Real Estate Matters, Spring 2003

Real Estate Matters, Spring 2003
Market Matters: State of Real Estate: New York City: Spring 2003
Joshua Kahr

Welcome to "Market Matters" is a new feature of Matters which will appear in every issue of this quarterly bulletin. This feature will seek to provide comprehensive, unbiased coverage of issues that brokerage firms typically are not comfortable discussing. This first installment addresses the weakening midtown office market and the bubble in Manhattan condominium units.

Market analysis of the New York City real estate market provides many challenges to the analyst. New York City has one of the most complex real estate markets in the world with its highly regulated residential market, its office market that dwarfs all else in North America, and its public works projects that are planned and constructed over generations instead of years (i.e., the Second Avenue subway). There are also multiple competing data sources for each product type and many more organizations interpreting and repackaging the data to argue their positions. Arriving at something that resembles the true state of the market is challenging, but the reward is that one never runs out of topics to cover.

The long-term goal of "Market Matters" is to be a resource to real estate professionals who want coverage of the entire New York City market and do not have the time to read reports from different brokerage services covering different product types. The feature will provide both regular indicators of the overall market's health and will also investigate specific issues.

Office
According to New York City's Office of Management and Budget, the city lost 70,000 jobs in the wake of 9/11 and 132,000 jobs in the period from 4th Quarter, 2000 to 3rd Quarter, 2002. To put that in perspective, for the month of November 2002 the national unemployment rate was 6 percent while the city's unemployment rate remained stuck at 8 percent.

Additionally, many of the jobs that were lost were high-wage financial services jobs and as the average office worker in New York uses approximately 250 sq. ft. (including common areas), the job loss has strongly affected the demand for office space. The finances of the city also have been affected and while it is unlikely it will face a repeat of the 1975 fiscal crisis, it will be at least a few years before the city is on sound financial footing again.

According to Colliers ABR in December 2002, midtown's vacancy rate for Class A office space was 9.8 percent and downtown's vacancy rate for Class A office space was 14.1 percent. There is an obvious divergence in the relative health of these two markets. Downtown used to be considered as a serious alternative to midtown when a company planned where to base its headquarters. After 9/11, with the damage to the transportation network and the uncertainty surrounding the World Trade Center site both in terms of what will be built and when it will happen, few companies are comfortable placing their headquarters downtown.

Downtown's high vacancy rate also implies that the market does not see downtown as New York's second CBD and rather sees it as a secondary location much like Jersey City. However, downtown has neither easy access to the low cost labor that is essential for back office operations nor sufficient distance from the midtown CBD that it could function reliably if midtown was attacked with a weapon of mass destruction. In today's New York, downtown is a market without a clear purpose.

This is not to say that the midtown office market is healthy. There is a glut of high quality finished space that is available for sublease. In fact, almost half of the space available consists of sublease space and not direct space. While landlords obviously prefer to have subleased space in the portfolio instead of vacant space (as the landlords continue to receive rent from the tenant on the over-lease), this sublease space is a threat to the health of the market. The sublease space drags down prices on direct space as it is in competition with direct space that is often in poor or unfinished condition.

Partially as a result of this available sublease space, the 1.2 million sq. ft. Times Square Tower is still entirely vacant even though Arthur Anderson terminated its lease at the end of June 2002 and has had the other half of the building available since pre-construction. Further east on 42nd Street is the CIBC tower at 300 Madison Avenue. It was announced in January 2003 that CIBC World Markets Inc. will take only 500,000 sq. ft. of the building and will leave the owner, Brookfield Properties Corporation, with 600,000 square feet of unfinished space. The construction of both buildings should be completed in 2003 and they will drop a total of 1.8 million sq. ft. of brand new Class A space onto an already weak midtown office market.

The ironic aspect of this story is that overbuilding was not supposed to happen again. The theory that was the rage in 1997 when REITs (Real Estate Investment Trusts) were growing rapidly was that the public markets were more efficient than the private markets and this efficiency would eliminate overbuilding. Both 300 Madison and Times Square Tower are being built by publicly traded companies (Brookfield Properties Corporation [NYSE: BPO] and Boston Properties [NYSE: BXP]). It appears that the public market is just as efficient as the private market in miscalculating demand.

As if an excess of high-quality sublease space and overbuilding wasn't bad enough, the situation became worse. "Shadow space" is the unspoken fear of the office market. Shadow space is space that is not being utilized by the tenant but the tenant is not marketing as available for sublease. In New York today, there are companies that have entire floors empty that they are not marketing for sublease.

Companies may choose not to market their available space for reasons including not wanting to publicly admit that their business is in trouble or not wanting to admit to themselves that their downturn in staffing needs could be long-term. Some companies are unwilling to market their available space because in order to manage earnings they need to plan when they take a write-down. There are several financial services firms that had poor years in 2002 and will now put their shadow space on the market so that any write-downs will occur in 2003 or later.

An example of the shadow space problem is NASDAQ's recent admission that they are not going to move operations to 1500 Broadway and will remain downtown. What are they going to do with the 53,000 sq. ft. that they just signed a long-term lease for last year? Will it go on the market? In the meantime, their silence keeps the available space rate at a lower number than it truly is. The events of 9/11 provide a window onto how bad the shadow space problem can get. The brokerage community expected that there would be a flood of tenants in need of space. This was not the case. While many of them shut down their local operations, a good number of them relocated to back office space or space that they had emptied previously due to layoffs.

Available space for sublease is much better for the long-term health of the market (and the market analyst) than shadow space. Sublease space is public knowledge and businesses can react effectively to this information. Shadow space lies in wait, ready to scuttle any recovery of the office market.

Regardless of the overhang of empty space of all flavors and the specter of overbuilding, some commentators have pointed to the relative strength of the investment sales market as a sign that investors feel that the office market is still healthy. Unfortunately, for building owners, this is more a reflection on the weakness of the equities market and notably low interest rates than any strength on the part of the office market.

Residential
The US economy has been on a slow slide and few feel ready to call the bottom. As if it isn't bad enough, the stock market is now down three years in a row, its worst performance since the start of World War II. Nonetheless, housing prices keep chugging along and in New York City, which has suffered significant blows to its major industry, housing prices have hit historic highs. Additionally, New York's prices are far and away higher than the rest of the country's. According to a recent paper that appeared in the Federal Reserve Bank of New York's Economic Policy Review, housing in New York City has risen greatly, relative to the rest of the country over the last 25 years. Of course, this needs to be understood in the light of New York as a global city. New York City is a veritable bargain when compared to Tokyo. According to a recent report by the Economist Intelligence Unit, the cost of living in New York is the greatest out of all North American cities but it ranks only #11 in the world.

Living in New York is still financially challenging for many residents. New York continues to have a foreclosure rate that is higher than the national average on account of our high prices, continued weakness in the job market, and well publicized incidents of fraud and predatory lending. Overall, the national foreclosure rate has stayed stubbornly high and while it showed signs of abating in the 3rd quarter, it has not turned around significantly.

Specifically, the price per square foot for Manhattan's condominiums reached a historic high at the end of the 3rd Quarter of 2002, and 9/11 appears to not have stopped the upward trend in prices. The first warning sign of a possible turn in this market will probably be a drop in sales volume. To date, we have not seen that and volume remains strong.

Measuring the price of condominiums instead of cooperatives is the best indicator of the health of the overall Manhattan owner-occupied residential market. The cooperative form of ownership plays less of a role in the Manhattan housing market than it used to. According to data compiled by the Real Estate Board of New York that came from the New York State Attorney General's office, in the period from 1997 to 2001, plans were filed to build 11,161 condominium units and only 1,408 cooperative units. For new construction, and by extension the future of Manhattan housing, the condominium is emerging as the preferred form of ownership.

One would expect that developers would produce much more housing in response to continued high prices and strong sales. As others have noted, it's not easy to build in New York City and so even as the market has remained strong, the filings with the Attorney General's office have remained low and the number of building permits issued for all housing, including rentals, has remained level. Manhattan developers are not overbuilding and this should cushion the market from severe price drops when the market does turn.

The other big issue concerning the rise in housing prices is the role of interest rates. While it has been noted that much of the rise in national housing prices has been on account of low interest rates, the average interest rate on a 30-year fixed-rate mortgage is now below 6 percent. It is unlikely that prices could be inflated any further by a drop in interest rates.

Conclusion
The next year will be tumultuous as the office market comes to terms with a glut of high-quality space and the residential market deals with potential price drops. The next installment will initiate coverage on both the retail and hotel markets. It will also follow up on changes in the office and residential markets and continue to provide charts of market indicators.