Is the Sky Falling?

Prophets of economic doom abound. Here’s what boards can do to weather any possible downturn.

It’s a staple of science fiction: the domed city, protected from the elements and, depending on the writer, radioactive mutants, alien death-beams, acidic pollution – and falling real estate prices?

Well, that last one is not actually science fiction, but it is New York in a nutshell. Or, rather, in an economic shell that, despite whatever’s happening in the rest of the country, seems to protect housing investments here. Or, so goes the mantra, which says that the “housing bubble” of rising sales prices won’t burst in New York City. It says that New York City is different, New York is a world city, hey, New Yawk is New Yawk, yo, fuhgeddaboutit! No one’s pushing and shoving in a crowded line to buy multimillion-dollar condos in Milwaukee, God bless The Brew City.

As Sinclair Lewis said in another context, it can’t happen here. Or can it? And, if it does, how should boards prepare for the worst?

The Trouble
Defined

First, the experts. “Housing markets by their very nature are local in scope and swayed by sentiment linked to the complexities of regional economic conditions,” notes Christian E. Weller, chief economist of the Washington, D.C., think tank Center for American Progress. And New York City “is definitely a different breed,” says real estate attorney and Bren Management president Martin S. Kera. “The bubble’s burst in Florida; I understand Las Vegas has the same problem. New York just chugs along.”

Look at the numbers, everyone says. From 1990 to 2004, the city inhaled deeply and its chest swelled with a net 800,000 new people – a million, probably, if you count the estimates for undocumented aliens. But in that whole 14-year period, developers filed only 147,510 units’ worth of city permits for co-op, condo, and rental apartments. Co-op and condo sales are outpacing construction and refurbishing so fast that the number of apartments for sale in Manhattan actually dropped 32 percent to 5,237 in the last year, according to a June report by Prudential Douglas Elliman.

“We’re not even close to producing enough housing to cover our population,” says Stuart Saft, a partner at LeBoeuf, Lamb, Greene & MacRae and chairman of the Council of New York Cooperatives & Condominiums. That’s a view widely held by everyone from artists and social scientists to politicians and Wall Streeters.

“Every demographic study I see says population is going to continue to grow – dramatically,” notes Patrick Niland, president of the commercial-mortgage brokerage firm First Funding. “Whether you want to live with that congestion and those prices is a whole other matter.”

And for now, it’s a matter that doesn’t matter. Demand far outstrips supply, keeping apartment prices climbing. Over the last decade, the median sales price of a Manhattan co-op or condo rose from about $275,000 to $875,0000, reports The Corcoran Group, or $895,000, per Miller Samuel Real Estate Appraisers (“median” means half the apartments sell for more than that figure, half for less). For the five boroughs as a whole, says the trade group The Real Estate Board of New York, the median co-op/condo sales price is $525,000 – a spectacular 16 percent rise from the previous quarter. Nationally, the median co-op/condo sales price rose only 2.6 percent over the entire past year, to $228,900, according to June 2007 figures by The National Association of Realtors.

But these are all just statistics. Housing markets rise and fall on psychology as much as on anything else – and a comment in August by Dolly Lenz, vice chairman of Prudential Douglas Elliman Real Estate, sparked enough vaguely panicky commentary to throw the blogosphere off its axis. In a panel discussion reported on by the CNBC website, Lenz sent tremors rumbling when she said that, in the market’s $10 million-and-up tier, “there is definitely a change in the last three weeks. It is a very rapid change, the quickest change I have ever seen in the marketplace, where people are really thinking about their purchases versus just running in and making a bid and securing the property. They’re taking longer to think about it and looking at more things and taking a breather.”

Wait…that’s it? People are stopping to think before plunking down $10 million or more on an apartment? People think about which bunch of bananas to buy at the grocery – why shouldn’t they stop and think before making a major real estate purchase?

They should, obviously, and the notion that there’s something wrong with that is the kind of thing that can crack the dome. So, a few people start to haggle, and sales prices drop a bit. So, housing prices, to throw around some hypothetical figures, jump only 10 percent rather than 15 percent in a given period, in a market where they’ve historically risen 5 percent. Are we really talking crisis?

For a builder, maybe. “If developers buy new land and start developing new buildings and upgrading older buildings, they’re doing so with expectations of condo [sales] prices going up 10 to 20 percent a year,” says economist Weller. “If they go up only by 4 to 5 percent a year, the economics don’t make sense anymore” – which would reduce supply in the face of continuing demand, so, all else being equal, the value of existing apartments would go up. Sweet.

Macroeconomics is more complicated than that, obviously. But a board can’t worry about the butterfly effect. It has to deal with foreseeable reality as best it can. Reality and realty are two different words, however, so let’s examine what happens if – despite all the numbers, despite the seeming logic, despite everything – sellers’ sky-high, dollar-eyed expectations of jackpot windfalls aren’t met at the high end, creating a panic that sends investor lemmings running and causing the housing bubble to burst, sending sales prices plummeting. How would that affect your building? What should a board do to prepare? You don’t want to be Chicken Little, but you also don’t want to be Chicken Too Little Too Late.

On the Bubble

What is a housing bubble, precisely? Financial analysts, op-ed columnists, and armchair bloggers talk about it as if there’s a single definition to describe it or a single way to measure it. But outside of the broad-stroke meaning – a dramatic rise in housing prices that eventually reaches an unsustainable level, bringing prices down – experts differ. What exactly constitutes “a dramatic rise” or “unsustainable” levels, for instance?

Go back to the archives, and you’ll read that the bubble was about to burst in New York City in 2003. Take cover! It didn’t happen. Then it was going to burst within months of a December 2005 New York Magazine cover story, among other articles. Didn’t happen. Pick any of the last few years, and you’ll find someone or other detailing how the bubble was about to burst.

Make no mistake: New York City housing prices do go down or can remain stagnant. The stock-market crash of 1987 continued to ripple for years; the median price of Manhattan co-ops fell 9.8 percent from 1992 to 1993, for instance, reports The Real Estate Board of New York.

Around the same time, the average Manhattan condo sold for 9.3 percent more in 1994 than in ’93, according to the real estate research firm Yale Robbins. But that was mostly studio and one-bedroom co-ops where prices were depressed – two-bedroom places did just fine. And unlike stocks and other assets, people live in these corporations, so barring a personal tragedy like major illness or prolonged unemployment – which can happen to individuals no matter how robust the economy – most sellers can just sit tight if they want to wait for a profit higher than historically reasonable norms.

Are we seeing ’87 crash all over again in the brief August stock market panic, and the failures of some mortgage companies in the subprime-lending market? (The term “subprime” doesn’t allude to the prime rate; it refers to less-than-prime borrowers whose credit history doesn’t let them qualify for low interest rates.)

“I’d characterize [the city’s current residential real estate market] as a high-level of volume with stable pricing, with the exception of the high end,” says appraiser Jonathan Miller, president and CEO of Miller Samuel. “Subprime did not have any apparent effect in New York City. This is not a big subprime market – there are pockets, but not like in Detroit or Baltimore.”

The problem did expand into the prime mortgage market, Miller notes, since all this economic volatility made investors “reluctant to buy mortgage paper, because they don’t feel comfortable with the risk-price relationships,” but the high volume of housing sales kept prices stable. “The last three quarters, we’ve had a record or near-record level of sales activity,” he says, “fueled by the falling dollar, which has driven a tremendous demand from foreigners for new development; Wall Street bonuses, which are at a record level; and a local economy that’s running well – the city has a surplus.” Even so, he cautions, “If any of these components changes significantly, you’ll see demand slow down and inventory build fairly quickly.”

A Wary Eye

So, boards should keep an eye on these three things. But what do you do if they trend downward beyond a level with which you’re comfortable?

“I would tell anybody who has a home to go back to basics: start saving money,” says Weller. This applies to building corporations as well as to apartment owners. “One of the biggest problems of the last few years is people seeing the paper wealth of their home as real money. We’ve seen a lack of diversification – people not building up savings outside of their home. Partly, it’s ‘the wealth effect’ – you feel wealthy because the value of your home went up. So, say your condo doubled in value in three years. You think, ‘Let me enjoy life a little more,’ and take out a home-equity loan on your home. But when things turn sour, a lot of this paper wealth disappears” – and an owner may be left owing more than the apartment is worth.

And that’s a danger not just for individual owners but for buildings and their boards. “If we really had a bad downturn, and people couldn’t sell or couldn’t afford the new payments on an adjustable-ate loan, the risk to co-ops and condos is that there would be a lot more sublets, some shaky situations, and foreclosures,” says Niland. “Then [buildings] are stuck with delinquent units.”

This affects condos less than co-ops, which may have to get possession of the unit from the bank, with all the attendant time and legal expenses entailed. But even a condo board may feel the sting since, remarkably, banks can be irresponsible about paying the monthly carrying charges on time.

“They’ve got thousands of these things, and the operations folk couldn’t care less – they do their 37.2 files during the day and whatever doesn’t get done, doesn’t get done,” Niland says. “Sometimes payments get accidentally sent to the wrong bank, et cetera.”

You can head off some of this by scrupulously checking a prospective buyer’s financials. How do you get a grip on a that? Boards need to think like a bank: is a given apartment priced reasonably enough that most buyers can afford to keep up the payments, or is it so high and will the buyer be so indebted that there will be a foreclosure, with all the attendant headaches that means for the board?

Here, then, are a few paragraphs of primer – a mini-phrasebook to help you translate the street signs in Finance Land and choose which direction your building should take.

The housing market’s two major categories of indicator are valuation and debt. The first tries to measure how affordable houses are to the average buyer. The second tries to measure how indebted a buyer becomes – which, from the standpoint of a lender or an interested board, means how likely the buyer is to keep being able to pay the mortgage and other monthly charges. Two of the major ways to measure valuation are price-to-income ratio and deposit-to-income ratio.

Price-to-income ratio is the measure of median home prices compared to median household income in a given locality. Homes generally are considered affordable if the price-to-income ratio is about 1:4 or less, meaning the price of the home is four times that of income – or, expressed another way, equal to four years’ worth of income. A 2004 Harvard study of 110 areas nationwide found that New York City was among 33 – up from 10 just five years prior – with a price-to-income ratio higher than 1:4. That may be mildly troublesome as a national trend, but in terms of New York apartment-buyer applications, it means a price-to-income ratio above 1:4 is normal for our area.

And other measures do need to be considered. The most important is probably deposit-to-income ratio. “Deposit” in this sense means “down payment,” and so the deposit-to-income ratio for a given locality is the measure of median “required down payment” compared to median “household income.”

These valuation measures are interconnected with those of the second indicator category, debt. Two major ways of considering whether a buyer can afford the monthly payments on a home are the housing-debt-to-income ratio, aka debt-service ratio, and the housing-debt-to-equity ratio, aka loan-to-value ratio.

Debt-service ratio is the measure of mortgage and related monthly costs relative to income. Lenders’ rule of thumb is that no more than of 28 percent of a buyer’s monthly gross income should go to paying the loan principal and interest, property taxes, and home insurance (a combination the industry refers to by the accidentally ironic acronym PITI). Lender’s other rule of thumb is a maximum 36 percent for PITI plus recurring debt (child support, car loans, credit card payments, and other such monthly obligations).

The final metric in this overview, loan-to-value ratio, measures mortgage debt compared to a home’s fair-market value, aka the home’s equity. This tells the lender and interested board whether a home can be sold for enough to recover the mortgage debt in the event of foreclosure. A 1:1 ratio means the debt and the equity are equal.

None of these ratios are rules, and individual buyers’ salary trends, etc. are all so different that nothing can apply to everybody. If someone’s monthly debt-service is 37 instead of 36 percent, that shouldn’t set off alarms. If it’s 47 percent, start listening for Klaxon horns.

Other Steps

You should also scrutinize the finances of owners who want to refinance or take out a second mortgage or a home-equity loan. Many people use such loans to go on buying binges and fancy vacations, and risk overextending themselves.

“Watch home-equity loans carefully,” says Kera. “You don’t want people loading up on [such] loans and then not having equity in their apartments. In condos, you don’t have much control, but co-op boards should approve every loan. Some boards don’t but should.”

If they feel the worst is coming – but not necessarily otherwise – boards should also consider reducing the amount of the purchase price that can be financed. “Maybe if yours allows 90 percent you should go to 75 to 80 percent,” Kera says – although doing so prematurely may contribute to a slowing of the market; it’s a delicate balance.

He warns strongly, however, that boards should not react to the possibility of an economic downturn by deferring building capital repairs and maintenance. “That ultimately comes back to bite you. You put off pointing the brickwork or fixing the roof, and then you get leaks and mold and it costs you more in the long run.”

If apartments aren’t selling, you also shouldn’t count on collecting much from flip taxes. That shouldn’t be a factor anyway, says Niland. “The monthly maintenance fees should be enough to cover operating expenses, and any flip tax revenue should go into the reserve fund. Boards shouldn’t be counting on flip taxes as a regular item in the budget since you can’t predict when a downtown will occur. If a condo or co-op gets in straits because of flip taxes, well, I say shame on them.”

And even here, there may be offsetting opportunities. “When the real estate sales market goes down, the rental market goes up,” notes David Kuperberg, president of Cooper Square Realty. “People still need a place to live.”

Speculator-owners who can’t sell for the price they want or part-time vacation-homers facing higher mortgage rates might turn to subletting. In some cases, too, owner-occupiers might find it more economical to move out and rent themselves a smaller apartment while they sublet their co-op or condo. If so, says Kuperberg, “Just as boards impose flip taxes, they can look at maybe having a similar surcharge for sublets, if they don’t already.”

Funny thing about bubbles – you can sometimes see rainbows in them. And the pot of gold at the end of the housing bubble may be that prices stabilize to a level that gives sellers a reasonable profit while staying affordable enough for the middle class to afford. You know, the way it used to be in the ’80s, say, when not just Wall Streeters and rich foreigners but also teachers, cops, plumbers, and shopkeepers – the people-infrastructure that keeps this city on its feet – could afford to own a home here. Now, wouldn’t that be something?