A Skittish Market Doesn’t Mean a Recession

Dire financial reports in the news have made everyone skittish. The mere fact that the stock market has dropped over two thousand points in the last month is enough to spook anyone. There is, however, a significant difference between the current economic environment and that which created the meltdown two years ago.

Back then, the country was overheated. Housing prices had accelerated over 100% in five years. The number of homeowners had risen to over 65% of the families in the country. This growth was fueled by toxic mortgages that offered unqualified purchasers a chance to buy a home with minimal equity and with variable rates on the loans. Bank lending was overextended. A lot of people knew that we had a time bomb ticking.

Currently, we see corporate earnings on the mend, mortgage rates at the lowest level in history, enormous levels of liquidity in the banks, and the United States government has finally figured out that it has no more money to spend. Is this a time of transition? Absolutely.

This is what I see. We are phasing out of our foreign involvement in Afghanistan and Iraq. Governments are becoming more prudent in spending. Job growth, although slow, appears to be gaining traction. Consumers are building their balance sheets and reducing debt levels. We are demanding greater accountability of expenditures by government officials. If you think about it, that sounds pretty good.

When I look at the local housing market, I see a declining inventory that has fallen below 9,000 apartments for the first time in years. I am hearing about bidding wars for two bedroom apartments priced between $1million and $2 million. Our real estate offices are seeing reasonably good attendance at open houses. While transaction levels throughout the city in June were disappointing, July performance was in line with expectations and August has been moving progressively forward. These are all signs that the economy is moving steadily ahead.

There will be bumps in the road – the excessive level of volatility in the current environment only affirms that we are all skittish and anxious about anything that spooks us.

This reminds me of something that happened during a balloon ride I took years ago on safari in Africa. Down below us were teeming herds of wildebeests standing idle as they grazed on the grasses. The balloon operator of the balloon said us, “Hey, you want to see how the stock market works?” He pulled down on a lever, and with a loud whoosh, a flame surged with the hot gas that filled the balloon. The noise alarmed the wildebeests. Suddenly en mass, the teaming multitude spurted into action, running widely in an undefined but uniform direction. It was a stampede of thousands lasting for about three minutes! Then just as suddenly, the animals stopped in their charge. They settled back to a casual graze as if nothing happened.

I propose that the S&P’s action in lowering our credit rating has created a similar frenzy. What does it mean? Probably very little. Does it mean that interest rates are going up? Probably not. Currently, Japan has a lower credit rating than we do, and their interest rate is 1%.

The level of supply and demand has not radically changed, and for entities looking to park funds into low risk assets, the U.S. Government is still the best choice. That’s why Japan has loaned us about $900 billion and why China, to which we owe $1.2 trillion, hasn’t skipped a beat in giving us even more money in recent days.

My advice is that the mend will continue and we should focus on those great interest rates and flexible sellers. It’s a good time to buy real estate if you have a good credit rating and enough equity cash. Smart buyers get it and so should we.

The Story Behind the Headlines: NYC Housing Market is Looking Better All the Time

The media have been having a field day describing the doom and gloom in the real estate market. According to the Wall Street Journal, the decline in home prices is continuing and sales prices have fallen to levels not seen since 2002. The story reported dramatic declines in cities such as Detroit and Las Vegas, where the decline has been particularly profound. It even reported a decline in New York City. We disagree. The current Manhattan real estate market was fine until the media said it wasn’t. Here is our perspective:

Timing: Media stories cited the Case-Shiller index, which evaluates the level of activity in closed transactions for the prior month or quarter. Given that a typical real estate transaction takes 90 days to close from inception of the signed contract, the state of the market at closing can be much different compared to state of the market at the time the buyer signed the contract. This delay is significant. The Case-Shiller index is based on deals that were agreed to during an extremely cold and snowy winter, when the press was pounding out reports about the pending financial catastrophe in Europe. This is not the case today. In fact, the current performance of our company in May was the strongest one we have had in over one and one-half years, based on registered offers and acceptances.

Price Declines: The Case-Shiller index’s finding that prices continue to fall is also extremely deceptive. As many of you know, last year the banks put on hold a large number of their foreclosure proceedings as a result of various issues about irregularities in mortgage paper work. Most banks did not move forward with foreclosure proceedings until the later part of 2010 and the beginning of 2011. Thus, there emerged a considerable backlog of properties in the foreclosure pipeline, which burst onto the market in a rather short period. This huge surge of foreclosure offerings created a crescendo of declining prices in selected cities, as opportunistic investors grabbed up bargains at pennies on the dollar. It is these foreclosures that are generating the reported price drops, not ordinary sales by sellers and buyers. It happened in 1990 and it is happening again. The law of supply and demand – you have a huge amount of supply without a lot of buyers and you get a tumbling market.

We compared asking prices for all properties offered for sale in Manhattan from July 2010 through May 2011, and found a minimal decline of 3% to 4%. Manhattan continues to be a strong performer relative to the rest of the country. There are a number of reasons for this, including:

Wall Street: The stock market has trended up considerably and even though there has been some variation from week to week, overall performance has continued rather firm. Wall Street firms are reporting sizeable bonuses to employees, and with stable prices and low interest rates it’s a great time to buy.

No Foreclosures: We should thank all those Coop Boards that have put buyers through a gauntlet to ensure that they meet the Boards’ financial criteria and put down a substantial amount of equity. The result has been a minimal level of foreclosures in Manhattan, with no downward price pressure as a result of foreclosure sales.

Price of Gas: The other day I was overjoyed to find a gas station where I can fill my tank at $4.29 cents per gallon. The enormity of this cost increase over the prior year is creating a shift in consumer buying habits. The media are reporting that SUVs are out and small compact cars are becoming more popular. Good news for city dwellers, who are in an energy efficient environment.

When you add all the pieces together the result is a compelling argument for New York City and particularly Manhattan. We are seeing this. We are seeing an increasing level of activity because buyers know they can get their best value now. Buyers know there are no fire sales and that Manhattan represents a secure real estate investment when compared to anywhere else in the country. Buyers are seeing the lowest interest rates in 50 years. They are seeing a limited level of inventory and future that is bright for New York City.

The 2013 Medicare Tax and its Implications for Real Estate

There have been many questions floating around about the new “tax on real estate.” This is somewhat of a misnomer. Let me set the record straight.

Congress passed a bill relating to the Patient Protection Affordable Care Act (“PPACA”), sometimes referred to as “Obamacare.” The act takes effect in January 2013. There is a Medicare tax associated with this act, which will affect all real estate transactions. Some people have erroneously referred to this as a sales tax levied on the sale of a home. This is not exactly correct, though under certain circumstances the impact is the same.

This new Medicare tax is an additional charge of 3.8% on “Net Investment Income,” which is defined rather broadly but would normally include the sale of a residence. However, the tax is levied on the gain experienced by the home seller above the profit exemption currently in place, which is $250,000 for a single taxpayer and $500,000 for a couple filing jointly.

Here’s how that works:

Mr. and Mrs. Jones purchased a home for $500,000 and sold it five years later for $800,000. Since they are a couple filing jointly, they are exempt from tax on the first $500,000 of profit. Thus they are not subject to taxable gain on their tax return.

Mr. and Mrs. Smith purchased a home for $250,000 and sold it in five years for $950,000. Thus, the gain realized is $700,000. They are exempt from tax for the first $500,000. However, the excess $200,000 is subject to capital gains tax. This tax for federal, state and local is approximately 25% (25.7% for taxpayers at the highest tax rates in New York State, which begins at income exceeding $500,000). If this transaction occurred in 2013, the taxpayer would also be subject to an additional Medicare tax of 3.8% on the $200,000 profit. Thus, the tax they would have to pay would be increased from $50,000 to $57,600. It is important to note that the Medicare Tax can be an adjustment reducing profit prior to computing capital gains tax.

Let’s take the above example for Mr. and Mrs. Smith and say that they sold their home for over $1,000,000. They would also be subject to a 1% “Mansion Tax,” which is levied any home sold in New York State where the sales price is $1,000,000 or greater. The law permits the Mansion Tax to be adjusted against the selling price to calculate the income that is subject to capital gains tax. Thus, if the price were $1,000,000, the Mansion tax would be $10,000. Therefore, instead of the recognized capital gain of $200,000, it would be would be lowered to $190,000. Therefore, the capital gains tax would be $47,500 (assuming 25% rate) and the 3.8% Medicare tax would be $7,220. The full tax would be $64,720. If you add all the taxes together, it comes to 32.36%.

So, you see that the Medicare Tax is not really a real estate tax, but it is merely a tax on the gain a seller realizes that is over and above the amount that is covered by the existing profit exemption of $250,000 (single) or $500,000 (married couple).

Current Controversies

March 2011

Current Controversies

Two recent events have complicated the job of the real estate agent even further: One, a court case surrounding the quotation of square footage in an apartment; the other, a court decision that may have a profound affect on the pied-a-terre market. Here is some insight into these events and suggestions about how we should deal with them.

Square Footage

There is a dispute taking place over 110 Livingston Street, new construction. The buyers signed a contract for a two bedroom apartment. The plan identified that the apartment had 743 square feet of space. After signing the contract the buyer went back and measured and found that there was actually only 634 feet of space in the apartment. The buyer sued seeking a reduction in price relating to the actually reduced footage as well as punitive damages. The developer, Two Trees, sought to merely give the buyer his money back but he refused.

The case is now going to court four years after it was initially filed. It is common in the law that “de minimus” differences between reported square footage and actual square footage do not warrant compensation; however, a court would be hard pressed in looking at a 15% variation as an inconsequential difference.

We should all take this case as a cautionary tale against materially misrepresenting footage. As real estate brokers we often represent the interest of the seller; however, we also have a duty of due diligence, and the mere fact that a seller advises us of a square footage figure does not mean that we are removed from responsibility if that figure ends up materially incorrect. Sure as shootin’, if a dispute occurs the real estate broker is going to lose his/her commission, and getting a judge to support our position is very unlikely.

What should you do?

1. Make sure you provide a disclaimer relating to square footage at the bottom of any point of sale material. You should have this disclaimer state that the information is subject to errors, omissions and that all footage is approximate and supplied by others. For example, on our listings on the web site, we use the following:
“All information furnished is from sources deemed reliable and is submitted subject to errors, omissions, changes, prior sale or withdrawal without notice, and to any special listing conditions. Areas and dimensions are approximate.”
2. Avoid talking about square footage unless you can verify the figure independently. Rather, it is appropriate to use the square footage in selected rooms such as the living room and dining room which you can verify. You also might consider expressing “usable footage,” which is the interior dimensions of all rooms added together.
3. In describing gross square footage identify the apartment as being in a certain class of apartments. For example is an “It’s an 1800-square-foot-class 3 bedroom. “
4. Make sure you tell the buyer that you have not verified the footage but that it has been merely reported to you.

Potential Tax Implications for Part-Time Residents

In New York State, full-time residents are responsible for reporting all income from all sources and paying tax on that income to the State. However, if a taxpayer qualifies as a part-time resident, then only the income derived from business generated within the state is subject to tax.

Accordingly, under this guideline, a resident who lives and works in New Jersey and owns a home in New York will not be subject to New York State income tax as long as the residency is part-time. The guidelines offered by New York State provided a basic formula that if you resided in the state for more than 183 days (and any portion of a day is considered a full day) you are a full-time resident.

Recently a case was heard by the Tax Appeals Tribunal, which is the appeals court for the New York State tax court. The issue involved John and Laura Barker, who own a home in Connecticut. John works in New York as an investment manager and commutes. The Barkers purchased a home in the Hamptons as a vacation residence, which they use from time to time.

The New York State Tax Authorities claimed that the Barkers were considered full-time residents and that all of their income from all sources was subject to New York State Tax. The Tax court held in favor of the New York State. The judge found that the state statute defines a temporary residence as cottage or vacation home where temporary occupancy is inherent in the nature of the abode. In the present case, the home owned by the Barkers was capable of being utilized as a full-time residence and, since it was suitable for year round use, the Barkers could have used it for that purpose and they are, therefore, full-time residents under New York law.

This has created a new and potentially onerous condition providing a framework in which tax authorities can assert that anyone who owns a pied-a–terre in New York City is a full-time resident even if the property is little used.

While the Tax Appeals Tribunal expressed that the findings of this case are unique to its fact situation and the State Authorities affirmed that they did not look at this case as expressing a new policy toward part-time residency, it still is creating considerable concern among attorneys representing clients with pied-a-terre homes.

The following seem to be useful as a guideline:

1. New York State tax forms relating to part-time residents now expressly ask the customer to define the number of days they were in the state. If the taxpayer is in the state for more than 183 days then the State will assert the tax payer is a full-time resident.

2. I have been told by a number of attorneys that they intend to advise their clients who are out-of-state residents owning pied-a-terre homes in New York City that it would be prudent to place ownership of the home into a trust or corporation in order to remove personal ownership from the property. It is their contention that this provides superior protection against the risk that tax authorities might make a claim.

3. It is important that the taxpayer carefully respect the 183 day rule. A calendar or log identifying where the taxpayer was located has become an important element in proving part-time residence.

As salespeople we should consider the following:

1. A party seeking to sell a residence which is a pied-a-terre is probably highly motivated to sell as a result of the risks that are now appearing.
2. Buyers who are looking for a pied-a-terre are probably more inclined to condos than ever before in order to insulate themselves with trusts or corporations against the chance of being deemed a permanent resident.

I would strongly urge any salesperson working with a buyer who is seeking part-time residence to withhold passing an opinion on the tax implications of their purchase and encourage them to obtain professional tax advice in evaluating a proposed transaction.

Reflections on the Real Estate Market

I have been engaging in a bit of reflection on the state of affairs over the last year. My thoughts center on what happened, who it happened to and the implications of these events on the future activity in the real estate market in New York City.

The Seller
There is a saying that the pain of a loss hurts twice as much as the joy of a gain. There is no question that a lot of sellers are having a tough time accepting that the sale price they hope to achieve is no longer possible. Sellers tend to take the following steps in coming to terms with a declining market:

Stage 1: Denial – The seller evaluates past sales in the building and perceives the value of his home in reference to those properties. The seller feels that the recession is happening to someone else and not to him. Brokers are evaluated based on how much they agree with his position.

Stage 2: Shock – There is limited buyer activity on the property. Then offers appear, which are unacceptably low. The seller becomes frustrated and angry with real estate brokers. Finally the seller begins to recognize that the property will not sell at the price hoped for.

Stage 3: Pain – The seller tries to figure out what to do. He begins to listen to brokers and friends who tell him he has to adjust his price. He tries to reconcile the impact of the lower price against his future financial position.

Stage 4: Confusion – The seller continues to seek advice from others. Even though he has altered his price he still is not getting reasonable offers. He starts to evaluate whether he should bailout for the best he can get or hold on in the hope that there will be future improvement in prices.

Stage 5: Reinvigoration – The seller begins getting offers that are in line with his adjusted expectations. He fights hard against buyer demands for further concessions. He becomes empowered by the chance to create a deal and get the transaction behind him.

The Buyer
The buyer is seeking to find an opportunity. She has long felt that prices were too high. Now that there is a decline in prices she is seeking to take advantage of the market to find an apartment that she views as “fairly” priced. She is well informed and monitors the Internet and classified advertisements regularly. Here are the stages in the buyer’s final decision to go forward with a deal:

Stage 1: Inquisitiveness — The buyer is aware that the market has declined and curious to see if the price adjustments are significant enough to warrant serious consideration for making a purchase. In addition to browsing Internet sites and reading the classified section of newspapers, she goes to open houses.

Stage 2: Caution – The buyer begins to see a chance to purchase a property that was previously unavailable at an affordable price. However, she is hesitant to make offers and does not feel she is under time pressure. She believes that the current price decline is not over and that there is more bad news to come that will affect prices. Bad news is good news to the buyer.

Stage 3: Opportunism – The buyer identifies a property which meets her needs and decides that she should make a bid. The bid is low, reflecting her desire to negotiate a good deal.

Stage 4: Reconciliation – The buyer recognizes that the seller is not going to accept the price she bids and that she has to improve the offer in order to obtain the seller’s serious interest.

Stage 5: Acceptance — The buyer agrees to a number higher than she originally intended, but still affordable. She accepts that this is the best that she can achieve under the circumstances.

The Banks
Banks make money by lending, of which home mortgages have been a huge area of profitability. When the economy soured, many banks found that some of the riskier loans they owned stopped paying and profits turned to losses. In this case, the government mandates that banks increase their reserves to ensure the availability of adequate funds to deal with the difficult economic environment. The need to generate greater reserves and anxiety about the economic environment causes banks to dramatically reduce lending and to make demand that many borrowers they repay their loans rather than seek to extend or renew them. This results in a credit squeeze – borrowing becomes difficult and lending terms more onerous.

Stage 1: Generous Lending – The banks have substantial amounts of cash and considerable profits. Their business clients are doing well and requesting loans to operate and expand the business. In addition, the housing market is vibrant and many borrowers are submitting applications for loans for new homes or for equity credit lines. Banks are finding that many borrowers are financially qualified and they are lending substantial sums and earning considerable profits.

Stage 2: Knee-Jerk Response – The economic news turns negative. The stock market declines. Banks realize that the economic environment has changed and policy directives are sent to all departments to refrain from issuing loans to all but the highest quality clients. In addition, banks direct that loans maturing should not be renewed.

Stage 3: Work Outs, Defaults and Foreclosures – With the change in bank lending policies and a negative business climate, many clients are incapable of paying back their loans. A portion of the mortgage loans start to show delinquency. Delinquency notices are issued, mortgage delinquencies get legal letters and foreclosure proceedings commence. In some instances, banks accept short sales, receiving less that the full amount due on the sale of a property. In other instances banks agree to “recasting” the loan at altered terms with lesser interest or lower amortization.

Stage 4: Restrained Lending – Borrowing terms are tightened and review procedures are intensified. Many business clients are showing poor financial reports as a result of the bad economic environment so qualifying for loans isn’t possible. In addition, many applicants for mortgages have poor credit scores because they had to deal with economic difficulties and cannot qualify for mortgages as a result of heightened credit score requirements.

Stage 5: Repositioning – New financial institutions appear as a result of mergers with weaker banks. Banks reposition themselves to provide new and creative ways to finance businesses with greater collateral requirements or guarantees. Loan terms become extended and mortgage financing programs become more actively marketed on a more conservative basis.

Real Estate Brokers
Real Estate Brokers are dependent on velocity; whether prices go up or down is not as critical as the number of deals performed since commissions are earned successful transactions. In the current environment, brokers retrench and reinvent themselves. There is considerable retrenchment as weak firms either fold or merge into stronger ones. Brokers become more flexible, going into areas previously ignored and handling rental transactions more aggressively. In this market we have seen:

Stage 1: Denial – Real estate brokers initially believe that the decline in market activity does not include their area of the business. Thus, when buyer calls slow down they view it as a temporary condition. When they start seeing deals fall apart because buyers and sellers can’t agree on price, they view it as the buyer’s fault for being intransigent.
Stage 2: Frustration – There is a continuation of slow buyer calls. Sellers become frustrated because brokers are not “working” their properties. Deals continue to fall with a “10%” gap that just doesn’t seem to go away. Agents start to get angry at buyers for refusing to be “realistic.” Some sellers remove their apartments from the market.

Stage 3: Confusion – Agents find themselves with less and less to do. Personal bills have to be paid and commission income from closed deals is falling. Buyers are not calling or are increasingly demanding. They see themselves as more informed than brokers because they scrutinize every Internet site for possible opportunities. Brokers call sellers to advise them to adjust their prices downward to accommodate new market realities. However, even with price adjustments buyers are still not responding. Brokers don’t know what to do.

Stage 4: Reinvention – Real estate agents begin to redefine their selling strategy. They become more attentive to buyers. They start looking at redefining how they spend their time in order to build a base of business from new resources.

Stage 5: Rededication – Transaction activity starts to resurface. The level of dedication to servicing buyers and sellers knows no bounds. As a salesperson said, “Before I was an amateur psychologist, now I’m qualified for a degree.” Everyone is empathetic and struggling to understand what reality of the situation. Will the board approve the lower price? Will the bank accept the financial condition of the buyer? Will the buyer stay committed? Every deal is a juggling act.

Going Forward
The year 2011 presents a new market dynamic. The past few years have been challenging, yet have resulted in a new way of looking at ourselves and how we can best operate in a vastly different, evolving environment. Many economists look at recessions like a wave, washing away the old and revealing new vibrancy. We are now climbing a new mountain and the landscape is bright and exciting. There will be considerable effort; however, the path is clear.

Why the time to buy an apartment is Right Now!

Everyone is talking about whether the real estate market will go up or down. A natural question, to be sure, yet for most buyers, that’s not the right question. What most buyers really want to know is “How much more will I have to spend to buy my next home?” This is known in the industry as “the leap.”

Up till now the cost of the leap from one apartment type to the next has been the single biggest obstacle for buyers. In the red hot market of 2007, the average amount of money required for a leap was:
Average Studio to Average 1 Bedroom: $ 300,000
Average 1 Bedroom to Average 2 Bedroom: $ 500,000
Average 2 Bedroom to Average 3 Bedroom: $1,000,000

Now the situation has certainly changed – creating a real opportunity. Average leaps are now:
Average Studio to Average 1 Bedroom: $200,000
Average 1 Bedroom to Average 2 Bedroom: $400,000
Average 2 Bedroom to Average 3 Bedroom: $750,000

But there is more to the leap than this arithmetic suggests.

For example, Susan G. owned a studio apartment and decided to sell it in a hot market for $500,000. She paid off her old mortgage of $300,000 and used the $200,000 difference toward the purchase of a nice one bedroom that cost $800,000. Susan had a leap of an additional $300,000, which she financed completely with a new mortgage of $600,000.

Susan’s neighbor John S. decided to wait to sell his home for a few years and he has missed the golden opportunity enjoyed by Susan. He resigned himself to the reality that his home is only going to sell for $400,000. His poor timing resulted in a sales price $100,000 lower than Susan got.

John recently started looking to buy a 1 bedroom apartment similar to the one purchased by Susan. He finds one, negotiates a good deal and buys it for $600,000. He only needs $200,000 in additional cash and mortgage, which is $100,000 less than Susan required.

Because the price drop on the average one bedroom was much more severe than the price drop on studios, John actually ended up doing economically better than Susan did, even though he sold his apartment for less.

And consider the financing. When Susan purchased her home she was able to get a great 30-year mortgage at 5.5%, which meant that her monthly payment was $3,408.

John financed 75% of the purchase price, as well. Yet bank rates have dramatically declined. Since the price he paid was $600,000, he took a loan for only $450,000 at a rate of 4.5% for a 30-year fixed loan. His monthly mortgage costs $2,281 per month.

The Bottom Line

In the leap, getting a high price for your home doesn’t necessarily mean that you do economically better when you move. The issue becomes what you do with the money. Given the market, sometimes what looks like a good opportunity is a leap of expensive proportions, and sometimes what appears to be ill-timed venture might be the best opportunity of all.

Getting a Mortgage on Coops and Condos in New York City: the Dust is Clearing

The bank rules relating to obtaining financing for a coop and condo apartments have created continued controversy over the last few years as the influence of Fannie Mae on bank lending practices has expanded. Now, practically all the rules that banks are dictating to borrowers are derived from Fannie Mae guidelines, so the differences between the lending policies of various banks are somewhat minimal. In large measure, the dust has settled and the confusion relating to lending policies have become somewhat stable.

Borrowers should now consider the following issues when seeking a loan:

Equity Requirements
Banks require a minimum of 20% down for any loan under $730,000, and 25% for any loan higher than that. In cooperatives, obviously, the boards’ lending requirements will cause the equity investment to be higher.

“Back End” Rules for Housing Cost Coverage and Credit Scores
Historically, banks relied on a ratio of the owner’s monthly cost of ownership to their income to determine if the applicant was qualified. This rule generally provided that if this ratio was 30% or better, the lender would qualify. However, banks quickly realized that this was insufficient. Borrowers with debt from second homes, personal loans, credit cards and credit lines, auto loans and other sources could easily find themselves in difficulty even if the lending ratio on the purchase appeared favorable.
Thus, for a time, there was a dual evaluation — the specific loan for the home purchase, which was called the “front end” ratio, and a second ratio, referred to as the “back end,” had to meet a minimum requirement of 45%.

The front end has now pretty much disappeared and banks are concentrating very diligently on the back end component to insure that all loans are included in the ratio. The banks’ conservative attitude is to ensure that if a person buys a home and has debt they can comfortably afford, their obligations not merely squeak by. In addition, to obtain the best rates offered by the bank, a borrower needs a credit score of 740 or above. If the score is below 720, banks will use “risk based pricing,” which will increase the interest rate on the loan. A borrower with a credit score of 620, which is generally the minimum, should expect to pay 2% more for the loan.

Ownership Concentrations
In the past, banks were indifferent to the affairs of the building in which the borrower was making a purchase. This is no longer the case. Banks have become acutely aware that the financial health of the building is intimately connected to an apartment’s value.

A great concern centers on the heightened level of risk associated with a high concentration of investor ownership. This has been defined as a case where one party owns 10% or more of the building’s apartments. Banks are concerned that the investor with such a large position may exert influence on the building’s affairs, which might diminish the normal investment in building improvements in order for the investor to protect his cash flow position.

Banks are also anxious that if the investor has financial difficulties or defaults, the impact on the financial health of the entire building could be substantial. In addition, if more than one party owns large concentrations, even if the 10% threshold has not been met, the bank will carefully consider this and may deny the loan.

Another bank concern is in new construction and recent building conversions. In these cases, banks are unwilling to lend if the sponsor/developer’s ownership position exceeds 50%, though in some cases this can even be as high as 70%.

The biggest reason for their hesitancy is due to the uncertainty surrounding the ability of the sponsor/developer to sell the remaining apartments. This creates a significant exposure to existing owners if the sponsor fails to be able to meet his financial obligations. There are numerous stories of newly constructed buildings where sponsors left the unit owners high and dry without covering maintenance costs on the remaining unsold apartments or using building funds or resources for completing or renovating his apartments. This can place a significant financial burden on the other unit owners, who have to cover the cost of operations without these essential funds.

10% Capital Improvement Fund Replenishment
Historically, cooperatives and condominiums have accumulated funds in order to maintain the physical condition of the building over time. However, it has often been the case that the amount that has been accumulated has proved insufficient to actually accomplish its intended purpose. Thus, it is common that additional funds must be collected through assessments. These assessments have proven to be of great concern to banks since they are not predictable and they are not considered in evaluating the borrower for a loan unless the assessment has been previously declared. In order to more accurately reflect the true nature of the long term cost of running a property, banks are now requiring that buildings allocate 10% of yearly maintenance collections for the reserve/capital replacement fund.

This new requirement has created a number of significant issues for buildings. Buildings typically have sought to increase the fund by about 3% a year, which somewhat matches the level of yearly depreciation deduction to which the building is entitled to deduct on its tax return. This has generally created a no or a minimal tax condition for cooperative corporations. However, aside from the necessity to dramatically increase the monthly charge by approximately 7% to conform to the new bank rule, the building will also have to raise the monthly charge to pay income tax on its positive income. Thus, 7% must really be 9% to cover the additional tax. While this onerous condition may be avoided in condominiums, it appears that it cannot be in cooperatives.

There are certain steps a building can take in order to alleviate this burden. Banks are accepting professional evaluations of the building’s condition to more accurate portray its obsolescence, and have been willing to adjust the 10% requirement upon a showing that a lesser sum would be adequate to address the building’s needs.

The good side of this new requirement is that buyers will be able to evaluate the ongoing costs of ownership more accurately since there will be a reasonable assurance that the necessary amount to cover operating costs and future improvements are being regularly collected.

Blacklisted Buildings
In addition to the demands of banks to minimize investor ownership concentrations and augment collections for replacement funds, banks are also carefully making a holistic evaluation of every building to ensure that there are no other issues which could impair their collateral position.

It is now common practice for managing agents to fill out building questionnaires as a condition to a prospective buyer getting an apartment loan. If the bank learns that there are adverse conditions they will not only deny the borrower a loan, they may also blacklist the building for anyone else as well. The following have been reasons for a building to be blacklisted:
• Land leases: If the lease term on the building is shorter than the term of the apartment loan, then it is unlikely to be approved.
• Litigation: If a building has onerous litigation it can impair its ability to be financed at the apartment level.
• Unusually high homeowner arrears: Where the amount of maintenance or common charge owed to the building exceeds 10% of the monthly collected rent, the bank will normally refuse to lend on the building.
• Unacceptable Insurance: Banks will only lend where the building maintains adequate insurance to cover the replacement cost of the property and will insist that the insurance provider be at least “A” rated. If applicable, the bank will also require adequate flood insurance and fidelity coverage equal to 25% of total revenue collected by the building. In addition, the building cannot have an insurance deductible greater than $25,000.
• Excess Commercial Use: If a building exceeds 20% by both footage or income from non-homeowner commercial sources, a bank normally will not lend on the property.
• Building Code Violations: Where there are material building code violations, a bank will insist that these be remedied prior to lending on the property.
• Mechanics Liens and Property Encumbrances: Where the building is materially delinquent in addressing vendor obligations resulting in a mechanics lien, if there is a real estate tax delinquency or there are recorded judgments, a bank normally will refuse to lend on the property.

This is only a partial list of items that banks have used as a reason to deny lending on a property. In many instances it is a subjective evaluation that changes regularly. Suffice it say that we have been advised by some banks to advise them about a pending deal prior to the buyer signing contract in order to make sure that the building being considered is on the bank’s “approved” list.

Investor Loans
A bank will not give an investor loan on a cooperative apartment even if no board approval is required and the owner has the right to rent. Investors are still able to obtain financing on condominiums, although the terms have become more conservative. For loans up to approximately $417,000, the investor can obtain 80% financing. The requirement is 35% equity for any financing above this amount.

Banks typically will not permit a second mortgage on the property, so one can’t rely on the seller or private sources to supplement the bank’s loan proceeds. In addition, banks will be anxious to ensure that the rent being collected on the property is more than sufficient to cover the full cost of ownership, including the common charge, real estate taxes and the monthly loan debt payment. If this cannot be done then the investor must contribute a larger level of equity.

Normally, investor loans are issued at an interest rate premium of .05 to 1.5% of the homeowner rate. The difference depends on the nature of the property, the financial strength of the investor and his/her banking relationship.

Heavy Leverage Loans (90% Financing)
There still is a market for borrowers looking to obtain 90% financing on the purchase of condominium apartments. This is available by the borrower obtaining Private Mortgage Insurance. Thus, the borrower actually engages in a dual arrangement of obtaining a loan from the bank and insurance protecting the bank’s position for any amount borrowed above conventional lending limits. The cost of this insurance adds 6 points at the time of closing (5% of the loan representing the first year’s insurance) and approximately 0.5% more on the monthly payment. The borrower must have a strong credit score and be able to adequately cover the loan payment based on back end rules (see above). Qualifying for private mortgage insurance is often more difficult than qualifying for the loan.

Markets: NYC Real Estate Better Deal than Apple

Many experts say the Great Recession is starting to recede. They point to statistics that show an increase in the Gross National Product for the first time in two years, a reduction in the trend of home foreclosures and an improving stock market. Yet there are others who tell a different tale. They say that the real estate market is still flagging. They point to high home prices and the fact that banks still aren’t lending. They say that sellers of real estate must keep lowering their sales prices even further.

I took an alternative approach in looking for an indicator of the economy, in general, and the Manhattan real estate market, specifically. The results are something to consider.

Measuring Market Confidence

I decided to identify a company that has not only reported strong financials, but has a favorable reputation as a business. That company is Apple.

Apple’s stock price has exploded over the last few years, from a low of $38 a share in 2005, to a current price of about $200 per share. It was during this time period that the company generated excitement with the iPod, the iPhone and iMacs. Apple’s future has been considered to be pretty good, and yet there are doubts the company’s ability to maintain its terrific growth with the new products it has presented. It has had a good run, but will it continue?

I decided to compare Apple to another computer company that has had a less-than-stellar path, Dell Computers. Five years ago, this company was selling at a price similar to Apple’s, around $38 a share; however, five years later this company is selling at $14. Dell suffered from the “commoditization” of its product and a failure to develop any new, innovative technologies that could permit it to distinguish itself in the marketplace. However, most people still believe that Dell creates a pretty good product, and it is the second largest producer of computers in the United States. Even though it has fallen, there still is an impression that it has bottomed out and stands a good chance of dramatically improving its position when a stronger economy arrives because of its aggressive pricing structure.

I wanted to develop a means to identify which company the marketplace thought was better. I decided to use a measure popular with investors in evaluating companies, Price Earnings Ratio, often referred to as “PE.” If a company has a high PE it means that the price is aggressive relative to its earnings. It is, therefore, a measure of the market’s confidence in the ability of the company to generate future profits. I was surprised to find that the PE ratio for Apple is 19.52, while for Dell it is 18.68. The level of similarity means that investors perceive that the upside for each company is about the same. Thus, Dell is as good an investment as Apple, at least based on this measure.

Evaluating NYC Real Estate Prospects

Now that I had a sense of the potential of computer companies to make me a profit, I decided to apply this same principal in evaluating real estate in New York City. I chose three companies that are active players in the local market, Avalon Bay, SL Green and Vornado.

Avalon Bay is a large Real Estate Investment Trust that builds and manages residential properties. The company has taken a major position in the New York City market. Five years ago its stock price was almost 68. It rose in the boom of 2007 to a high of 146 and then declined, due to the current economic circumstances, to a current value of $76. It currently has a PE ratio of 39.

SL Green is also a Real Estate Investment Trust, which owns predominantly New York City commercial properties. Five years ago its stock price was approximately $58, and now its stock price is about $46. It currently has a PE ratio of 85.

Vornado is a large Real Estate Investment Trust that is substantially positioned in retail real estate in New York City. Five years ago its stock price was $71, and its current stock price is $62. Its PE ratio is an astounding 1,140.

In looking at the PE ratios of these companies, I am astounded by their strength! Every one of them has a PE ratio that leaves companies like Apple in the dust. The fact that a company’s stock price goes up or down is clearly not an issue — what is important is what an investor thinks the company will do given what is known today. It seems to me that investors are saying, “Given what I know right now, New York City real estate is good opportunity.”

I agree. The inventory of available prosperities in the summer was over 12,000 units in Manhattan. Now the inventory is around 8,700 units. That’s almost a 30% reduction in supply. Mortgage money is really cheap for qualified buyers and it’s readily available. Sellers are still very accommodating, but I don’t that will last for long.

The Future?

While there are some experts who may have qualifying language about PE ratios, I propose that every one of them would say that the market has expressed a very positive indication about the near term prospects for New York City real estate.

It may not look that good today, but the investing public thinks that New York City real estate is a better deal than Apple. I think that’s food for thought.

Neil Binder
President
Bellmarc Realty

On Twitter: twitter.com/bellmarc
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On the Web: bellmarc.com

Wave Theory

The next time you are at the beach, watch the waves rolling in and out. Each one rises to an apex and then crashes down. Then the next comes, rising and then crashing. This same ebb and flow is a good representation of the real estate market in New York City.  We began with a wave of tsunami proportions in 2008. The wave crashed down, then slowly receded, taking a portion of the sand back to the ocean with the force of the undertow. Then a smaller wave rose and it too fell. Now another is beginning to appear as the preceding one finishes receding.

The surge of business activity, which ended in the summer of 2008, was America’s economic tsunami. The real estate market dropped 75% from is peak level of activity and prices dropped by 25% to 35 % in Manhattan. This enormous wave receded in the first quarter of 2009 taking a substantial amount of wealth with it.

Another surge crested in June, when business activity rose to its highest level in a year and a half. In July the wave came down and now, in August, it is again receding. Business activity in July dropped a third from what it had been in June and dropped another third in August. As we enter the latter part of August we are seeing another wave appear. Open houses are showing increased activity. This wave will appear in its fullest in September and October and will again recede in November and December.  These waves will continue unless something of unexpected dimension occurs which disrupts this trend.

What Causes this Wave Pattern?

Consider the nature of the supply and demand between buyers and sellers. An increase in the size of the inventory represents a weakening of the seller’s position.  The resistance of buyers to prices demanded by sellers leads to market inactivity and inventory buildup. Some sellers eventually acquiesce to demands by buyers to lower prices, leading to a cascade of falling prices as other sellers follow suit.  Lower prices bring more sales. As product is absorbed by the increased level of transactions, inventory declines. Lower inventory causes sellers to firm up their positions and prices to rise.  As prices rise, buyers stop buying and the level of activity again recedes. Accordingly, inventory again rises and the cycle repeats.

Let me give you a more concrete scenario. Last year, the West Side activity was at a low level relative to our other neighborhood offices. Prices on the West Side were relatively high when compared to other neighborhoods. The East Side, in turn, was showing greater activity because its prices were relatively lower. A sudden a shift occurred in May. Prices on the West Side dropped, activity shot up and the level of transactions on the East Side quickly receded.

Take the experience of Mrs. Smith, who owned a Classic Six on the West Side. She believed her apartment was worth $2,000,000. It had been for sale on the market for over a year. There were three other apartments in the building like hers and they, too, had been on the market for some time. One day, the seller of one of the other apartments decided to reduce his asking price to $1,800,000 to stimulate buyer interest. After hearing this, Mrs. Smith realized that she, too, needed to reduce her price to be competitive. In short order, everyone selling an apartment in the building was forced to reduce their prices. Finally there was a sale at $1,600,000. Even though Mrs. Smith was not happy about it, she really wanted to sell her home, so she accepted that this was the new benchmark for the apartment’s value.

Now look at Mr. Gold, who has a two bedroom on the East Side. He wants to sell the apartment for $1,800,000. There were other two bedroom apartments in the building that recently sold at a similar price so he was confident that he could also achieve this figure. Offers came in at $1,600,000 and he turned them down since he still believed that the higher price he placed on his home was justified. Sales activity in the building all but ceased. After a few months of inactivity he decided to accept a previous bid of $1,600,000 to move the apartment. He called the broker, who told him that the potential buyer already purchased a two bedroom on the West Side for $1,600,000. Mr. Gold decided to drop his price officially to $1,600,000 to find another buyer.

Surfing the Wave

These waves of activity and inactivity are happening in the general market and in various neighborhoods. The key is to look at the inventory in the category you are seeking to buy or sell. Are there a lot of choices at the present time?  If the inventory is high, the wave is against the seller.

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September 2009

Neil’s Musings…

Wave Theory

The next time you are at the beach, watch the waves rolling in and out. Each one rises to an apex and then crashes down. Then the next comes, rising and then crashing. This same ebb and flow is a good representation of the real estate market in New York City.  We began with a wave of tsunami proportions in 2008. The wave crashed down, then slowly receded, taking a portion of the sand back to the ocean with the force of the undertow. Then a smaller wave rose and it too fell. Now another is beginning to appear as the preceding one finishes receding.

The surge of business activity, which ended in the summer of 2008, was America’s economic tsunami. The real estate market dropped 75% from is peak level of activity and prices dropped by 25% to 35 % in Manhattan. This enormous wave receded in the first quarter of 2009 taking a substantial amount of wealth with it.

Another surge crested in June, when business activity rose to its highest level in a year and a half. In July the wave came down and now, in August, it is again receding. Business activity in July dropped a third from what it had been in June and dropped another third in August. As we enter the latter part of August we are seeing another wave appear. Open houses are showing increased activity. This wave will appear in its fullest in September and October and will again recede in November and December.  These waves will continue unless something of unexpected dimension occurs which disrupts this trend.

What Causes this Wave Pattern?

Consider the nature of the supply and demand between buyers and sellers. An increase in the size of the inventory represents a weakening of the seller’s position.  The resistance of buyers to prices demanded by sellers leads to market inactivity and inventory buildup. Some sellers eventually acquiesce to demands by buyers to lower prices, leading to a cascade of falling prices as other sellers follow suit.  Lower prices bring more sales. As product is absorbed by the increased level of transactions, inventory declines. Lower inventory causes sellers to firm up their positions and prices to rise.  As prices rise, buyers stop buying and the level of activity again recedes. Accordingly, inventory again rises and the cycle repeats.

Let me give you a more concrete scenario. Last year, the West Side activity was at a low level relative to our other neighborhood offices. Prices on the West Side were relatively high when compared to other neighborhoods. The East Side, in turn, was showing greater activity because its prices were relatively lower. A sudden a shift occurred in May. Prices on the West Side dropped, activity shot up and the level of transactions on the East Side quickly receded.

Take the experience of Mrs. Smith, who owned a Classic Six on the West Side. She believed her apartment was worth $2,000,000. It had been for sale on the market for over a year. There were three other apartments in the building like hers and they, too, had been on the market for some time. One day, the seller of one of the other apartments decided to reduce his asking price to $1,800,000 to stimulate buyer interest. After hearing this, Mrs. Smith realized that she, too, needed to reduce her price to be competitive. In short order, everyone selling an apartment in the building was forced to reduce their prices. Finally there was a sale at $1,600,000. Even though Mrs. Smith was not happy about it, she really wanted to sell her home, so she accepted that this was the new benchmark for the apartment’s value.

Now look at Mr. Gold, who has a two bedroom on the East Side. He wants to sell the apartment for $1,800,000. There were other two bedroom apartments in the building that recently sold at a similar price so he was confident that he could also achieve this figure. Offers came in at $1,600,000 and he turned them down since he still believed that the higher price he placed on his home was justified. Sales activity in the building all but ceased. After a few months of inactivity he decided to accept a previous bid of $1,600,000 to move the apartment. He called the broker, who told him that the potential buyer already purchased a two bedroom on the West Side for $1,600,000. Mr. Gold decided to drop his price officially to $1,600,000 to find another buyer.

Surfing the Wave

These waves of activity and inactivity are happening in the general market and in various neighborhoods. The key is to look at the inventory in the category you are seeking to buy or sell. Are there a lot of choices at the present time?  If the inventory is high, the wave is against the seller.

State of the Market

You wrote a month ago that the recession is over. Do you still believe that?

Two months ago the reported inventory of active listings for sale as reported on bellmarc.com was 12,100. Today this inventory is 10,800. That’s a 10% decrease in one month! However, there has also been a significant decline in prices. In large measure I believe this is due to the fact that sellers have reconciled themselves to the current state in the market and are no longer expecting appreciation. This, plus the awareness that summer months are normally a slower period have caused many sellers to bite the bullet and accept the price reductions required to make a deal.

 Going forward, we still see a resurgence of buyer activity.  Buyers are hearing about the heated level of business and recognize that their best opportunities are now. The recession is over and the trend is a continuation of higher levels of business activity.

What do you think is the state of new construction in Manhattan? 

Historically, new construction sold at a 30% premium over resales. This premium surged to 60% as a result of the enormous interest by foreigners and investors in new construction condominiums. As this segment of the buyer market declined substantially, developers were left with considerable inventories. News reports about buyers of new condominium projects seeking to back out of their deals also have not helped developers support their current price structures. 

Some developers are having serious financial difficulties, while others are shaving back prices to respond to market realities. There is also considerable activity in bulk sales, where developers off-load large numbers of apartments in a single transaction to a vulture fund or opportunistic investor. A significant number of these apartments are being rented as a last resort.

My forecast is that the number of new projects will dramatically decline. The glut in inventory, the elimination of tax laws that favored residential construction and the pressure on banks to cut back on big lending has made the environment unfavorable. The only projects that will be going in the ground are those where prior commitments have been made and the developers have deep pockets to provide significant equity to the projects.

What do you think of the rental market?

The bad economy has eliminated much of the upside potential for rental properties. Many developers are finding it slow going to fill their properties and landlords have resorted to paying commissions where, for years, commissions were paid by the tenant.  We are seeing owners offering free months’ rent in addition to lowering monthly charges. I view the rental market has a soft component for some time until the economy shows a lower level of uncertainty. There are too many properties available to support any strengthening in prices of these properties.           

Where do you see mortgage rates going – up or down?

For years mortgages rates were a function of the tradable values of mortgage-backed securities on Wall Street. Since there were enormous sums of money going into this market, interest rates remained historically low. This has substantially changed. 

The U.S. government’s takeover of Fannie Mae and the government’s significant influence over the entire banking industry has cause interest rates to become part of political policy. The current low level in interest rates is very much a function of the federal government’s intention to keep the mortgage markets open and affordable regardless of market conditions. I don’t think this is likely to change in the foreseeable future. Interest rates will sell within a limited band of 1 or 2 percent with a target rate of 5 to 5.5%. We will also see a substantial reduction of adjustable rate mortgages that are under 5 years. The government is looking to create stability and variable rate mortgages are a large threat to that goal. 

When will Manhattan housing prices go back up?

There are two factors that need to be resolved before substantial price appreciation will appear.

The first is confidence. The typical buyer must feel secure enough with the economy and their employment status that the challenge of buying a more expensive home is an opportunity worth taking.

The second is inventory. A further reduction of inventory is needed to support a more favorable position for sellers relative to buyers.

There are many people who believe that, as a result of the enormous amount of lending incurred by the government, inflation is pending and that real estate is a good hedge in this kind of environment. Many economists are unsure that inflation is clearly in the winds since the money supply available in the market at any given time is being controlled by the Fed.  Therefore, I am unclear if the possibility of inflation will really appear and what affect it will have in the marketplace.