Will Uncertainty Cloud the Recovery?

While investment activity is still on pace to exceed the volume posted in 2010, a shaky economic recovery marked by anemic job creation and a sovereign debt crisis has given real estate investors reasons to pause.

While investment activity is still on pace to exceed the volume posted in 2010, a shaky economic recovery marked by anemic job creation and a sovereign debt crisis has given real estate investors reasons to pause. Moreover, dysfunction in Congress, pending changes in regulation and the rise of populist protests could affect long-term implications for commercial real estate.

Both Germany and the European Central Bank rejected calls to expand the bailout to include large-scale bond purchases, stating that the economic costs of any form of monetary financing of public debts and deficits outweigh its benefits and will not help to stabilize the current situation.

What began with a few hundred Occupy Wall Street protesters in Manhattan in September has spread to protesters in dozens of cities worldwide. Although the movement has stayed away from electoral politics—unlike The Tea Party movement, which has identified the government as culprit—its rhetoric has focused on the financial sector.

The pressure to deal with federal budget shortfalls has centered the debate around the proposed tax increase on carried interest. Carried interest is a share of profits in partnerships paid to the manager of the partnership (affecting mainly private equity and hedge funds). Currently, carried interest is taxed at 15 percent, equal to the capital gains rate. Many would like to see that raised to match the highest marginal income tax rate, currently 35 percent. A significant share of all investment partnerships are real-estate based. Carried interest is used to reward general partners for taking on the investment risk and liabilities. A tax change could increase the cost of producing new housing and cause capital to flow out of housing and commercial real estate markets.

Another concern with the deficit reduction is the continuing rise in property taxes. In New York City, one of the largest commercial real estate markets in the U.S., approximately 50 percent of the city’s revenue is generated by real estate taxes, water and sewer taxes, mortgage recording taxes and transfer taxes. The average property tax rate for Midtown office space is $25 per square foot. When operating costs of $10 to $15 per square foot are added to this amount, a property would need to achieve rents of nearly $50 per square foot to break even (this does not take into consideration debt service). On the residential side, property taxes for a typical mid-rise apartment building can be as high as 30 percent of the rental revenue.

Another area of uncertainty clouding the investment landscape is the tepid job creation. Unlike retail and office markets, the multifamily industry has benefited, to some extent, from the decline in homeownership and rise in foreclosures, but a persistently high unemployment rate will threaten long-term demand creation. Of particular concern is the 80-million-member Generation Y. According to the Bureau of Labor Statistics, there are now 3.3 million unemployed workers between the ages of 25 and 34, double the level from four years ago. Moreover, there are 2 million unemployed graduate students, triple the number from 2007.

In response to the uncertainty in the market, we have seen hundred-point swings in the Dow Jones Industrial and TED spread levels not seen since mid-2010 (the TED spread proxies for risk aversion). However, real estate capital markets, fueled by low U.S. Treasury yields, have continued to be a readily available source of capital for commercial real estate. Encouraged by record earnings, stronger balance sheets, lower loss provisions and improved credit quality, lending institutions are ready to lend. Only a continuing sluggish economy and weak credit demand will hold back loan production.