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Portfolio > Alternative Investments > Real Estate

New York: the Next Bubble to Burst?

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The New York City metropolitan area produces around $1.6 trillion worth of goods and services annually, which makes it the world’s 11th largest economy, placing it above Australia and just below Canada. The fastest growth in recent years has been centered on Manhattan and surrounding neighborhoods. Real estate prices have rocketed: at the end of 2014, the average price per square foot reached $1,459, or nearly 20% above the pre-2008 peak. The city created over half a million private sector jobs in the decade since 2004—many of them high-skilled, high-paying ones in high-tech, construction and health care.

Optimism abounds. New apartments and office towers are rising on every city block and old buildings are converted to more profitable uses. It is a Mecca for tourists and has the most expensive hotel rooms in the nation, with occupancy rates approaching 90% despite a hotel construction boom. The city wants to attract 10 million more visitors by 2021, 18% more than last year. Consumer confidence stands at 88.7 in the city, compared to 81.9 upstate.

Yet, New York City real estate is a monstrous bubble and a prime candidate to be next in line to burst.

Blame the Fed

Look at Russia. In 2013, its nominal GDP measured $2 trillion and it was the world’s ninth largest economy. Not anymore. Oil, Russia’s main export, halved in price in the second half of last year, leading to a 45% ruble devaluation. This year, its economy will measure below $1 trillion, which is good for 15th place, below Mexico and almost level with the tiny Netherlands.

Oil markets have been in a bubble stage for a while. Prices dropped sharply in late 2008, but were almost immediately on the rise again, reaching pre-crisis levels by early 2010. Annual averages were above $100 per barrel through 2013, even though production was rising steadily and world economic growth—and petroleum use—lagged behind.

The reason for this was the Fed’s monetary stance of responding to the financial crisis with plentiful free liquidity. With stock and real estate prices still depressed and economic activity sluggish, commodities proved a good place to park that cash. That was when gold reached highs above $2,000 per ounce.

The Poor Fed. It was tricked by persistently low inflation and very low bond yields. While price stability was not in danger, it kept pumping in liquidity through a variety of quantitative easing schemes in order to take care of the second half of its mandate: to achieve full employment. Labor markets were recovering very slowly, and so the Fed maintained monetary ease for an unprecedented seven year stretch, ignoring concurrent asset price bubbles. With the U.S. economy picking up steam last year, the Fed stopped its QE programs. And with the unemployment rate inching toward the pre-crisis level, Janet Yellen has now started to talk about raising interest rates.

Except that there are asset price bubbles to consider. Just by stopping its last QE program, the Fed triggered a dramatic drop in oil prices. Talk of higher interest rates has brought about extreme volatility on Wall Street. But stocks are not an immediate danger. Tighter money will bring some of the heady NASDAQ valuations back to earth, but corporate profits remain still very high. The party on Wall Street will go on, at least for a while.

Real Worries

Real estate bubbles, on the other hand, are worth keeping a close eye on, and New York City’s most of all.

True, there are lots of good things going for New York. There is that healthy job creation trend, plus demographic changes (which suggest that young people as well as more opulent baby boomers prefer to live in big cities rather than small suburban towns), plus the influx of foreign money buying U.S. properties, etc. But in every bubble, there has never been a shortage of reasons why it will keep inflating forever. We have seen this, most recently, during the subprime mortgage bubble. It is only when the bubble pops that analysts start writing outraged commentaries demanding to know who could ever believe that a 700 square foot studio apartment on a pothole-ridden street could be worth over a million dollars.

Consider these alarming facts:

  1. Real estate is a highly leveraged business. With plentiful loans at zero percent and plentiful investment opportunities in New York City real estate, there is a huge temptation to leverage to the hilt. As a developer, you use 10% of your equity and reap all the benefits of the (very rapid) appreciation. If interest rates creep up, even slowly, some projects will be in trouble.

  2. New York real estate is a tricky business. It’s not an accident that so many companies are family-owned, where the tricks of trade pass from one generation to the next. Now, there are plenty of newcomers who have never been tested by a downturn. Increasingly, new developers are foreign-based.

  3. Foreign money has been dominant in pushing New York real estate prices, definitely at the high end, but in the mid-market range, as well. There are plenty of problems with that. The New York Times did an investigative report recently, looking into shell companies that do such purchases. But aside from tax cheats, money launderers and other unsavory characters who come under scrutiny by the authorities in their own countries as well as in the U.S., there is a stark economic reality: With lower oil prices there will be fewer petrodollars sloshing about, and if the Fed starts tightening liquidity, there will be far less cash floating around both in the U.S. and abroad.

  4. Housing markets tend to be stable—even though not rock-hard, as the 2008 financial crisis demonstrated. However, many properties in New York City are bought as an investment and rented out by absentee landlords. Such owners will be quicker to sell if their investment strategy doesn’t pan out.

  5. For all the attraction of New York City, and the stream of job creation, it is still a very costly place to do business—and becoming costlier by the day. The American Legislative Exchange Council (granted, a conservative think tank) ranked New York last among U.S. states in terms of competitiveness. As the city gets more crowded and its aging infrastructure creaks on, the quality of life will also deteriorate.

  6. An influx of Chinese buyers and developers should also ring some alarm bells. Three decades ago it was the newly wealthy Japanese who snapped up US properties, including, notoriously, New York City real estate. They soon discovered that they were buying at a peak and had to liquidate their holdings at a trough.

None of these factors alone will spell disaster for the city. But coming together they will, and a Fed interest rate hike—even if very modest—could trigger a market implosion.

The Fed is facing a nasty dilemma. The bubbles are there and, judging by the frenetic construction activity in New York City, they probably can’t be deflated in an orderly and painless manner. And, unlike a bubble in the stock market, once a real estate bubble starts to lose air, even resuming pumping money into the banking system won’t stop the process. In general, with interest rates already at zero, and fiscal policy effectively paralyzed, the authorities have almost no ammunition left.

New York City is not the whole of the U.S., as national politicians like to note. True enough, but its GDP is equal to nearly 10% of national GDP and it is also the nation’s financial and banking center. Just as in the 1970s, when New York City’s dark days corresponded to Wall Street’s lowest ebb of investment activity, the deflation of the city’s massive real estate bubble will certainly be felt negatively by the rest of the country.


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