Commercial, Residential and Mortgages

The nation's leading real estate experts expect the sizzling commercial real estate market in the US to slow in 2008, with a healthy correction that will likely bypass long-term investors but penalize late-to-the-game speculators and overleveraged buyers, according to the annual Emerging Trends in Real Estate 2008 report.

According to the report, real estate investors and developers believe uncertainty will characterize 2008. They expect capitalization rates to rise and risk to be repriced, with the harshest effects being felt by those who have relied on debt strategies. More than three-quarters (78%) anticipate more stringent underwriting standards in the year ahead. Yet, despite this apprehension, respondents expect most real estate investments to outperform both the US stock and bond returns in the year ahead, and are counting on ample capital sources to cushion the property markets.

Commercial
Respondents believe the correction in the commercial market will not be as severe as in the residential real estate market. Commercial real estate supply and demand is relatively strong, development is in check and the fundamentals are still healthy, according to respondents.

“The commercial real estate market has been going full throttle for several years with easy money and low interest rates that drove some sectors into questionable lending practices and highly leveraged spending,” said Tim Conlon, partner and US real estate practice leader, PricewaterhouseCoopers. “But the run went on too long for some participants. Those who went beyond moderation will likely experience some headaches in 2008. Depending on what happens with the US economy as a whole, it could be painful for some, but overall, a correction could be good for the industry, keeping supply and demand in balance, curbing overdevelopment and flushing out low-quality investors. By the same token, there are still investment opportunities and there is still a good deal of demand from investors.”

Richard Rosan, president, ULI Worldwide, said the report points to the value of sustainable building, which results in development that remains in demand despite market cycles. “We are seeing an increasing emphasis on building efficiently to accommodate growth-on pedestrian-friendly, mixed-use development, communities that provide housing near jobs, and development connected to transit,” Rosan said. “What is selling now and will continue to sell are projects that cater to strong consumer desire for convenience. Those are the best bets.”

The report ranks New York City as “the hottest commercial real estate market in the country” and the “ultimate American 24-hour city.” “Vacancies in New York are in the mid-single digits, rents have skyrocketed and pricing is at all-time highs.” And while the market may have peaked recently, the weak dollar actually makes the city's “monster” prices look cheap to foreign investors who are pouring money into Manhattan real estate, the report says.

According to surveyed real estate experts, not only is the New York market hot, but the entire commercial real estate industry has also acquired a “New York state of mind” as Wall Street and real estate have converged. In part because of its sheer size, New York now sets the tone for the entire US commercial real estate market and influences investor psychology as the standard for the rest of the country. According to the report, real estate used to be characterized by local buyers and local lenders, and is now dominated by national financial institutions and landlords, many of whom are located in New York.

Residential
On the national level, sales of existing homes slowed by 17% in the second quarter of 2007, compared with the second quarter of 2006, while inventory swelled by 16%, according to figures provided by the National Association of Realtors. New homes fared even worse: they fell by almost 19%, according to Commerce Department figures.

In Manhattan, by comparison, sales of new and existing apartments more than doubled. In a trend that could shift quickly in light of the recent problems in the credit and stock markets, inventory shed a third of its bulk. It dropped to 5,237 units, despite the influx of several thousand new condos.

After a boom with annual price increases of 20% or more ended in mid-2005, prices have continued to rise overall, but not as sharply. In the second quarter of 2007, Miller Samuel said the average sale price of a Manhattan studio climbed 16.5% compared with the second quarter of 2005. The average for a one-bedroom climbed by 18.4% and a two-bedroom by 5.9%.

Apartments with three bedrooms, which make up about 6% of the market but appeal to an ever-more-moneyed class of buyers, rose by 17.9% in the same period.

Whether this momentum can be sustained remains to be seen, particularly in light of the recent gyrations in the debt market, which have led to a reduction in the availability of large mortgages and to an increase in their rates. A deepening credit-market crisis and national housing slump could squeeze the economy, the stock market and bonus pools.

Meanwhile, renters have emerged as a force in the market, particularly for entry-level apartments. “Rents are rising again, and that pushes people back into the condo and co-op market if they have more than a one- or two-year time frame for living in Manhattan,” said Stephen G. Kliegerman, the executive director of marketing for new developments at Halstead Property.

“There are so many new units coming on the market and being sold, but the real heart and soul of the co-op market is really depleted,” said Barbara Fox, the president of the Fox Residential Group, a Manhattan brokerage firm..

Consequently, brokers say, many prewar apartments in good condition, along with family-size apartments of any vintage, are being snatched up in bidding wars whose aggressiveness outrivals those of two years ago.

“The new rule is that there are no rules, and when you're lying bleeding on your way to the emergency room, you're still shouting, ‘Higher offer, higher offer!’” said Julie Friedman, a senior associate broker at Bellmarc.

Mortgage Outlook
Mortgage lenders everywhere are going back to pre-boom lending standards, so obtaining a mortgage is harder for buyers with pockmarked credit or sketchy employment. But there is no panic over rising mortgage rates on jumbo loans (those exceeding $417,000), at least not now.

While the most obvious projection of interest to real estate investors is the mortgage rate, this is not the result of a single factor involving just the supply and demand for homes. Like every other financial factor, it represents a combination of elements working in concert. With that in mind, here is what the Chairman of the Federal Reserve Ben Bernanke said in his semiannual testimony to the House of Representatives Financial Services Committee: Falling home-building activity “will likely continue to weigh on economic growth over coming quarters,” he said, but the drag should ease over time.

He also said that despite a “significant” deterioration in the subprime mortgage market, which caters to borrowers with blemished credit, overall financial conditions remain supportive of growth.

Financial markets have shown signs of stress as details have emerged about investment banks' exposure to bad loans, such as Bear Stearns' revelation that two of its hedge funds with extensive subprime bets now have little or no value. In spite of a widening of credit spreads on lower-quality corporate debt, “credit spreads remain near the low end of their historical ranges, and financing activity in the bond and business loan markets has remained fairly brisk,” Bernanke said. At the same time, the Fed chairman deplored what he described as “abusive lending practices and outright fraud” that had accompanied an expansion of mortgage lending. He promised the Fed would act to rein in questionable practices. “Rising delinquencies are creating personal, economic and social distress for many homeowners and communities—problems that likely will get worse before they get better,” he warned.

“Overall, the US economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend.”

As a result, he expects housing market woes to dampen an expected pickup in US economic growth, but he restated that the central bank's main worry is inflation.

Bernanke said the drag on growth from a downturn in the US housing market should ease over time, but there is a risk the slump could last longer than anticipated, undercutting economic growth. He also listed a number of factors that could spark inflation, including a tight job market and the possibility that energy prices could move higher.

The Fed has held its benchmark overnight interest rates steady at 5.25% for more than a year in the hope that the relatively slow economic growth would curb price pressures and thus, inflation.

Gloomier Forecast
As a result of weaker than expected home building, the Fed cut its forecast for growth this year by a quarter-percentage point to a range of 2.25% to 2.5%, and downgraded its 2008 projection.

Still, Bernanke kept true to the Fed's most recent policy pronouncement in citing inflation as the top concern. He said a recent moderation in core inflation, while favorable, may be the result of temporary influences.

While the Fed expects core inflation (which strips out volatile food and energy costs) to “edge a bit lower, on net” over the remainder of this year and next, this result was by no means assured. “With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the Fed's policy panel has consistently stated that upside risks to inflation are its predominant policy concern.”

Bernanke said big jumps in food and energy costs had pushed a price gauge closely watched by the Fed—the so-called PCE price index—up at a pace that “would clearly be inconsistent with the objective of price stability” if it were to continue.

A separate inflation measure released just before Bernanke testified—the US Consumer Price Index—showed a 0.2% increase last month in both overall prices and prices excluding food and energy. Over the past 12 months, core prices rose 2.2%, the same as in May, but the overall index gained 2.7%.