we are today, it is very important to take into consideration what the Fed’s policy on interest rate fluctuations has been going back to the early 90’s. From 1994 through 2000, as we were coming out of the recession of the early 90’s, the Fed kept the Federal Funds Rate between 5.5% and 6.5%. In 2000, with the overseas credit markets getting a little squishy, the Fed began a policy of cutting interest rates. Between 2000-2003, the Federal Funds Rate was dropped in 13 successive sessions from 6% to 1% (see graph). This extended period of interest rate cuts brought interest rates to a point where they were below the rate of inflation. Let’s consider this for a moment; if interest rates are lower than the inflation rate, monies kept in the bank have less purchasing power in the future than they do today. This dynamic creates a tremendous incentive for people not to save and to purchase long term assets. What is the long term asset of choice for many investors? Real estate. This created tremendous incentive for people to buy apartments and to buy investment properties and led to excessive domestic demand in our real estate markets. This is when tremendous upward pressure on pricing began.

Looking at the Fed policy from mid-2004 to mid-2006, we observe a period of 17 successive sessions where the Federal Funds Rate was increased from 1% to 5.25%. During the period of 2000-2003 when the Fed was cutting rates, mortgage rates adjusted almost instantaneously. As the Fed was increasing rates from June 2004-June 2006, the lending rates did not increase in concert with the Federal Funds Rate increases. The market was simply not reacting. As the excessive demand continued and banks were competing viciously to put debt dollars on the street (which kept compressing spreads), our low interest rate environment persisted.

In the pre-August 2007 market, we were faced with a perfect storm of scenarios in our building sales market. 1) Low interest rates 2) Low supply of available properties in New York City 3) High demand for Manhattan and Brooklyn properties both from domestic and foreign purchasers (it is important to note that in the period 2001-2007 there was more economic global expansion than during any other period in history) 4) Lower yield expectation on behalf of buyers 5) A growing percentage of sellers were opting to effectuate 1031 tax deferred exchanges. Up until this point prices kept going up, tremendous amounts of capital were created and the infrastructure in which to invest all of this capital lagged behind the amount of capital that was created. Shortcuts were taken in due diligence processes and the result was continually escalating prices.

During August and September of 2007, we saw a number of confluences. The sub-prime crisis started to have a tangible effect on the market; interest rates starting rising; recession fears started growing; institutions were coming to grips with the fact that multi-billion dollar writeoffs were eminent; unemployment started to escalate; consumer confidence was falling; consumer spending was slowing; and the dollar continued to get weaker. All of this led to a tremendous amount of uncertainty and for those two months, the market was very reminiscent of our New York City market from 1990-1991 when things came to a standstill. During this period in the conflict of fear versus greed (in which greed normally wins 75% of the time), we saw that fear was winning. We also started to see cracks in the global economy. The result was that banks started to increase spreads, debt service coverage ratios increased, amortization returned as a component of almost every loan (which was not the case previously) and loan to value ratios were dropping. More equity was required and, given that equity is more expensive than debt, intuitively you would think that prices would fall.

Let’s look at the market from October 2007 through today. The Fed has started cutting rates and for four sessions in a row (plus a mid session cut) the Federal Funds Rate has dropped from 5.25% to 3%. Interest rates are coming down. There remains a very low supply of available properties in New York City, demand is still very strong and the influence of the U.S. economy relative to the global economy has become apparent. It is amazing to think that the U.S. Gross Domestic Product is 4.5 times the size of China’s and in fact Wal-mart buys more goods than China and the entire United Kingdom does. There must be a word missing from this sentence? Also, layoffs have not been as severe as had been anticipated. However, GDP growth has been very low with a significant portion of that growth coming on the heels of increased exports based on the very weak U.S. dollar.

The question remains, are we headed into a recession? Four main indicators that economists look at to determine whether we are indeed in a recession are 1) Real personal income levels 2) Employment 3) Industrial production 4) Retail and manufacturing sales. We are presently in an economy where these indicators are showing about 40% positive, 40% negative and 20% unchanged. In a great economy 45% are positive, 35% are negative and 20% are unchanged, so presently things are not so bad. What we are facing is a liquidity crisis. The fundamentals of the real estate market remain strong, with Manhattan residential vacancy hovering around 1%, office vacancies in Midtown Manhattan at 4.6% with a $74 per square foot average and the Manhattan hotel market continuing to thrive as the weak dollar continues to attract foreign travelers to New York. This also keeps domestic travelers within the U.S. as international travel becomes cost prohibitive for many.

Looking forward, we believe the volume of sales, in terms of the number of properties sold in New York City, will decrease approximately 10-15% in 2008. It is important to differentiate volume on a “number of transactions” basis from “aggregate dollar of volume of sales basis” as we believe the aggregate dollar volume of sales will be off more substantially as the number of billion dollar transactions decreases in 2008. Thus far, we have seen prices remain fairly stable as cap rates may be inching up slightly but given the increases in rents that the market has experienced over the last few years, even with slightly increased cap rates, prices per square foot continue to escalate. For certain, transactions require more effort to close in the current market, but there still is a good flow of activity even under these new market conditions.