New York City’s Office Market Raises Some Positive Flags

By Dr. Peter Kozel Senior Managing Director FirstService Williams New York City

Mounting evidence suggests that the New York City office sector is scraping along the bottom of its cycle and laying the foundation for an improvement in operating performance. The property market itself is offering some of this evidence. Additionally, data from the economy and business sector are providing greater clarity about the dimensions of the contraction in business activity plus what are likely to be the contours of the eventual economic recovery.

Demand for office space evaporated during the first four months of 2009, with leasing volume declining to a monthly rate of just one million square feet, and much of this activity involved 5,000 square foot and 10,000 square foot transactions.

In June and July, however, leasing volume escalated to 2 million square feet in each month, roughly equal to the average monthly total in 2007. An important part of this increase stems from the substantial number of leases signed in those two months for over 50,000 square feet. From approximately mid-June to the end of July, FirstService Williams counted twenty-two lease transactions for 50,000 square feet or more including ten for 100,000 square feet or more. Undoubtedly, there were additional confidential transactions that were not reported.

Some of these large deals were completed by tenants that had been in the market looking for space since 2007. In a few cases, they were close to a deal. But, as rental rates started to decline, they decided to wait. With the average effective rent now down by close to 40% from the peak – and more in some submarkets – these firms must have decided that rents were close enough to a bottom so that a deal struck at this time will not prove to be overpriced six months from now. Additionally, their own business situations must have stabilized to the point that they can gauge how much space they would likely need and what they can carry in occupancy costs.

Since mid-May, net additions to the amount of available space has also slowed from the pace in the previous nine months, down by nearly 50%. The amount of space that is listed as available continues to increase; but what is less clear is whether or not these new listings are really newly available space. The stock of shadow space began to grow in 2008, and some of it has now been shifted to open listing.

In the Midtown North market, availability registered 14.8% at the end of the second quarter of 2009. Our reading of the data points to a peak of 16.8% by the end of 2009 and about the same at the end of 2010. Even though the New York City economy should be on the mend by early 2010 - with modest additions to employment – a little over three million square feet of newly constructed office space will be added to the inventory, keeping the availability high.

So what is the broader economy telling us? The average unemployment rate for the first six months of 2009 in New York at 8.3% remains below the national average of 8.7%. Moreover, the labor force continues to increase in New York City, while it is trending downwards for the nation as a whole.

For the past 24 months, office sector employment is down a total of 5.8% for the U.S. but only 3% for New York City. By contrast, in the 2002/2003 cycle, New York City suffered a 9% cumulative decline but just a 2.4% reduction for the nation. The consensus forecast now looks for the U.S. economy to grow by 2.5% to 3% during the third and fourth quarters of 2009. Since New York City has consistently outperformed the nation during this recession, the city should enjoy a solid bounce in the second half of 2009.

There are plenty of credit problems yet to be worked-out during the next several years. So the recovery will be bumpy. But as the partial sale of 485 Lexington Avenue by SL Green for a 6.2% cap rate indicates, confidence in the New York City office market is beginning to return.

New York City Tri-State Area: Era of the Loan Extension

With a paucity of new capital coming into the system and many loans maturing, most property owners have limited options. In some cases the value of the property has fallen below or near the loan balance. Most lenders appear to be opting to extend with modest pay downs. This explains why fewer borrowers are refinancing. The option with the least friction for borrowers is to ask for a loan extension. These extensions differ from securitized loans and non-securitized loans.

Borrowers who have securitized loans maturing must deal with special servicers. When the loan is likely to go into default or in default, the securitized loan moves from the master servicer to the special servicer. In most cases, special servicers are determining whether the extension will create a higher NPV than foreclosure. Most extensions are for one year and could involve a loan pay down, increase in interest rate or increased reserves. Commercial banks are dealing with extension quite differently. Unlike the special servicer, the banks are not entirely motivated by an NPV analysis. The banks will consider the same evaluation but also consider the borrower’s relationship with the bank. Most bank extensions can involve a pay down in exchange but the extension period is often greater than a year.

Loan extensions are solving the borrower’s short-term need to avoid foreclosure, but they are also causing the lender to defer the problem, hoping for improved market conditions down the road. And this is the big question – what will leasing, the debt and equity markets, cap rates and the cost of debt be down the road.

If loans are not extended and properties foreclosed or handed back to the lender, the rapid drop in property values could lead to greater short-term stress on the financial institution and ultimately nearby property owners. Neither the extension nor foreclosure option is ideal, but for the time being loan extensions are solving the borrowers and lenders short-term needs.

New York City Tri-State Area: Early Signals of a Bottom?

Hedge funds, private equity funds and top-tier investment banks that inhabit or inhabited Midtown offices along the premier Avenues were the first companies in New York City to experience the tumult of the current recession. Of course, the declines in their respective businesses that began in the second quarter of 2008 were preceded by the burgeoning collapse of the residential housing market that began a year earlier in the rest of the country.

When New York City’s financial sector started to contract in 2008, demand for office space in the Midtown market shriveled. As a result, the availability rate escalated dramatically within key Midtown submarkets such as the Plaza and Rockefeller Center/Fifth Avenue districts

By the end of the first quarter of 2009, the office availability rate in Midtown was 13.3%; substantially higher than the availability rate in both Midtown South and Downtown, which ended the quarter with availability rates of 9.8% and 10.8% respectively. The financial sector is the lead horse that pulls the New York City economy, so the other major sub-markets in Manhattan were expected to follow the downward trend and show weakness in subsequent months.

This projection has in fact been borne out by the very preliminary numbers for the second quarter of 2009, which indicate that the degree of weakness among the major Manhattan markets is beginning to equalize. In the second quarter, for example, the overall Midtown availability rate likely increased to about 15%, or 1.7 percentage points higher than the end of the first quarter in 2009. Both the Downtown and Midtown South markets, however, will see substantially larger percentage gains. For Downtown, it probably jumped into the 12.5% area; and for Midtown South, the move was to 13%.

Manhattan’s office property market likely sustained further deterioration in the second quarter. But the more pressing concern centers on how long the decline will continue and how far it will drive availability rates up.

In recent weeks there have been some references to green shoots [meaning the beginnings of economic growth towards the end of a recession] when talking about the national economy’s incipient recovery. Virtually all of these instances were supported by observations that the rate of economic decline was slowing. The recent uptrend in the stock market, for the moment, confirms that upbeat assessment. While it is important to avoid getting caught up in overly optimistic scenarios based on a few positive developments, it’s important to note that our preliminary data for the Manhattan office market during the second quarter also shows some green shoots springing up among the rubble.

In May, the total amount of office space that was added to the total supply available for leasing did increase. But the total amount of space added during May was about 60% less than the amount added during each of the previous six months. The deluge of new space into the Midtown market slowed even more, with 70% less space hitting the market in May versus the preceding six months.

With net absorption of office space negative, the amount of available space continues to increase. But the pace of deterioration has slowed. All of this data indicates that Manhattan office market fundamentals are still weakening, but at a much slower pace. Again, one month of data does not prove a solid trend, but there is additional fundamental data that may lend credence to the property level statistics.

Again, based on the preliminary data, the employment situation in New York City does not seem to be weakening as fast as it was during late 2008 and early 2009. The year-over-year job loss in total employment is about 100,000, or 2.4%. In the financial sector, employment levels seem to be holding steady, and the business fundamentals in that industry are improving. The unemployment rate for residents of New York City has been steady over the last few months, and the labor force number has continued to rise. These are additional positive signs.

While we have only a few indicators and observations from those measures of business activity, the incoming observations over the last month have turned more positive.

Dr. Peter P. Kozel, Senior Managing Director, FirstService Williams

New York City Tri-State Area: Data Points - Where & How the Trades are Happening

The investment market held its collective breath late last week as the 10-year US Treasury touched 4% before settling at 3.79% on Friday. The sharp upward movement of the 10-year was a reminder of how important debt is to the overall economic recovery and our business in particular. Over the past twelve months, we’ve seen the continuation of a number of debt trends that are shaping the deals that close today: assumable debt that drives transactions; regional lenders filling a lending void for smaller (sub-$25MM) deals, and Fannie & Freddie drawing buyers to multi-family with attractive first mortgage financing.

The potential for out-sized returns created through in-place debt is helping to make larger purchases possible, as we experienced with the sale of Corporate Center last week, a 1,046,811± SF multi-headquarter office campus located just off I-84 in Danbury, Connecticut. Constructed as the Union Carbide World Headquarters, Corporate Center is primarily leased to major credit quality tenants including Boehringer Ingelheim, Praxair and Honeywell, and was 62% occupied at the time of sale. The property’s $72.4 million price was driven, in part, by existing short-term financing that yields a nearly 20% first-year cash-on-cash return based on the in-place NOI. The amenity-rich headquarter property and strong in-place financing made Corporate Center an attractive investment.

The Corporate Center transaction also highlighted something we’ve discussed in the recent past on this blog: the reemergence of the private buyer. Patiently waiting on the sidelines for the past few years, the private buyer is back and bidding more aggressively.

We cover this and much more in our team’s Summer 2009 newsletter.

New York City Tri-State Area: 'Fannie' & 'Freddie' Not Only Good For Golf

With next month’s U.S. Open back in nearby Bethpage, New York, it seems timely to consider how real estate, like golf, needs good support to create high performance over a career. Knowledgeable golfers understand the importance of Fanny Suneson, the caddie, who supported and guided Nick Faldo during his four major championships and who recently supported Henrik Stenson during his win at the Player’s Championship, golf’s “fifth major”. Additionally, “Freddie” Couples is known for his calm demeanor during stressful rounds and his clutch performances that have propelled him to captain of the American team during this fall’s Presidents Cup.

For those who do not play golf, or deal regularly with multifamily assets, the connections of “Fannie” and “Freddie” in both golf and the investment real estate industry may be missed. The competitive programs offered by Fannie Mae and Freddie Mac have buoyed the multifamily asset class and have allowed multifamily buyers to purchase at still attractive yields. These programs offer up to 80% LTV, some interest-only financing, and sub 6% interest rates, which office, industrial and retail buyers are no longer able to achieve. We recently closed a $42 million, 436- unit apartment portfolio sale in suburban Hartford, Connecticut, using this debt platform and will seek similar financing options for four separate multi-family deals (1,561 total units) we will be brining to market at the end of this month.

The Freddie Mac and Fannie Mae platforms, especially the fixed rate programs of Fannie and the capital market ARM programs of Freddie will continue to play pivotal roles, guiding and stabilizing prices similar to impact their golfing counterparts have had on the game.

New York City: A Downturn With Different Stripes

By Dr. Peter P. Kozel, Ph.D.
Senior Managing Director, Consulting Group
FirstService Williams   

    Just like the national economy, Manhattan office market fundamentals seemed to hit a wall as 2008 ended and 2009 began. The office availability rate for Manhattan as a whole–space that is being activity marketed for leasing–increased from 9.7% at the end of the third quarter 2008 to 12% at the end of the first quarter of 2009. In Midtown, the increase in the availability rate was even larger, rising from 10.4% to 13.3%. The availability rate in Midtown is now already higher than it was in mid-2003, the peak level during the previous cycle. Meanwhile the average asking rent is down 15% to 20% from the peak reached in early 2008.

    However, the actual effective rents, which include adjustments for tenant improvement allowances and the free rent period, are down by substantially more. The decline in rent levels has been more rapid and larger than the consensus was projecting only a year ago. Of course, the increase in rents from 2006 through the early months of 2008 was much larger than the basic supply/demand fundamentals seemed to justify.

    Everybody knows that the office property sector has suffered reversals during the past year, so the numbers just reviewed above shouldn’t be very surprising to anyone. What business or economic fundamentals, however, are driving this pervasive sense of weakness? Through March 2009, the preliminary numbers report that seasonally adjusted total nonfarm employment is down by 100 thousand from the peak level reached in early-2008.

    By comparison in the early 1990s, total employment fell by 350 thousand, about 10%, and the loss was close to 200 thousand in the 2000/01 recession. The Federal Reserve’s forecast, along with other projections, predict that national employment will continue to decline through 2009; even with that outlook, it doesn’t seem that the property markets should be performing so badly; but they are. Not only do the usual demand drivers seem to be less important this time, but the relative performance among the city’s major submarkets is not following the usual pattern.

    The declines in occupancy and rent levels during the current cycle occurred earlier and were more pronounced in the Midtown market than the Downtown and Midtown South markets versus previous cycles. Obviously, a more complex set of forces are at work in the markets today than one would find in a simple business cycle. Is it really that important that we attempt to find out what these new forces are?

    I think the answer has to be yes. The questions plaguing property owners, tenants and third party investors are how long this weakness will persist and how robust will the rebound be once the bottom has been achieved. If we can figure out the dynamics of the downturn, then we might be able to provide a reliable outlook. Going forward, we will investigate these issues and propose some answers for these important questions.

New York City Tri-State Area: Distressed Buyers Seem Distressed

Properties aren’t the only thing falling into distress these days. Private buyers, whose higher yield requirements left them on the sidelines during the 2004-08 run-up, see opportunity in distressed assets and are eager to purchase. Unlike the early 1990’s, however, when banks and the FDIC sold many single assets as well as bulk real estate portfolios, the abundance of distressed product has yet to surface. The current lack of “troubled” properties originally expected by potential buyers, is a function of several factors: significant foreclosures in many parts of the country have yet to occur, banks are more patient and hopeful that asset pricing will return to a higher level, and the commercial real estate world is waiting to see what effect TARP, TALF and any future government programs have on the market.  While note purchases are an alternative for various “debt funds” and buyers with deeper pockets, the high-yield small-to mid-size private buyer continues to wait their turn. Based on our read of the tea leaves, the wait will be a bit longer.

New York City Tri-State Area: Increasing Optimism

There appears to be an increasing air of optimism among real estate owners and investors with the recent increase in housing starts and apparent stabilization in the stock market. However, financing remains limited and expensive as spreads remain very wide and LTV’s very low.

Unlike the early 1990’s, when banks and the FDIC dumped real estate assets, the banks today are exercising far more patience and appear willing to hold and manage foreclosed assets until pricing improves. Based on the proposed federal assistance that the feds plan to give to banks and the relaxation of mark-to-market accounting sales, we expect many banks will partner with third party real estate operators to augment the condition and ultimate value of their foreclosed assets.

With further white collar layoffs projected, certain office markets will face increased pressure on rents and occupancy. Apartment projections are holding up best among all of the food groups, despite slightly increasing vacancies.

Overall, investors for multi-family and industrial assets are moving off the sidelines while many retail and office investors remain cautious.

New York City Tri-State Area: Cash is King

Cash is increasingly becoming king. This is evidenced on several fronts:

1. Major corporations are increasingly evaluating the sale and leaseback of corporate facilities to generate cash. Longer leases (15 years or more) and parent guarantees are becoming the norm.
2. Lenders on commercial properties are requiring far more equity than in the past. Life companies are requiring 40% - 50% in equity and only lend on the highest quality real estate.
3. Funds that can write the check for the entire acquisition price without the need for financing are the preferred buyer among sellers. The assuredness of closing typically wins out over higher offers with financing contingencies.

New York City Tri-State Area: New Trends Becoming Evident

As we approach the 2nd quarter of 2009, several trends are becoming apparent:

Many institutional owners are under pressure to sell assets in order to redeem capital to their investors and, in some cases, to avoid violating loan covenants.

Special servicers for CMBS commercial loans in default appear increasingly willing to provide time to negotiate terms. Many want a pay down in the debt balance – most start foreclosure proceedings at default.

Strong regional and National banks are making more acquisitions and refinance loans, particularly for well capitalized owners. Their terms are often more competitive than life companies and CMBS lenders.

New “private capital” and offshore buyers are entering the market while most public REITs and pension funds remain on the sidelines. Private capital will account for an increasing share of acquisitions in 2009.