Real Estate Report 2007

A bubble’s destiny is to burst. Otherwise, it’s not a bubble. This year, however, the New York housing bubble—the ominously overinflated market that experts have been warning us about since the current run-up in housing prices began—has begun to seem more like a protective sphere. West of the Hudson, things are looking bleaker by the day: 180,000 homes fell into foreclosure nationwide in July alone, with up to eleven times that figure feared by the end of 2008. Sales of existing homes were down 17 percent in the second quarter; for the fourth quarter, Goldman Sachs forecasts a 15 percent nationwide price decline. “We’re in the worst housing recession in 40 years,” says Nouriel Roubini, professor of economics at NYU. “It’s an absolute disaster.” In our charmed city, meanwhile, the weather—for the moment, anyway—appears to be fine. In the second quarter, the price of an average New York apartment rose by 8 percent. The luxury sector went positively berserk, with four-plus-bedrooms in Manhattan going for 20 percent more than last year. And 15 Central Park West, “the new Dakota,” famously raised its prices nineteen times before finally selling every one of its 201 units for a combined, staggering $2 billion—including Sandy Weill’s $42.4 million penthouse.

The near-obscene disconnect raises the question: Is New York immune to the market forces presently shaving billions off home values in the rest of the country? Some say yes. A few years ago, economists Joseph Gyourko, Christopher Mayer, and Todd Sinai coined the phrase “superstar cities” and posited that some lucky areas—this metropolis very much included—are simply different, possessing the right combination of “inelastic supply” and near-bottomless demand to untether them from national trends. On the supply side, New York is geographically small and decidedly finite, and the red tape required to build here is staggering. (Gyourko has calculated that the inflated values created by artificial stifling of construction cost the average New York homeowner more than $7,500 a year—a de facto “preservation tax.” Others say that number may be closer to $10,000.) Even Michael Bloomberg and Dan Doctoroff’s pro-building agenda, which includes tax breaks for developers, aggressive rezoning, and a taste for neighborhood-altering megaprojects, hasn’t really done much to pump up inventory. Despite what our own eyes tell us (“I live in Tribeca and can count 40 separate construction projects in my neighborhood right now,” says Roubini), new construction is not adding nearly enough units to glut the market. Low crime, plentiful jobs, and the resurgence of big-city sex appeal, meanwhile, have led throngs of people to want to live here and, in a huge paradigm shift, stay even after they breed. To well-heeled newcomers, our enormous rents make our enormous mortgages a relatively sane proposition, and our international character, combined with the soft dollar, also make us one of the few American cities with a global buyer pool. “We have the Google effect,” says Brad Inman, the Berkeley, California–based publisher of the real-estate news service Inman News. “You got the Irish effect. They’re buying $10 million apartments!” (Inman is referring to upper-class Dubliners’ newfound longing for Manhattan pieds-à-terre, which is strong enough to have caused some developers to market whole high-rises exclusively to the Irish.) Brits, Japanese, Saudis, and other groups, of course, have all, at one time or another, developed mass crushes on New York as well.

All told, the city’s population is expected to grow by 200,000 in the next three years, and by half a million by 2020. It stands to reason that if enough “high-income superstar earners,” in Gyourko’s parlance, disproportionately file into New York and pay a premium for the privilege, home prices will continue to rise. As Gyourko’s colleague, Harvard professor Edward Glaeser, puts it, New York’s boom is “driven by the reinvention of the city as a center for idea creation in finance and a playground for the prosperous.”

But what if the prosperous stop prospering and don’t feel like playing? Though some experts believe that the current subprime-mortgage mess will be contained, it points directly to our Achilles’ heel: what Inman calls “the deadly marriage between New York City real estate and Wall Street.” Housing-wise, financial types are a dream demographic—they generate wealth for clients and snap up extravagant abodes for themselves—but it’s easy for the market to get addicted to yearly infusions of investment-bank bonus cash, and the withdrawal can be painful. After the 1987 stock-market crash, Manhattan median home prices plummeted by 26 percent. Should the current liquidity crisis spread, New York real estate could theoretically crash without a single subprime foreclosure in the five boroughs: Others’ grief could catch up to us via bad brokerage-house bets and the plummeting profits and pink slips that come with them.

There are other, wonkier, reasons to be afraid. If we look at the instruments economists use to take a market’s temperature, many point to an imminent bust. For one thing, we appear to be reaching the peak of a so-called Minsky cycle. In Hyman Minsky’s ingenious model of asset bubbles, economic stability breeds riskier and riskier investors: First come the “hedge borrowers,” who play with their own money; they are followed by “speculative borrowers,” who have enough cash flow to keep the lender at bay but not enough to cover the principal investment, and finally “Ponzi borrowers,” who are, as the name suggests, borrowing to refinance other debts they can’t meet, in the wild hope that the market will keep climbing. The Minsky model is remarkable for having been proved the way we like our economic models proved: recently, the hard way, and twice. We cycled through it in the eighties with junk bonds, and in the nineties with tech stocks. As it happens, the latter-day brownstone-flippers, financing each new property with the last one’s equity, are the dictionary definition of Ponzi borrowers. In fact, it’s almost unbelievable that the obvious junk-bond and dot-com analogies would ever pass us by. But such is the boom mentality. First you think the bust isn’t going to happen, then you think it’s not going to happen to you.

Another frightening omen: Glaeser has studied housing data from every metropolitan area in the country between 1980 and 2004. Based on his research, he has estimated that on average, for every dollar a city gains in prices over five years, it loses 32 cents over the next five years. It’s a simple and brutal equation. “New York City has had a great past five years,” he points out. “This bodes poorly for the future.” For someone who bought at the top of the market, seeing one-third of the value shaved off the purchase price is a potential disaster, especially if there’s a home-equity loan or second mortgage involved.

Scarier still, there are indications that the slump is already under way—there’s just too much of last year’s bonus cash coursing through the city, or so the theory goes, for us to notice. A closer look at the latest figures shows pockets of weakness. This summer, it was moneymaking Manhattan pulling up the stats for the rest of the city, with a few Brooklyn enclaves coming along for the ride. But Queens, the city’s leader in foreclosures (up by 92 percent this spring), and the rest of the boroughs went on a backslide that roughly mirrors the broader American slowdown. The wider the net, the worse the numbers: The S&P/Case-Shiller Home Price Index, for instance, which takes into account the entire metro area, shows a 3.4 percent year-over-year decline in New York since June 2006. The co-creator of the index, Yale professor Robert Shiller, has impeccable Cassandra credentials: He correctly predicted the tech-stock disaster in his 2000 book, Irrational Exuberance. Still, some economists argue that the index does not accurately reflect conditions in Manhattan because it includes parts of Connecticut, New Jersey, and Pennsylvania, and thus mixes co-op and condo data with single-family-home sales.

So, which is it? Irrational exuberance or irrational paranoia? Bubble or Biodome? We turned to some of the brightest minds in real-estate economics—Glaeser, Inman, Roubini, Tim Harford (author of The Undercover Economist), George Mason University’s Tyler Cowen, and founder Noah Rosenblatt—to come up with competing best-case and worst-case scenarios from now to 2010. Because economists are loath to utter concrete numerical predictions on the record, we mashed their guesses together; the results are composites of frequently divergent individual opinions and should be treated as such.

In this scenario, a full-fledged credit crunch rips through the system. The August employment figures, showing no growth for the first time in four years, are the beginning of a serious downward trend. The economy heads for a hard landing, and an all-out recession ensues.

2008: Consumer spending weakens nationwide, as the slackening economy, soft labor market, and progressively crunched financial markets create a vicious circle. By the beginning of the year, the economy enters a recession. The Fed has cut the federal-funds rate, but it’s too little, too late: In the wake of the bad-debt wave, there’s been a significant repricing of risk. As a result, safe government-bond yields fall while lending rates rise. About $1 trillion in adjustable-rate mortgages reset at a higher rate, including billions’ worth in New York. Subprime-related foreclosures are not a significant cause for worry—there are relatively few in New York—but those who can’t afford the new rates are beginning to sell at a loss. Meanwhile, the qualified-buyer pool is shrinking because jumbo loans are harder to get, even with good credit. Wall Street gets hit on three sides: Banks and brokerages cope with large losses, stock prices reflect the recession, and everyone sheds excess personnel. Smaller Christmas bonuses guarantee that the demand for four-plus-bedroom apartments won’t pull up the rest of the market. In addition, some of the younger banker types who bought in 2006 are now laid off and pondering selling. Inventory swells, and the price slide begins in earnest. “Pockets of distress” (former fast-flip frontiers such as Bed-Stuy and Crown Heights) lead the way down.
Correction: 5 percent.

2009: There is an insolvency crisis afoot as homeowners, mortgage lenders, home builders, financial institutions, and even some corporations go into debt distress. The economy is buckling under unserviced debt. The recession is the last nail in the coffin of the Republican majority; Democrats march into Washington, solidify control of both houses of Congress, and promptly raise taxes, which initially affects Wall Street negatively. In some pockets of the country, new homes lose up to 50 percent of their value. Here in New York, the ailing financial-sector labor market and ever-decreasing bonuses continue to chip away at the local pool of qualified buyers. Among those who can afford to live in New York, conservatism spreads. It is now common wisdom to sit tight and ride out the storm. Finally, toward the end of the year, rental prices come down, making renting, for the first time in a long while, an appealing alternative to homeownership. Subprime borrowers who are still hanging on, as well as arm recipients whose loans had reset in 2008, are seriously tempted to sell—at a loss if need be—and start renting. The city bids farewell to Bloomberg, now irrationally blamed for “too much new construction” as Greenpoint luxury condos stand half-empty or turn rental. The decline accelerates.
Correction: 18 percent.

2010: There’s a new mayor in town! Regardless of his political affiliation, Bloomberg’s tax breaks for developers remain in place, but new construction is limited by smaller developers’ reluctance to enter the fray. The 2007–8 credit crunch is still reverberating on Wall Street, depressing stocks. However, housing prices are now low enough that cautious buyers begin to think they’ve spotted the bottom of the market and start to get off the sidelines. There’s an uptick in the buy-side demand, especially from wealthy speculators, individuals thinking long term, and foreigners snapping up New York apartments at fire-sale prices. The U.S. economy recovers from the 2008–9 recession. Inventory tightens back up. We’re on our way to normalization.
Correction: 3 percent.

In this instance, the current liquidity problem is contained by the end of the year. Employment figures pick up in September. Global growth continues.

2008: The credit crunch is over. Hedge funds and corporations successfully isolate bad assets and cut losses, making up for the hit they took by paying lower taxes for 2007. Since there’s no need for more liquidity, the Fed keeps interest rates level after cutting them in late 2007. The new stability plays well on Wall Street, gains continue, and the wealth effect spreads into the housing market. Bonuses are a little off compared with 2006 but still enough to treat oneself to new digs. The inventory in Manhattan (down 32 percent since June 2006) stays tight, and the outer boroughs successfully absorb a smattering of foreclosures.
Appreciation: 2 percent.

2009: Despite the Bush administration’s attempts to take credit for the quick turnaround, Democrats win the presidency, primarily owing to the war in Iraq. One of the first economic measures taken is to assist subprime debtors through Fannie Mae, Freddie Mac, and various incentives to private agencies. Despite raising some taxes, the new administration preserves Bush’s cuts in capital-gains and carried-interest tax laws. Wall Street breathes a sigh of relief, and money once again flows into hedge funds. Higher borrowing rates are a drag on housing prices, but a strong job market offsets them. Later in the year, the relationship between the bond market and lending rates begins to normalize. As foreclosures taper off, the price of risk goes down. Lenders begin to loosen the standards they tightened two years ago, but with the lessons of 2007 firmly in mind. Renting remains an expensive proposition; ownership is still seen as preferable. More rental buildings go condo.
Appreciation: 4 percent.

2010: Continuing globalization bears fruit in the form of a stable and steadily growing U.S. economy. Salaries outpace inflation. Stocks chug along with low volatility, in a consistent upward spiral tempered by short, manageable corrections. Wall Street bonuses become dependable again. The Fed maintains the federal-funds rate between 5 and 6 percent. The new mayor continues Bloomberg’s policies regarding new construction and institutionalizes homeowner tax rebates. The population of New York has grown to 8.4 million, up 200,000 since 2007, and inventory can barely keep up. A stronger dollar stems the flow of international buyers, but since New York is trendier than ever, domestic demand picks up the slack. Apple-Google introduces a terabyte iPod.
Appreciation: 4 percent.

What will really happen to the New York housing market? The consensus among the experts interviewed for this story is that the third- and fourth-quarter figures of this year will begin to show New York feeling some of what the rest of the country is going through—call it a slow-leaking bubble. A couple of lean years will then be followed by a relatively quick return to normality. Exactly how quick remains a matter of debate, but the longer the view, the more sanguine everyone starts to sound. Inman, a short-term pessimist (“It’s going down. Everyone’s gonna suffer”), sees normalization by 2009; even the doom-and-gloom Roubini is bullish in the long run. Glaeser, who’s extensively researched California’s eighties and nineties boom-bust-boom cycle, offers this: “In a sense, one lesson of California is that those people who waited out the bust did fabulously well.” Given a ten-year horizon, he adds, “I would certainly continue to bet on New York.” People trying to play the market right now may be forgiven a less confident view.

A Look at Potential Buyers and Sellers
A Neighborhood Risk Analysis

Real Estate Report 2007