Market perspectives from the first quarter of 2008

At the end of the first quarter, prognosticators that see the glass as half empty may be pleasantly surprised by the tenacity of the N.Y. real estate investor and developer who continue to execute sound deals. Of concern is the market liquidity and thus, the credit risk. Naturally, balance sheet lenders can ameliorate some of this credit risk by vetting borrowers carefully. The bigger problem is that the banks are worried not only about their exposure, but of their rival's exposure. As one banker, recently said, "When analyzing a submarket of N.Y.C., I am not so concerned about how we analyze deals and how our lending committee analyzes the transaction, as I am about how the deals being underwritten by my competitors and what effect, in the third or forth quarter these loans banks underwrote and made will have on the overall conditions of sale of the real estate assets in that marketplace." This author believes that on a local level the market will not be as strained due to restraint and lessons learned over the last down cycle. One indication is that commercial mortgage-backed securities are down about 6% since last fiscal year, yet commercial mortgage-backed securities are scheduled to gain momentum to as much as $8 billion by the end of the first quarter. However, the momentum of this cycle is still in its infancy. If January was a harbinger of what is to come-not one commercial mortgage backed security was sold-the first CMBS deal was completed the second week of February and came with the benchmark 10 year, 27% subordination bonds priced at swaps plus 235, nearly 200 basis points wider then similar rated bonds pricing one year past. The point is, the market has many conflicting facts to be analyzed and contemplated. The issue becomes how to price into the market the soaring perceptions of risk-to buy real estate now or wait? On a micro basis, deals in downtown Brooklyn, one market that Troutbrook continues to develop in, deals that were trading several quarters ago in "A and B locations" are transactions that are being completed with single digit discounts, or low double digits discounts on pricing. Tertiary locations are being discounted by as much as 20% from one year ago. Development in this city is usually a 2-4 year process, if not longer, therefore at various stages of the economic cycle it often takes a steely appetite for risk and equity to get through said cycles. As an example, areas around the Gowanus neighborhood of Brooklyn is one area in transformation. Only several years ago, this area was a locale of primarily industrial and commercial buildings. A recently traded Comfort Inn hotel with 106 keys sold for $22 million. In the past month 80,000 s/f of land at Third and Douglas closed for about $130 per FAR buildable with an investor entertaining the prospects of retail development. Because the development process in NYC is more time-consuming than other parts of the country, developers who are seeking higher returns must take on added market risk. Development deal pricing in the coming year for retail, hotel, residential or office will take on a different matrix of caution at the underwriting stage. Deals of a certain scale will continue to attract great bidding interest if they are in locales where the bidder can perceive a change in future valuation due to either the development itself, or the acquisition being priced at a discount. While we can never know how the future will unfold, real estate is by nature a cyclical asset class, and though there might be shocks to the asset valuation in the short term, and decreases in cash flow, preservation and the intrinsic value of real estate in NYC (and the country) will not decline over the long run due to a number of factors including a decline in the volatility of inflation rate and a a more neutral structural nature of the capital market that should prove to be a lasting phenomenon. Marc Freud is the principal at the Troutbrook Co., New York, N.Y.