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Riding the Wave of a Rebounding Economy: Secrets of the Expert Advisors

Over 150 corporate executives, real estate developers and design professionals attended "Riding the Wave of a Rebounding Economy: Secrets of the Expert Advisors," an executive seminar co-sponsored by Ernst & Young LLP, North Fork Bank, DSL.net and BBL&A on March 16, 2004 at the University Club in midtown Manhattan. Barry LePatner moderated a distinguished panel that included:

Click any of the above names to go directly to their presentations. A recording of the event on CD is available for purchase. Contact Brad Cronk for more information.

 

Barry B. LePatner, Esq.
Founder and partner of Barry B. LePatner & Associates LLP

As economists and politicians have come to learn, the past few years have confronted us with a fascinating one-of-a-kind national economy. Over the past three years our nation has seen a federal budget surplus of $237 billion disappear until today, we face a budget deficit that continues to grow dramatically. What has buoyed our economy, as never before, is consumer spending.

Although many corporations report healthy profits, in large numbers these profits are not the result of successful operations. To the contrary, many companies report that substantial percentages of their profits are being derived from currency fluctuations as they increasingly derive more and more of their profits from business overseas.

As we now move beyond the recent recession, many corporations, investors and real estate developers are awash in cash waiting for new opportunities to arise; yet, it is the consumer that is keeping our economy afloat. From Walmart to Macy's to luxury goods purveyors such as Asprey and Gucci consumer goods at all levels are selling well. And while new housing construction remains at or near all-time highs, job recovery lags terribly. During the strong economy of the 90's the United States saw new jobs increase by 23 million - at a rate that regularly increased by 300,000 new jobs a month. Yet, today's job growth is 21,000 a month - a loss of 2.3 million jobs in the past three years. So it is that economists and politicians alike are thankful for the fact that the consumer has accounted for more than two-thirds of all spending in this country.

The yin-yang, good news/bad news of where we are in this election year looks like this.

The negatives include:

  • A federal budget deficit of $530 billion (not including costs for the Iraqi rebuilding effort);
  • Low interest rates that will undoubtedly rise after the November elections;
  • A trade deficit of about $400 billion that has seriously lowered the value of the dollar against other currencies; and
  • A jobless recovery and a 6.2% unemployment rate with little change in sight.

From a positive standpoint:

  • There is little inflation for us to deal with;
  • Low interest rates continue to provide incentives for new real estate investment;
  • A rebirth in the technology sector after three consecutive years of sub par performance;
  • A stock market rally of the past year that is likely to continue; and
  • Productivity gains that are very strong averaging since 1965, about 2% a year with a projected jump of 6% for the coming year.

In the real estate and construction markets there will be pockets of positive signs overall even as new housing construction muddles along for the next year or two. If you speak to hotel executives they will point to encouraging signs while mumbling that there is a long way to go. New hotel construction still frightens most companies although Hilton Hotels expects to add 100 to 115 hotels to its portfolio in the next year. Wall Street, institutional and private investor money is ready to flood the market by purchasing existing hotels at what is perceived to be the bottom of the current market.

Dick Anderson will address us in a while on the New York Metropolitan Construction Market which totals approximately $15 billion a year. On the national level, 2003 construction contracts of $505 billion are projected to increase 1% in 2004 to $509 billion. Interest rates for fixed mortgages according to the National Association of Home Builders will rise to 6.2% this year up from 5.8% and likely climb to 6.7% in 2005. As a result, single family housing starts will drop by 4.9% in 2004 from a record year in 2003.

From the standpoint of new hot areas where our city and region will grow and develop let me cite what I believe will truly be the future. Without doubt, the most valuable and underdeveloped arena in the New York metropolitan area is our 532 miles of coastline property. City and regional planners of yore badly missed the mark when they dedicated waterfronts throughout Manhattan, Brooklyn, Queens and New Jersey with myriad roadways and railroad track. Fortunately, today the recognition of these under-resourced areas is being seen for what it is: the opportunity to recapture a prize for our region that will make the metropolitan area even more attractive and financially sound in the decades to come.

Three recent examples of this type of development with which my firm has been involved include:

  • a $400 million development of the Silvercup Studios property in Long Island City adjacent to the Queensboro Bridge. Currently in design to proceed through ULURP, this project will include new housing, commercial properties and neighborhood-enhancing amenities;
  • Jersey City rejuvenation led by Goldman Sachs' new tower, the Liberty Science Center and new housing projects along the shoreline; and
  • A little known project of great significance is the New York City Economic Development Corporation's recent retention of two world class architectural firms: Richard Rogers Partners and SHoP/Sharples Holden Pasquarelli to prepare joint concept studies for the redevelopment of the East River shore front from the Battery to 14th Street.

As projects such as these move forward during the decade ahead, our city and region will certainly retain its luster as a world class destination for visitors and business people from around the globe. And the citizens of New York and the surrounding areas will enjoy greater amenities as well as positive growth that will address our existing shortage of housing. All of this will offer enormous opportunities to many of you who are here from the real estate, design and construction communities.

 

Introduction of Dr. Irwin Kellner by Barry LePatner:

Our first speaker this morning is an expert that most of us recognize immediately as the chief economist and the early morning on-the-air commentator for CBS Marketwatch.

As someone who gets a chance to take a lot of ribbing for being a lawyer, which means I hear a lot of lawyer jokes, I think it's OK for me to tell you a little story here. A woman went to her doctor and found out unfortunately that she had only six months to live. So she said; "Doctor, is there anything I can do"? The doctor said, "Yes, you can move to South Dakota and marry an economist". She said; "Will that cure me"? He said; "No, but it'll sure make those six months seem much longer".

If you happened to miss his TV segments on CBS each morning you might wisely consider becoming an avid reader as I am of his commentaries on the CBS Market Watch web-site. Dr. Irwin Kellner truly is one the most trusted and knowledgeable economic forecasters in our nation and he holds the Augustus B. Weller Distinguished Chair of Economics at Hofstra University. Dr. Kellner is also Chief Economist for North Fork Bank Corporation, one of today's seminar sponsors. I had a preview of Irwin's presentation today and I promise that it will be enlightening, packed with news that we can use, and perhaps even a bit startling. I personally have known Irwin for many years, and at times I wonder if he might be more aptly described as a CEO, 'Chief Economic Oracle'. Please welcome Dr. Irwin Kellner.

 

Dr. Irwin Kellner,
Chair of Economics at Hofstra University and Chief Economist for North Fork Bank and CBS Marketwatch

Thank you very much Barry, notwithstanding the economist joke. Barry wanted me to give you an optimistic talk this morning. So, I am an optimist, and I'll give you my definition of an optimist as somebody who falls off the tenth-floor of an office building and as he passes the fifth floor he says, "So far so good".

The economy and real estate are very much intertwined, no more so then here in NYC. So let me give you the broad economic overview to set the stage and tie it in to real estate as I see it from the top down. You've got the specialists here that can give you the much greater detail then I can give you. Right now, economic growth is just fine, but the question is how much longer can it last? There is no secret as to why the economy is growing as rapidly as it is. Economic policy is very stimulative. All three levers of policy that the government has at its disposal are in the wide-open throttle position. Interest rates, as you know are at 46 year lows when it comes to short-term overnight rates, and long-term rates are down quite significantly as well. By accident or design the Bush administration has cut taxes three times in three years, and don't overlook the possibility of another tax adjustment in this key presidential election year. At the same time government spending is soaring. So we have a lot of push from monetary policy as well as from fiscal policy and in the foreign exchange markets, so crucial to many companies especially those domiciled here. The dollar has weakened and the administration, while never owning up to the fact that they would like to see it go down, is certainly not doing anything to discourage people from selling the dollar. That of course helps our beleaguered manufacturing sector by making our goods more competitive and foreign goods more expensive.

This year's outlook is pretty good so far. Temporary tax breaks embodied in the last cutback in 2003 are boosting capital spending. In the old days when we talked about capital spending we talked about spending on plant and equipment, that was capital spending. Today with so many square feet vacant, with so much manufacturing activity being moved abroad, the capital spending is mostly equipment and not physical plant. As a matter of fact, if you take a look at business spending on construction - and I am not talking about residential construction but factories, office buildings, shopping centers, warehouses, hotels and the like - in real terms it is no higher today then 25 years ago. All of the surge in capital spending is on equipment, and this is good news/bad news. The good news is it is making business much more productive. The bad news is it is coming at the expense of jobs, and a lot of this equipment - as you can tell from the Blackberries, cell phones and the computers that you carry around with you - is not made in the US, it's made elsewhere.

The low interest rates that I referred to a few moments ago are supporting very strongly the real estate market, both commercial as well as residential. Corporate profits are being bolstered by efficiencies. All this investment in technology that is taking place and that has taken place in the 1990's has gone for the most part to the bottom line. In the old days, when workers were more productive their living standards went up because their employers could pay them more, not have to charge more, and the net result was an increase in real buying power which propelled the economy forward. But in recent years, this increase in efficiency has gone mostly to the bottom line. Corporate profits are up quite sharply and that is one of the problem issues. Right now many companies complain they have no pricing power. This of course excludes health care and energy and isolated areas in food. For the most part companies have to hold down prices because of foreign competition. That being the case, with all the money that is flooding through the economy which has been keeping interest rates low, there are a number of people who are expressing the opinion that the days of no inflation and no pricing power may soon be behind us. Even China, which has been accused of exporting deflation to the U.S. and other countries by keeping currency artificially low is at the same time generating inflation because of its voracious appetite for raw materials. Scrap metal prices are going up because China needs all of that to use as input to produce the products that they send to the U.S. and other countries. The dollar has indeed helped the manufacturing sector and will most likely trend lower. Ironically, efforts by China to peg its currency to the dollar and by Japan to kind of keep its currency from going up too much against the dollar is helping to keep long term interest rates down because they are doing this by buying long term treasuries.

The stock market has sold off in the last few weeks, not at all surprising in view of the sharp run-up that occurred last year and from the low point back in October of '02. Depending upon which index you look at, the market is up anywhere from 25 - 40%. I think the market is going to tread water for a while to wait for profits to catch up.

The real dark cloud on the horizon is the job situation. We are down 2 ½ million jobs from the peak back in early '01. If anything like this continues over the balance of the year, President Bush will be the first President since Herbert Hoover to preside over a net loss of jobs. He's trying his best to try to pump up jobs, but it's not all that easy. Companies are apparently reluctant to hire, they are not sure that demand for their goods and services is going to last, they are concerned about competition from abroad and where a warm body is necessary, technology is allowing more and more jobs to be outsourced. There is some controversy as to what extent outsourcing is responsible for our job problem. Just yesterday in one of the newspapers there was a report from the Federal Government suggesting that we have actually benefited more than been hurt, because although a number of our jobs have been outsourced, a number of other countries are outsourcing their jobs to the U.S. Go tell that to the computer programmer who has a PhD and hasn't been able to find a job for two years.

Outsourcing has been a way of life for decades, but up until recently it has been the blue-collar manufacturing types that have been subject to this. More recently it's the white-collar PhD's, highly educated folks who are losing their jobs, and every time I write a piece for Market Watch on that subject, I get tons of e-mail. The depth of resentment out there towards jobs being migrated overseas is nothing short of amazing. USA Today had an article the other day on how a number of companies are now waving the flag and they are saying, "We are keeping our jobs in the USA. We are manufacturing our goods in the USA." There are even websites that have sprung up where you can check and see not only what industries, but what companies have outsourced and what industries and what companies have kept their jobs in the USA. I don't know if this is going to catch on, but it certainly is a trend worth noting and it gives you an idea of the feelings people have towards this issue which is obviously the major issue in the presidential campaign. Many people have been out of work for so long they've lost their jobless benefits. As a matter of fact, the percentage of the unemployed, better considered long-term unemployed, i.e.: half a year or more, is now the greatest since 1984. Which in turn was the largest since the end of World War II and a fifth of the unemployed are college graduates and white-collar workers, and that's a record level.

Now, because consumer spending is 2/3rd of the economy and because spending growth has exceeded income growth - not surprising in the view of the paucity in the job creation - people have turned to debt, and borrowing is a way of life for more and more people. Today the average household's debt, which includes credit card, automobile loans, department store charges, and mortgage debt, is now equal to 110% of annual incomes. 10 years ago it was 85% and 20 years ago it was 65%. Back in the early '50's, which is the earliest for which we have data, this ratio of total debt to incomes was only 30%.

I was interested to read in today's New York Times that Alan Greenspan, all of a sudden isn't worried about debt. Well, I think he's a little bit misplaced on that as he is on a couple of other issues like social security, but suffice it to say that almost half the debt that people are taking on is related to a short-term or an adjustable interest rate. This ties the Fed's hands, because if the Fed raises interest rates, then the cost of servicing this will obviously go up and will call into question people's ability to handle their debt. And if that's the case people will cut back their spending, companies will cut back their jobs even more, and the next thing you know, the economic expansion becomes at risk.

I think that policy will continue to remain stimulative. Don't overlook the possibility that in a desperate effort to create some jobs the administration will cut taxes, perhaps this time on the folks who are more likely to spend it, the lower and middle income people. The Federal Reserve will not raise interest rates anytime soon. The Federal Reserve's Open Market Committee is meeting today and they are not going to raise interest rates. They may change their policy statement a little bit, but right now nobody in the markets is expecting the Fed to do anything.

Let me just quickly tie the big picture to real estate and then leave it to my colleagues to pick up from there. In spite of 9-11 there is still a fair amount of excess office space. This is because of the cutbacks that were made earlier by Wall Street, the ongoing downsizing by corporate America, not to mention out-sourcing.

Technology is a factor, too. When I started out working many years ago the average office worker needed about 400 square feet of space. Today, thanks to smaller computers and workstations and the like it's more like 250, at the most 300 square feet of space and that of course means extra space. Vacancy rates are high, sublets are growing and rents are still on the weak side. But on the other side of the picture the demand to buy these properties as opposed to rent is fairly strong. There's a lot of investment money out there looking to buy Class A trophy properties with tenants with long-lasting leases. This is because notwithstanding the rise in the market a lot of institutional investors would like to diversify yet they remain wary of stocks. Bond yields, great for borrowers but not so great for investors are very low. But companies that are looking to buy want low vacancies and long leases. They are using these low interest rates to help finance acquisitions. The types of properties that we see in strongest demand, in no particular order, would be those can be developed into or are already such facilities as: hospitals; doctors' offices; assisted living; gated communities… am I giving away my age here? Education, educational facilities, tax centers, bank branches, back office redundancies for financials, high-end retailers, these are the kind of properties that are in greatest demand now. Also conversions from industrial to residential space for sale, as co-ops or condominiums. Again, the rental market on the residential side is relatively weak but on the buy-side for co-ops and condos relatively strong.

The hotel market has, as you know, suffered from the post 9-11 drop in tourism and my guess is that the attacks in Spain the other day and the rumors linking them to al-Qaida will not do anything positive for future growth in the hotel market over the near term. So let me conclude by saying that in terms of the big picture, the US economy is growing nicely but that's because policy-makers have pulled out all stops to push the economy ahead. But you can't run an economy without workers and unless job creation picks up soon all the debts that people have taken on, that have been used in lieu of income to spend and support the economy, will soon come back to haunt them and this economic recovery's days could very well be numbered. So, let's keep our fingers crossed and hope that job creation picks up at a much better rate then we have seen over the last couple of years. Thank you.

 

Introduction of Richard T. Anderson by Barry LePatner:

Irwin did me a favor, he was going to announce that stocks were going to rise 35% today but, I told him that nobody would stay for the rest of the speakers, so, thank you Irwin.

Our next speaker this morning is to my mind and to many others in New York City a living legend. Dick Anderson is one of the nation's foremost urban planners. Today he is President of the New York Building Congress, a position he has held for the past decade. Prior to the Building Congress, he served as Executive Director of the Dallas Plan, a non-profit group formed to prepare a long-range capital improvement strategy for that city. And as President of the Regional Plan Association, Dick served admirably as head of the nation's oldest metropolitan planning organization. Dick Anderson is also a nationally recognized association executive, he is an advocate of effective infrastructure and economic development, and has been very strong and prominent in promoting the long-term growth of America's urban centers, and most fortunately for us, New York City, over the last 10 years. In 2001 he received the prestigious George S. Lewis Award for the NY Chapter of the American Institute of Architects. Please welcome my friend Richard Anderson.

Richard T. Anderson,
President New York Building Congress

Thanks very much Barry, and good morning everybody.

I'd like to shift from the big picture that Irwin and Barry talked about to the five boroughs of NYC. In the past couple of years we have enjoyed 'banner growth'. The economy for construction design and real estate activity was really quite strong, with one exception, in the office sector. But the series that we began just four years ago 'NYC Construction Outlook' has been a very important product for the NY Building Congress. We tried to take a look three years out at where the five borough construction market is headed. And since 2001 we have been doing quite well, in fact we've been doing much better than other sectors of the economy. Nearly 17 billion dollars was spent on residential, non-residential and infrastructure projects in 2003 and that's actual construction activity. The housing market, I think Barry said we were muddling along, I think we are doing a lot better than that. I remember 10 years ago we were happy with 4,000 units in the five boroughs. We are at almost 21,000 units and are expected to stay above that over the next few years, and that's largely because of the lower interest rate environment. If interest rates stay moderate, and demand we know in the five boroughs is quite strong, we should still have a strong residential market. The office market has been strong. We added 5 million square feet of office space in 2003, the third successive year of major office construction. But the outlook right now is not strong.

A real source of strength in the 5 boroughs has been infrastructure. This has been the NYC Capital Budget, the Metropolitan Transportation Authority capital program, The Port Authority, the State University, the City University, the State Department of Transportation, the Dormitory Authority and more. This has been about half of all construction activity. It was up again in 2003. If you look at construction spending over the past decade you can see the trend-line is definitely up. The construction market in the mid-1990s was almost depression-like in the City of NY. And it continued on a steady upward spiral to 2003 which has been the highest level we've seen in a generation. Our forecast is that it will continue to be strong over the next 3 years, slipping a little bit in 2004-2005 and then growing again in 2006, and the rest of the decade could be sources of enormous growth if a lot of projects and infrastructure activity are going forward.

Now looking at the various components of the market: I mentioned the strength in the residential market; 20,800 units in 2003. This is enormous by historical comparison. We have not built 21,000 units in the city of NY since the 1960s. Now the downside is we need 20,000 units roughly to stand still, just to replace units that are lost in the normal market cycle. So we are not really investing residentially at least for enormous activity going forward, but at least we are not losing out like we were year after year, in past years.

The non-residential area: after peaking at over 21 million square feet in 2001 non-residential construction fell to 15 million square feet in 2002. This was in response to the events of September 11th, 2001. The real pullback in office construction, which is the main part of the non-residential area - two things happened - there was a real downsizing of office activities but also there was a dispersal. A lot of office activities that were in the city of NY moved, such as Goldman Sachs, Jersey City. Jersey City got a lot of growth, as did Westchester, Long Island and New Jersey. So we not only lost jobs through downsizing in the city, we lost through decentralization. A big question going forward is whether and how much the city will recover on that. We expect modest growth to about 17 million square feet in 2003 once we see the final numbers, followed by a real decline in 2005 and then the rebound in 2006. In fact, in the office area right now you can count the major office projects on the fingers of one hand. We've got the Bank of America building for Durst that's underway; the Hearst building; the New York Times we hope will be underway; Number 7 World Trade Center; and of course the Liberty Tower. But after that there's not much office construction in NYC.

Institutionally, we have been doing very well. Public spending underwrites most of this activity and between 2004 and 2006 we see some shifting in the components of institutional activity. But it should remain strong as universities, medical facilities, and courthouses go forward. School construction continues to be strong in the NYC Dept. of Education, although there has been some cutback in the last year or so. The NYC capital budget will decline moderately in the next few years. There's real pressure on debt service for the city, but the MTA and the Port Authority are the question marks. I think the Port Authority will stay strong. The MTA will not have the huge increase in its next 5 year capital program that it had 4 ½ years ago. There's real pressure on the MTA and state government for there are no readily available sources of money to turn to for the next capital program. The federal government certainly will not pick up the slack. So one of the things we need to do as an industry is to get behind and support the MTA in its next capital program.

The construction employment forecast is really quite strong. If you're looking for a job engine for the city compared to other sectors of the economy construction employment looks good. The steady increase in jobs has been apparent for the last decade and we expect that to continue. In fact, in 2006 we could hit 125,000 jobs and that's reported jobs. In construction there are a lot of jobs that go unreported and they are above that 125,000 figure. The outlook for construction spending: in 2004 we think it is about 15 billion dollars down 10% from 2003, followed by about $14.6 billion in 2005. The big question mark is, of course, the insurance proceeds that Larry Silverstein receives and what the market is downtown. We could reach close to 16 billion in 2006 and continue up from there. But much depends on the infrastructure contribution where the public agencies get their money, because when we have a 15 billion dollar annual infrastructure program in NYC it is shared between city, state, and federal agencies and less than half of it is the city's capital budget. Much more than half is state agencies, particularly the MTA. But this 15 billion dollar program, which of course no single person or level of government is in charge of, really drives our construction economy to a great extent.

With all the reliance we have on infrastructure for the construction market itself to under-gird the economy as a whole, now is the time for us to turn even more to dedicated infrastructure funding. We have dedicated money through the water board for the Water and Sewer Program of the Dept. of Environmental Protection. We don't have much dedicated money for other kinds of infrastructure and we rely on contributions from different levels of government; for transportation in particular. Also, it is very important that the Bloomburg Administration's programs for the far West Side and for Lower Manhattan come to fruition. We need those areas as the growth centers going forward for the city's economy. I think it is time to consider a stimulus for the office market. The demand-side I think would be enhanced if we could bring down some of the costs of office construction. Different programs to lessen property tax, provide property tax relief and other incentives for the office market might be timely partly because our industry is so much subject to the business cycle. We lose people in droves when we have a very difficult time and then when boom times come we don't have skilled people available to staff the needs of the future economy.

Barry, I thank you for the opportunity to address this group. Many of you I know are members of the Building Congress. You'll have your next edition of 'Outlook' in a few weeks. Thank you.

 

Introduction of Kenneth Krasnow by Barry LePatner:

Thank you Dick, as always a wonderful insightful perspective on our local city capital and construction needs.

Our next speaker this morning leads a virtual army of 180 commercial real estate brokers, who generate 200 million dollars of revenue per year for Cushman & Wakefield. As Senior Managing Director for the NY Metropolitan Region, Kenneth Krasnow has his finger on the pulse of the region's real estate market. I dare say he has achieved this rather lofty position because he has an uncanny ability to think years ahead of the real estate business cycle. Those of us here today should make careful notes of Ken's insightful observations. He'll be sharing with you this morning his trend spotting prowess and from there I'm confident you'll be able to translate this information into manners that will be specifically helpful to you in your own business initiatives. He was recently named one of Real Estate New York magazine's "40 Under 40" and is one of Real Estate Forum magazine's roster of the next great real estate leaders. I am pleased to introduce as our speaker this morning, Kenneth Krasnow.

Kenneth M. Krasnow,
Senior Managing Director, New York Metro Region, Cushman & Wakefield

Thank you Barry. No pressure…(laughs)

Dr Kellner and Dick Anderson talked to you a little about the top-down perspective of the market and the economy and how construction and the overall macro-economy effect the real estate market. I'm here to express the 'bottom up' view from the street: what our clients and our companies are saying, what they are doing; what they are looking for, and where they are thinking. A few highlights in terms of 2003 and where we stand in 2004. We've started off 2004 pretty strongly. I think it mirrors what we saw in 2003. A few themes you'll see in my remarks today: signs of stability, signs of improved confidence. Our overall vacancy rate has remained relatively steady for the last 3 quarters of 2003 and really up only slightly from where it was at the end of 2002. This was a marked difference from the move made from '01 through '02 where the vacancy rate had a dramatic increase. Two big trends that we saw in the last 12 months were the decline in the sub-lease space market and the increase in renewal activity. We've also seen some new industries take a lead position in this city historically reliant on the financial services industry. A lot of activity in the law firms and legal services industry and regional firms from outside of NY looking to expand their presence here in NY, similar to some of what you see in the regional banking community. Dr. Kellner talked about the investment market, I'm going to touch on that, but clearly there has been a tremendous amount of capital infused into the real estate market, and record pricing, and I'll talk about who's been doing the buying in 2003.

Everybody's talking about jobs - that's all we seem to talk about today - and this chart gives you a little perspective about how the occupancy rate or vacancy rate mirrors the amount of people that are employed in the office sector in Manhattan. In the low 1990s, for example in 1992 we had a vacancy rate of about 18%. This was probably the low point in the city, even coming out of this latest downturn our vacancy rate is now about 12 ½ %. We are starting to mirror our recovery out of the last recession. You'll see some trends about how we are really mirroring the exiting of the last recession in the 1995-97 period. You'll see significant improvement from exiting that recovery and exiting this one, as I mentioned, vacancy rates at 12 ½%. If you notice the trend-line, historically vacancy rates have followed the 'direct space', space that is directly available by landlords. The big dispersion that we have seen in the last 2 years has been the amount of sublease space. Again, at the end of the '96-'97 time period sublease space was not a factor at all in the market, it's comparable to where we are today. But now sublease space is twice what it was back in that period and you'll see the spread between the vacancy rate and the space that the landlords have to rent today. Landlords are in what we would consider to be an equilibrium stage, a relatively healthy state. The market perceptions, weaknesses, etc. have existed in the sublease space market, and here's where you can see why. We are in historical levels in terms of sublease space, a lot of the excesses of corporations' boom in the late '90s, early 2000 resulted in a tremendous amount of space being brought back to the market, record levels in 2002. The good news here is that you've started to see dramatic declines in the amount of sublease space as a percentage of the market. This is not your typical sublease space from years back, this is well built space, well capitalized space, Class A assets that were built by Goldman Sachs and other companies of that ilk. So, very attractive space for the corporations that are in the market for it today. I think we are going to see that number probably go down to slightly under 20% by the end of 2004 as the pace of activity continues in that market. Rents generally speaking on a Class A basis as they start to stabilize have stabilized at levels historically above where we exited the last recovery. Right now your Class A rent is stabilizing at around $50 per square foot. When we exited the last recovery they were stabilizing in the low to mid $30s. We've had a significant price appreciation, even though we've come down they've stabilized at much higher levels than they ever have before.

Leasing activity: Companies have been active the last couple of years - this is new leasing activity - the difference is that this doesn't account for renewal activity. There is a tremendous amount of renewal activity in the market. New leasing activity has been pretty consistent the last couple of years, around 20 million square feet. But of the major leases that were completed in 2003, 6 out of the 10 were renewals. That's the sign of confidence, that's the sign of a company who is looking at the future and who is saying "I'm ready to make a commitment, I believe the market has bottomed out, I'm ready to look to the future and increase my commitment to my building, my space, my people, the city." Also interesting, only one of these top 10 is in the financial services sector, that's again something we haven't seen in this city for a long time. Six of the top ten drilled down a little further, twenty-eight of the top fifty were renewals.

That's not reflected in the new leasing activity. Midtown, where we've stabilized in 2003-2004 is in that high $40 per square foot range in terms of asking rents, and this is overall in Midtown. Our forecast is that we are going to have a relatively stable 2004. We are tied to job growth as much as anybody. I don't think we are going to have any significant price appreciation unless we start to some appreciable job growth. Our economist friends keep talking and every 6 months it keeps getting pushed out further but they are still talking about potentially such job growth at the end of this year. We generally lag behind the economy a little bit in terms of realizing that so we are looking for some mild appreciation as we enter into '05 and '06.

I'll spend two seconds on downtown because, clearly post 9-11 downtown was thrust into the national spotlight, and I think it has been one of the true success stories of the last decade, potentially of the century. It's the third largest CBD in the entire country, but it's a stepchild of Midtown Manhattan. Dick Anderson talked about the infrastructure: Right now there's 10 ½ billion dollars of infrastructure, with most of it geared towards downtown and most of it in infrastructure. We are talking about a one-seat ride to JFK, we are talking about a new Fulton Street transit hub east/west traversing downtown Manhattan, the potential sinking of West Street so that downtown Manhattan crosses over and takes advantages of the waterfront, an expanded South Ferry St. Station, and the new PATH Station that will be up and running by 2009.

The other thing that I think was touched upon was the conversion of residential units. In downtown alone we have had over 5,500 new units since 2000. A lot of that has been taken out from the commercial stock. We have 15,000 units on the board by 2008. The positives of that is clearly some of the old antiquated real estate is going to be removed from the market and a new influx of people downtown, creating of new public places, schools, hospitals, all the areas that Dick was talking about in terms of construction. A lot of it of it is going to be geared in the downtown market. Historically, downtown never has had the price appreciation that Midtown had. In the mid-'90s downtown's vacancy rate was around 20%. In 2000 the downtown vacancy rate was under 4%. When downtown moves, it moves quickly, because of the financial service gorillas, when they move they move quickly. They don't move in little steps, they move in leaps and bounds. The trend that I think you will see over the next few years is the diversification of the downtown market. It is still going to be concentrated in the financial services but it is not going to live, eat, and breathe on financial services. You are seeing health care, you are seeing medical, non-profits, schools, and I think the demographics are shifting away from Midtown for some of the workforce and for some of the companies that are looking for a workforce. If you are 25 years old today and need to find a place to live in NYC you are probably not going to be on the Upper East Side or the Upper West Side but somewhere in Carroll Gardens or Brooklyn or New Jersey. Publishing, media, and entertainment companies are looking downtown right now because that's where their workforce is coming from.

Construction is integrally tied to the real estate industry. I am going to have to disagree a little with my colleagues in terms of the need for stimulus for new construction. I think if you see what has historically gone on with construction over the last twenty or thirty years we weathered the storm through the '90s and in through the recovery. The landing was much softer due to the lack of new speculative construction and I thank my friends at North Fork and the like for not giving the developers the cheap and easy money that they had in the '70s and '8os to go out and build speculative new construction. In the '70s and '80s historically we added about 20% new stock to the market during those decades : 40-50 million square feet per decade. In the '90s it was less than 10 million square feet. That buffeted the general economic and the corporate downturns, and was not the flood of the space on the market that would have created the perfect storm that existed in the early '90s. And rents are the sign of that, it's a supply and demand type of equation. Not a lot of stock was added to the market in the '90s. As the economy recovered you can see a significant price appreciation that we had the run-up to through the early 2000s. As I said before, we are not coming down to the levels that we came out of in the mid-'90s. Those levels are up where they are, they've stabilized, they have room to grow but they are not coming back down to the levels that we saw in the early '90s.

Vacancies: basically the same thing. New projects that are under construction: 10 million square feet, Bank of America's new building and 7 World Trade Center and so on. The difference is, of that 10 million odd square ft., maybe a little bit more than 50% of it is already pre-leased. So we are not bringing 10 million square feet to the market, we are bringing 5 million square feet to the market in terms of new construction.

I'll touch on quickly capital markets because it has really been the 'disconnect' in the real estate market over the last couple of years. Leasing fundamentals have not been strong, vacancy rates have been rising, rents have not been appreciating and yet pricing, the amount of capital, has gone through the roof . We talked about interest rate on record level, very inexpensive capital, both debt and equity that's out there. New York is very hot, NY and Washington DC are probably the hottest investment markets in the country, not perceived to be tied to the tech boom and the ups and downs. A very hard city to get into, barrier to entry and as Irwin and everyone have pointed out, premiums for Class A well-stabilized assets. You see the pricing there topped out and look where the activity is. Of almost $10 billion of new investment in 2003 almost $7 billion was in the Class A, what I would call the "trophy asset" class, just to give you a little perspective.

The only thing that's a little bit interesting with regard to the pricing in '02 and '03, it is not necessarily the pricing, it's who is buying. You had RITs and a lot of foreign money buying real estate in 2002. They accounted for almost 75% of the buying in 2002, and in 2003 they were probably less than 27%. A lot of private money has had access to this cheap and inexpensive capital and a lot of pension fund activity. There is a tremendous amount of money coming through the pension funds out of Germany A lot of people are looking to get their money out of places like Germany (that have their own issues), so a tremendous amount of capital is flooding into NY. This would give you a little perspective of some of the notable building sales. Downtown Manhattan Class A stabilized asset are going for more than $200 per square foot. Obviously one example is the General Motors building that is pricing over $730 per square foot - 1.4 billion dollars. Third Avenue, generally not speaking what a lot of people would consider the core CBD market, is at over $500 per square foot for Class A well-stabilized assets.

In conclusion, I think that job growth is going to be the key to our market. We are in a stabilized environment for the time being, but without significant job growth we are not going to have any price appreciation. But we have stabilized and I think that the market has spoken in terms of its confidence in the city.

I'll take one exception with regards to diversification and dispersion. I think post 9-11 we were all sitting here and we were all wondering if companies were going to flee NYC and were going to look to move all their operations out of NYC. This has not been the case. Over 77% of the companies who were downtown remained in NYC. A tremendous amount of them have actually gone back downtown. Yes, there has been some diversification of operations back-office, but the primary operations, the capital, the intellectual capital is staying in NY. NY has stabilized but we need the job growth to really grow. Thank you.

 

Introduction of Mark Smith by Barry LePatner:

Our final speaker this morning is Dr. Mark Smith. He is the Global Director of Real Estate Services for Ernst & Young, another of today's generous seminar sponsors. Mark truly is the go-to person for many of the nation's corporate real estate owners, user groups, and construction contractors and guides them in areas of strategic development, planning, engineering and construction controls. Like each of our speakers this morning Mark is a superb trend-spotter which is why we wanted him to speak this morning on the national perspective. Mark is the co-author of the best-selling construction accounting textbook, Construction Accounting and Financial Management, in its 5th edition. This is no 'fly-by-night' book. He is the contributing author to Construction Litigation: Representing the Contractor Construction Change-order Claims and Construction Insurance Bonding and Risk Management. Would you please welcome my good friend, Dr. Mark Smith.

Mark Smith, Ph.D.,
Global Director for Real Estate Advisory Services, Ernst & Young LLP

Barry, thank you very much, good morning everybody. The unfortunate thing about going last is all the other speakers used all my statistics and facts and figures, so I'm probably not going to talk too much about facts and figures.

When people ask me about what's happening in the NY real estate market I typically ask the question, how many people have been watching "The Apprentice" on Thursday evening? My typical answer is that when you have a business partner and potentially a residential partner like Donald Trump how can you not think that NY real estate is doing well. I'd like to talk about what we hear from our clients, and I think that that will support some of the facts and figures we heard this morning and maybe also challenge some of them with what we are hearing from our global clients. We deal a lot with multinational companies and every multinational company wants to be in NY. That doesn't necessarily mean that they will be here but everybody wants to be in NY. And then there is the analysis they go through about whether they can support the costs of that or not. There are questions about the amount of investment dollars that are out there in real estate right now. There is a tremendous amount of investment dollars for real estate. One of the recent studies that we've done at Ernst & Young just on real estate opportunity funds, they are going to add another $17 billion to their coffers this year which means that they will have over $100 billion to invest into real estate and that's just the opportunity funds. 40% of those funds will be invested here in the US. Another 60% will be invested overseas. We used to talk about real estate as being a local economy. Well, what you've got now are funds that want to invest in real estate and are truly looking at real estate globally. When we look here at the US and especially at NYC it is a very attractive investment offer for a lot of the opportunity funds. You are seeing a lot more foreign investment coming to the United States, A lot of this has to do with a lot of the treaties that have been signed over the last couple of years, but for countries like Australia - I'll give you just an example - where the Australian pension fund now has the opportunity to go outside of Australia to invest in real estate. The available real estate that they'd like to invest in Australia is a pretty limited market, so they are coming to the US to invest their real estate dollars. A typical example is we have a client that is not only the pension fund, but also an Australian developer who wants to come to the US and basically invest and develop student housing for US universities. We think that is a trend we are going to start seeing. Foreign companies coming into the US to invest. Much like the degree of development of some of our universities and hospitals, you are going to see foreign investment coming into that. The investment dollars that are out there are plentiful but there is also going to be a lot of competition, not just with US dollars but also with foreign dollars coming into the US.

Let me speak briefly about NY in general and then try to drill down a little bit to Wall Street. If you look at NY one of the things that we are seeing is a change. The clients we have and that we are speaking to over the last couple of years have been basically in a situation where they haven't been making a lot of decisions about what to do with their space, or whether to move out or not. They have been contemplating it but not a lot of action has taken place. We are seeing a major up-tick now in discussions with our clients about what they want to do here in NY. A lot of the discussion is happening with the financial institutions where they are looking at their back-office space. A lot of it has to do with risk minimization, again trying to diversify their back-office support and maybe other types of support that they are potentially going to move out of NY. And there is a lot of discussion going on now with those kind of clients about whether that is the right move or not. I think we'll see a lot of activity actually over the next 6 to 12 months in that form or fashion, and primarily for the financial institutions. I agree with Ken on Media and Entertainment, we are seeing those kind of companies wanting to stay here in NY.

In general what we are seeing is very much of an up-tick now of the leisure traveler coming back to NY. After 2001 we are now starting to creep back up to where we were before 2001. We are not quite there yet: last year in 2003 our hotels here in the city had an occupancy rate of maybe 70-71%, we are predicting for 2004 that will up-tick perhaps 2-3 points up to around 74-75%. If you look at what new hotels are going to be built for the city, what's currently in the planning from our analysis, about 12 new hotels are going to come online between now and the end of 2005. The interesting fact is that of those 12 new hotels, not one of them is a luxury hotel. They are all on the low end, mid-value hotels: the Holiday Inns; the Hampton Inns; those kind of hotels are coming to the city. Why is that? One is because when you look at the hotel situation a lot of it is gearing more towards the leisure traveler coming back to NYC. They are not necessarily gearing to the fact that we are going to have a big influx of business travelers back to the city. I think that is an interesting fact to continue to watch. If you look at the one luxury hotel that has just opened, the Mandarin Hotel, with a development cost of something like a $1 million per room, the economics that support those luxury hotels are just not there at the moment, at least from the investor standpoint. If you look at the amount of transactions that we have been involved just over the last 9-12 months, we probably have had more transaction volume from our firm helping with looking at due diligence and transactions of real estate than I've seen in the last 5 years. A lot of that has to do with the investments that are going to make sense. It's not going to be necessarily the high-end trophy projects, people are still very leery of that and I think that is a trend to be watchful of.

If we look at Wall Street, my comment is that Wall St. is not disappearing by any stretch of the imagination. I do think we are going to see some substantial changes. The traditional way of looking at how we develop in Wall St. will change, has to change. If you look at what's there in terms of the $5 billion that's currently invested into downtown and with billions of dollars more to come, a lot of that is being primed by the public sector, trying to bring back what we think will be the new economy into downtown. That new economy, though, may not be again the traditional financial services. It is going to be a lot of mixed use in terms of residential as well as retail. If you looked at the amount of retail space that was in downtown before 9-11, you had about 400,000 square feet. Right now, what's being planned is something in excess of 1 million square feet. So the whole dynamics of how that is going to change is going to be very interesting. You are going to have a lot more mixed-use buildings in terms of combining residential, retail, and commercial than you had in the past. So when we look at real estate for Wall St. and for the rest of NY, it will be different from what we've had in the past.

When you think about real estate and construction, when people look at our industry they probably shake their head and say, "Don't those people ever wake up and see what really the future looks like"? That's always been one of the knocks, especially on the construction industry, where we've always done things like we've always done things. I think that will be something that will change for us in terms of looking into the future. How will NY change? Again, what we are seeing is; we will see some job loss especially in the financial institutions; we are seeing that people want to stay and live and play in NYC. People want to live in New York City and enjoy all the cultural activities that the city offers. What kind of development and what kind of investments will be looked at will be things like the residential, retail, and the innovative ways to mix all of that together including the commercial office space.

With that I'll stop my comments, Barry, thank you very much.

 

Questions and Answers and Concluding Statements

Barry LePatner: I do think if you come away with anything this morning, it is for all of us it is to change our perspective of how we view the downtown portion of Manhattan. Historically all of us have looked at it as someplace where there are canyons and Wall St. and so on. Our firm has been involved in the last year and a half in at least six projects down there, from 7 World Trade Center to the East River Development, to contracts for one of the major transportation centers. There are two major transportation hubs going up and they are billions of dollars each, as well as several other projects. It is really changing the entire way that the downtown area is going to fit into the entire fabric of our city. If you wander down there you will see an entirely different picture if you haven't been there in a couple of years, and it will change even more dramatically in the next few years.

But here's an instant survey result - so Irwin, tomorrow we are going to hear about this on CBS Market Watch. Here's what you have said. Outlook: for the office sector for the coming year it will be stabilized but may decline a bit. This is what you said, forget about the experts. Multi-family sector: you said, will improve somewhat. Retail: stabilized and may improve. Hotels: stabilized for now but may decline. Interest Rates: split, right down the middle; half of you said they probably will rise a bit, half of you said, stay the same. And for stock market performance, the big consensus overwhelmingly was: modest gains in 2004. So thank you for your instant analysis on that. Now let me take any questions from the audience because we have the panel here that is ready to catch up on any of your questions.

Q: Could Dr Irwin Kellner please comment on where if at all the government can assist in job creation and also to the extent that you can, the notion of free trade. How does that impact on job creation?

A: Dr Irwin Kellner: There are a lot of things that the government could have done to create jobs. I'm not sure there's enough time for the incumbent administration to create enough jobs to take the jobs issue off the table. But basically the reason why we are not growing jobs here the way we should be at this point in an economic recovery which for the country as a whole we are in the third year, is that labor costs here are relatively high compared to other countries. In other countries, for example, not only do they pay lower wages, they keep their currencies low, they don't pay health care, they don't get involved with worker's compensation, and they don't have other costs associated with workers including environmental costs. So, one way to make us more competitive would be to look for ways to cut labor costs, especially in the area of health care which is a real growing cost area, and as part of that, tort reform.

Then, I would suggest that they try to put money into the hands of people who are more likely to spend it. For example, lots of people have run out of their jobless benefits because they have been out of work for so long. The government should restore and extend these benefits; you give an unemployed person who ran out of benefits a dollar, and he or she will spend $1.10. Payroll tax and social security tax is the largest tax the household pays. Washington should suspend that for a couple of months, again putting money into the hands of households that are likely to spend it. By the way, don't worry about the Social Security Trust Fund, it only pays out $1 for every $2 it takes in. It is in massive surplus right now and it is not going to run out of money for the foreseeable future. Another issue is states and local governments. As fast as Washington is pumping stimulus into the local economy, states and local governments are taking it out because unlike Washington, they are not allowed to run budget deficits. So states ranging from NY in the east to California in the west are raising personal income taxes, sales taxes, property taxes and cutting spending and laying off people in direct contradiction to what Washington is trying to achieve. So Washington ought to step up its aid to states and local governments.

There also ought to be credits for workers to retrain themselves for the 21st century economy and that would also go for employers as well. And finally, there are still a number of activities that are labor intensive and need to be done onsite. I'm talking about infrastructure projects: the last time I looked you can't build a bridge in India and bring it to the United States. When you are working on the Long Island Expressway you are working on it in Queens and Long Island with local labor and local building materials and the like. So the administration should encourage these types of activities because this will keep jobs here and these are not just blue-collar jobs, these are white-collar jobs, architectural jobs, financial services and the like. So these are just some of the things that can be done. Whether or not they are going to be done, and if so, if they will be done quickly enough and take effect enough to take jobs off the table this year is a major issue in the political campaign. I seriously doubt it.

In the ivory tower of academia free trade is the ideal. The country that produces the item the cheapest should be allowed to provide it for everyone else. But in today's world, as President Bush's Chief Economic Advisor learned, there is more to it than that. I would amend 'free trade' to say 'fair trade'. We don't have fair trade because other countries deliberately keep their currencies low, keep their costs low, they need to come up to our standards. If they did, then free trade would indeed work for everybody and we wouldn't be suffering a loss of jobs.

Q: First, I thought that is was a very informative subject. My question is to Dick Anderson, You talked about some of the factors that could effect the construction economy in the NY region, and one of those was infrastructure, Our company works out of California and we have seen a disaster in the infrastructure out there. What is the vulnerability factor in New York? What are some of the factors that could change your forecast?

A: Richard T. Anderson: One of the largest areas of uncertainty in the forecast is the public money that will be available for the various infrastructure programs and that's at all levels of government, they are all under pressure. The surface transportation T3 Bill is up in Washington this year and is a source of great debate because with the huge deficit that the administration has created, there isn't money for a strong transportation bill. The Chairman of the Transportation and Infrastructure Committee Don Young would like a $375 billion bill. The administration countered with a $250 billion bill. It will probably end up somewhere in between, but that is just one level of government. The state governments and local governments are under enormous pressures and one of the areas that gets hit is public spending for infrastructure. I mentioned the State Department of Transportation program has been held down in NY, the same is true in other states. The NYC capital budget is under pressure and there is a real push to keep debt service down, although really that is a political judgment. You can spend operating money on debt service or you can spend it on other kinds of things, but in this city there is pressure on the operating budget in a lot of areas.

I think the short answer is as much as public infrastructure is needed, as much as it does create jobs here and now for Americans, for local people, there are a lot of pressures to keep spending down in that area. I think infrastructure is one of the best investments we can make. Not only does it create jobs now, but it paves the way for the growth of the rest of the economy, but this administration in Washington doesn't see it this way. They see investments in lower taxes as solving everything else and that's a real fundamental difference. I think in this election, that's a real choice you make. Do you believe that tax cuts will solve everything or that government spending pro-actively can create jobs and do things for the economy. There really is a difference between the two candidates for national office in this regard.

Barry LePatner: Let me thank all of our speakers here who have been wonderfully insightful and whom I am certain give each of you the opportunity to walk away with some very valuable information.

I also really want to thank our sponsors: Ernst &Young; North Fork Bank; and DSL.Net; as well as our law firm. We really do spend a lot of time trying to put together a program that we think will be insightful to the spectrum of all of our friends and clients in the industry and I am appreciative to them for all of their help. I thank you for joining us on this morning.

 
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