The deceleration of China and resulting commodities crash have created a problem for developers of ultra luxury condominiums.
The ancient Egyptians believed that the sky was a solid dome, the belly of the goddess Nut who arched her body from one side of the horizon to the other. Every day, the sun god Ra emerged in the east and sailed in his boat across the sky until dusk when he disappeared in the west by dipping below the surface of Nun, the ocean upon which the whole flat earth floated.
This story would have been useful two years ago when Manhattan real estate was soaring and many participants were proclaiming that the sky was the limit. It turns out that that particular sky, the ‘real estate sky’, is not as infinite and rich in wonders as the real sky. It is instead very finite like the sky of ancient Egyptian cosmology, its hard boundary formed not by Nut’s belly but by the marginal buyer’s stomach for paying ever rising prices.
Until recently, the strong Chinese economy and resulting surge in commodity prices had fueled an economic boom in many developing countries. With this boom came rapid wealth to a segment of the population sometimes referred to as the oligarchy, or the world elite, or the global UHNW (ultra high net worth) class. And with that wealth, largely earned within the borders of countries with an unpredictable polity, came the logical and prudent decision to place some of it abroad where the likelihood of seizure or expropriation by unfriendly authorities was deemed to be low or nonexistent.
There seemed to be a large conduit, a money superhighway, running beneath the world’s oceans through which trillions of dollars flowed smoothly for thousands of miles from that Chinese demand to that commodities boom to that sudden wealth and finally to this prudent decision. A great many of this conduit’s outlets were invisible and hidden in the hushed basements of Swiss or other offshore private banks. Yet others were semi-visible in the proliferation of hedge funds, private equity funds and other ventures solely dedicated to the management of paper assets.
And finally some outlets were very visible in the real estate markets of London, New York, Miami and other cities. The trillions of dollars on the money superhighway traveling inbound from Russia, China, Brazil, Qatar and other places have seeded and fertilized Manhattan’s Billionaire’s Row on 57th street and other parts of Midtown, resulting in the sudden emergence, like weeds out of the ground, of tall and super-tall condominium towers.
If they were trees instead of buildings, they would follow the normal cycle of nature rationing their reserves in winter and flourishing in the summer. But human constructs are less well calibrated and real estate cycles can be difficult to navigate. It takes a long time to carry a new building from conception to delivery. Few developers have the wherewithal or the resources to make big plans in the trough of a bust. But many embark on long cycle projects during boom times, accepting the risk that completion may not come before the next downturn.
Until now, the way to market these new condominiums was to sell as many units as possible pre-construction or during construction, thereby transferring the time-related risk to the buyer. This approach worked beautifully in recent years as evidenced by the huge success of the Time Warner Center, 15 Central Park West and of a good part of One57, the first in this cycle among several tall ultra-luxury towers.
Then, a virtuous cycle
How did we get here in the first place? And why was Manhattan a choice destination for this foreign wealth? The answer is that, in addition to offering the promise of secrecy and safety, new condominiums benefited from lax regulation and zoning and preferential tax treatments.
When secrecy was no longer as readily on offer at Swiss private banks, foreigners shifted their sights to other havens and found US real estate to be a uniquely welcoming alternative. Here, it was still possible for agents to transact via shell companies that were organized onshore or offshore, ostensibly to conceal the identity of foreign parties who preferred to remain anonymous.
A recent Washington Post article explains:
What many Americans might not realize is that foreign-owned shell companies play a big role in the U.S. economy through the real estate market. When purchased through a shell company, an offshore company or a trust, U.S. real estate offers wealthy foreigners a stable and secretive investment.
In the last quarter of 2015, 58 percent of all property purchases of more than $3 million in the United States were made by limited liability corporations, rather than named people. Altogether, those transactions totaled $61.2 billion, according to data from real estate database company Zillow.
The U.S. government doesn’t ask real estate brokers to monitor their clients for money laundering risks, the way that banks and other financial institutions – and real estate brokers in some other countries — are required to do. The 2001 Patriot Act gave the Treasury Department the ability to do this, but lobbying from the real estate industry has helped secure an exemption for the last 15 years.
Last year, an extensive report by the New York Times titled Towers of Secrecy investigated shell companies that invest in Manhattan real estate. The report estimated that in six of Manhattan’s most expensive buildings including 15 Central Park West, One57, The Plaza and the Time Warner Center, shell companies owned between 57% and 77% of the condominiums.
Across the United States in recent years, nearly half the residential purchases of over $5 million were made by shell companies rather than named people, according to data from First American Data Tree analyzed by The Times.
In addition to favorable regulation welcoming this wave of cash, New York’s tax policy also made it easier for developers to meet the surging demand. Some ultra-luxury buildings received tax abatements initially intended to encourage the construction of affordable housing.
Now, a perfect storm
Today however, the money flow, safety, secrecy, regulation and tax policy that enabled the boom are all threatening to reverse course at the same time, creating a new reality that may be problematic for investors and developers.
It is a new reality that could also be problematic for the city. Money in Swiss private banking accounts can be easily withdrawn but money withdrawn from luxury condos with limited local appeal leaves a large footprint behind. Foreign money can be quickly gone but the buildings will be here quasi-forever.
With the slowdown in China’s economy, commodities have crashed and the money flow from emerging markets to midtown Manhattan has slowed from a gusher to a stream, or perhaps a trickle. As a result, the profitability of many condominiums that are now under construction looks less assured than it was eighteen or twenty-four months ago.
In addition, there are new calls for better monitoring of shell companies and for disallowing tax abatements in the case of super luxury apartments.
This weaker demand is coinciding with a rise in supply with several of the long-ago planned towers only now rising above street level and boosting the pre-construction inventory. A top Manhattan broker told populyst that the high luxury segment (apartments priced over $10 million) had buckled under a worsening macro environment, with signed contracts running at 38% below last year. Meanwhile, new supply is up 5.4% from last year and expected to continue growing.
Sales at some of the new condominiums are likely to do well while others suffer. Because of its location and the success of 15 Central Park West designed by the same architect Robert A. M. Stern, it is fair to expect that 220 Central Park South will do fine by attracting demand from New Yorkers and wealthy Americans. Other buildings with less enviable locations will probably do well in their upper reaches but may have trouble selling mid-height units where views do not clear surrounding buildings.
Asking prices are already being adjusted downward. Extell Development lowered its total sellout price by more than $200 million to $1.87 billion for its One Manhattan Square project. Toll Brothers has had price reductions at 1110 Park Avenue and 400 Park Avenue South. World Wide Group and Rose Associates have followed suit at 252 East 57th Street. And at 111 East 57th, JDS Development Group and Property Markets Group will wait about a year before launching sales at their ‘Billionaires’ Row’ tower.
The broader market seems to also be coming under pressure. A recent study by research firm Miller Samuel for the Real Deal estimated that “by the end of 2017, Manhattan will have five years of excess inventory”.
Roughly 14,500 units are expected to hit the market between 2015 and 2017. But by the end of 2017, just over 5,000 of those units are expected to have sold, and going by the current rate of sales, it would take more than five years to sell all that excess inventory.
The analysis looks at all new units that have launched or are set to launch in Manhattan over a three-year period, across all price points. It assumes the same rate of sales the new development market saw during the second half of 2015, which equates to just under 1,850 closed sales per year.
Based on that absorption rate, more than 9,400 new units would be unsold by the end of 2017.
What may retrenchment look like for Manhattan now? According to a recent New York Post article,
In the past five years, about $8 billion worth of apartments worth $5 million or more have been bought, or three times higher than years previous. Most troubling is that 50 percent of these have been bought for cash, forked out by shell companies controlled by persons unknown.
An end to secrecy is supported by the G7, United Nations and the Organization for Economic Cooperation and Development. The concern is that countries with hot money outflows are being destabilized, while countries inundated with illicit cash are developing real estate bubbles and high housing costs for ordinary residents.
The biggest losers are China, where $1.39 trillion left between 2004 and 2013; Russia, with $1 trillion hidden, and Mexico, with an outflow of $528 billion.
In some African nations, the outflow of funds is so sizable that it is shrinking the size of their economies and sabotaging their societies.
Meanwhile, in New York, the flood of buying by persons unknown is damaging the housing market. Between 2010 and 2015, the average square-foot price of a residence in New York City jumped from $1,000 to $1,450, an increase of 45 percent.
The bottom line is that there are now many factors conspiring to slow down the tens of billions of dollars moving from emerging markets into US and European property markets. Profitability models for individual projects drawn during the boom are now incorporating less ambitious assumptions. Can the global economy reaccelerate in the next two years to vindicate the initial return projections? Anything is possible but this would require a stabilization of the Chinese economy and some recovery in commodity prices.
Instead of the soaring rocket of boom years, the real estate cycle is more akin to the journey of the sun god Ra, who at night “visited the underworld, a watery realm of the demons of the dead, where he battled with the serpent of chaos, and victoriously returned to the day each morning”.
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