The Bulls Versus the Bears (Part 4)

This week, we conclude our discussion of the divergent perspectives of the optimists and the pessimists.11) Cap Rates: Going into this down-cycle, it was expected that cap rates would rise significantly as significant levels of distress were evident in the marketplace. Cap rates had risen anywhere from a low on some product types of 50 to 75 basis points, up to as much as 250 to 300 basis points on others. It appears that, given the constrained supply of available assets and the significant demand chasing those assets, there is presently downward pressure on cap rates as they have not risen nearly as much as had been expected. Is this a temporary phenomenon or does this mark the beginning of a recovery? As usual, it depends upon your perspective.The Bulls: The bulls believe that we have passed the bottom in terms of a high cap rate environment and that cap rates will continue to stay, essentially, where they are or go down slightly as the significant amounts of capital on the sidelines rush in to create significant demand for properties. They believe that the recovery is upon us and that value is rising. They point to the lack of suitable alternative investments and the low yields available on cash and cash like assets which provides motivation to own real estate yielding modest (by historical standards) returns.The Bears: The bears believe that, while they have appeared to have plateaued, cap rates have only done so because of the acute supply / demand imbalance that the market is currently experiencing. They believe that when distressed assets come to the marketplace in the numbers that actually exist, the supply will be increased significantly, placing significant upward pressure on cap rates. The bears believe that with interest rates rising, cap rates will rise accordingly and that, if history repeats itself, a period of positive leverage will return to the market.12) Supply and Demand: We have frequently referenced the significant imbalance between supply and demand in today’s investment sales market. The supply of available properties for sale is normally fed by discretionary sellers who decide that, for whatever reason, now is the time to sell their property. As value falls, as we have seen during this downturn, discretionary sellers withdraw from the market. The supply of available properties then typical gets fed by distressed sellers.Everything that has happened from a regulatory perspective has allowed many distressed sellers the ability to not have to address their problems. Changes in mark-to-market accounting rules, bank regulators allowing loans to be held on balance sheets at par even though the lenders know the collateral is worth less and modifications to the REMIC guidelines, which address how CMBS loans are dealt with, have allowed lenders and servicers to kick, the proverbial, can down the street.This has led to a sharply constrained supply and, with significant demand in the marketplace, there are far more buyers than there are properties available for sale. Demand has been seen from many sectors. These include: 1) high net worth individuals, 2) families that have been investing in various markets for decades, 3) institutional capital which was sidelined after the credit crisis started to be felt in the summer in 2007 is now back with distressed asset buying funds and opportunity funds and, 4) foreign investors have come into the marketplace in numbers not seen since the mid 1980′s.The Bulls: The bulls believe that demand is so significant that it has the ability to absorb even a significant increase in the supply of available properties for sale. They believe that we are past the bottom and that upward pressure on pricing significantly exceeds downward pressure. They feel that the downward pressure on cap rates and the resulting upward pressure on values is not based simply on a supply / demand imbalance at a relatively short period in time, but a fundamental shift in investor perspective. While they believe this imbalance has exacerbated market conditions, they believe the imbalance is given too much credit for present conditions.The Bears: The bears believe that the supply of distressed assets will eventually create an abundance of properties for sale which will drive prices lower as investors have significantly more options and competition for existing availabilities gets diffused.  They believe the supply / demand imbalance is the primary cause of today’s value levels and that supply can only rise from here. They point to tremendous pent-up demand on the sell side as many discretionary sellers who may have wanted to sell have delayed these decisions based upon soft market conditions. As time goes on, these sellers will decide they no longer will delay their action and many of these properties will come to market. Additionally, the number of distressed assets hitting the market have been minuscule compared to those that exist in the market and this condition will change. As supply increases, downward pressure will be exerted on value.        13) The Recovery:  The question here is whether the economic recovery is tangible and sustainable or has unprecedented levels of government intervention propped up the market resulting in seemingly unnatural bottoms being achieved.The Bulls:  The bulls believe that the worst is behind us, inflation is not a concern, employment will begin to pick up and bank balance sheets are not in as much trouble as everyone thought. The bulls see fundamentals getting healthier. They believe that the stock market is a proxy for this recovery and that there is nothing but blue skies ahead.The Bears: The bears believe that we are sitting in the eye of a hurricane. They believe all is calm which is providing a false sense of security about our being out of the tough times. They are quick to point out the massive need for refinancing and the still nowhere-to-be-found CMBS market. The bears are very concerned about rising interest rates and what they may do to the market moving forward.Many of you have sent me emails stating that the issue is not really about the bulls and the bears but rather about the realists and those who cannot see things clearly. While I agree that realism is important, interpretation of statistics is based upon one’s psychology and one’s perspective. Whether a glass is half-full or half-empty is dependent upon perspective and interpretation.As far as the bulls versus the bears go, time will tell who is correct. Until then, all we can do is take things one day at a time and do the best we can.Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having a market value in excess of $6.2 billion.