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Manhattan Real Estate More Mental Than Rental

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Although the Manhattan real estate sales market has long been a full-blown spectator bloodsport worthy of an X-Games-like nightly television special, the rental market has patiently remained in the background, a cerebral cousin who stays home and plays it safe.

The rental market is much more responsive to changes in economic conditions, especially rising unemployment. Many firms are cutting back on hiring or are downsizing. In better times, new hires were a key driver of the rental market as new employees often rent first, then buy.

Many spectators incorrectly assume that the falling sales market would yield a rising rental market, that would-be purchasers become renters as credit went sour. After all, our second quarter market sales report showed a 25.6% year-over-year decline in resale apartment prices and a 50.3% decline in the number of sales. Therefore the rental market should jump, right?

But there's more to this. The modest 8.7% rise in sales inventory over the same period reflected the emergence of "shadow inventory" as a two-tiered formidable market phenomenon. This inventory type is comprised of apartments ready to be listed for sale but are withheld because of weak market conditions.

Many individual sellers who would throw their apartment onto the market at a price they demanded, opted to wait until the housing market improved. This had the effect of keeping the pace of rising sales inventory in check, but raising the probability that sales inventory at some point in the near future, would suddenly become bloated.

The more serious form of "shadow inventory" relates to new development and it is rising. A developer does not usually offer up all available units for sale as a marketing technique to create urgency. For a 150-unit condo, a developer might offer 50 units for sale initially and as those units sell out, release additional blocks of units until all units are eventually sold.

What happens if the initial block of apartments do not sell out?

A significant backlog has developed market-wide as new buildings enter the market and aren't being absorbed. As a result, a large number of units that are completed or nearing completion, have accumulated behind the public view. By some estimates, there are about 7,000 of these condos units in "shadow inventory" and growing. Add them to the 5,000 condo resale and new development listings formally on the market and there are roughly 12,000 condos to sell in Manhattan.

At a post-Lehman bankruptcy pace annualized pace of 3,200 condo unit sales per year, it would take 45 months to absorb all condo listings, 5 times more than the 9-month average absorption rate of the last decade.

Enter the rental market. That's got to be in better shape, right?

Developers and banks holding construction loans on new projects will likely be forced to rent out the remaining units on the rising number of stalled new development projects adding to the rental inventory. If the developers are foreclosed, the banks -- many of those have serious balance sheet pressures--will need to stem their bleeding by renting out the remaining units until they can sell them off. Individual sellers who need to sell but can't or won't sell at a loss, opt to rent out their apartments. Rental inventory continues to rise and rental prices fall.

We just released our rental report for the second quarter and the results sounded vaguely familiar to the sales trends. Rental inventory is rising at a 28.8% clip. There was a 17.5% year over year decline in rental price per square foot and a 58.3% decline in the number of new rentals.

One of the key culprits for the rental price and activity drop was the record low mortgage rates in the spring, which pulled many first time buyers out of the rental market (if they could qualify under the banks newly-found underwriting conservatism). Combine that shift with rising unemployment and there is less activity and downward pressure on rental prices.

One could therefore argue that the rental market is a leading indicator for the purchase market, at least in Manhattan. When the economy improves and the pace of unemployment begins to ease, the number of rentals should begin to rise, eventually followed by sales activity.

In other words, Manhattan real estate is more mental than rental.