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After The Fall: Saving Capitalism From Wall Street--and Washington

After The Fall: Saving Capitalism From Wall Street—and Washington

by Nicole Gelinas

The Developers’ Bailout
Propping up politically connected real estate won’t help New York.
24 February 2009

In yesterday’s Daily News, Avi Schick—the former head of Albany’s economic-development agency, the Empire State Development Corporation—unveiled a truly awful idea. And that’s really saying something these days. Schick wants to use taxpayer-guaranteed state and city pension funds to prop up the city’s teetering commercial real estate. His proposal would likely exacerbate our commercial real-estate problems, while imperiling pension funds and thus tax dollars.

Schick notes that in today’s financial crisis and economic upheaval, “office and residential buildings, warehouses and distribution centers” in Gotham “can’t be financed, and those that need to be refinanced have nowhere to turn and will be in danger of default.” His solution: “New York should create its own fund to provide financing to critical real estate and development projects across the state.” To pay for the program, the city and state pension funds would put up $2 billion in public money to be matched by union pension funds from the private sector and, Schick thinks, bank funding. Schick believes that the public and union money, along with the initial bank money, could raise at least $5 billion. Further, he thinks that the money could attract additional Federal Reserve and other federal government money.

What’s wrong with this idea? It’s hard to know where to start. First, subsidizing new construction would add to a growing glut of empty real estate in New York. “Building values are dropping as unemployment worsens, offices empty, rents decline, credit remains tight and buyers expect higher rewards for taking on more risk,” the New York Times reported last week. The commercial vacancy rate has risen from under 6 percent to double digits in less than a year. Why create even more “critical real estate and development projects” that nobody wants?

Second, preventing buildings from falling into default isn’t the noble goal that Schick suggests. When buildings default, their prices fall, and that leads to lower rents for tenants. Over the past several months, office-building values in New York have fallen off a third or more, and office rents have dropped nearly 16 percent. This correction is necessary. For the past few years, the Manhattan real-estate market had sizzled as hedge funds, banks, finance-related law firms, and the like paid escalating amounts for premium space. In 2005, 2006, and early 2007, owners bought buildings—and lenders financed them—based not on income from current rents, but on the expectation of ever-rising rents.

Now, every Wall Street firm and nearly every commercial bank that has failed, or nearly failed, needs to shed office space. Citigroup, Merrill Lynch, Lehman Brothers, Bear Stearns—their imploded profits have all left behind acres of empty space overlooking midtown and downtown Manhattan. Wall Street may not regain anything close to its super-profitable bubble-era form; and though New York, provided it keeps up public safety and the like, certainly can attract new industries to replace Wall Street, those industries almost certainly won’t be so flush with cash, so lower rents are inevitable. The commercial real-estate market needs to purge itself of its speculative assumptions built on twin bubbles in credit and in the financial industry—and that will hurt.

The good news, though, is that lower commercial rents are not a bad thing for New York. Excessively high commercial rents benefit only owners. They hurt tenants, and thus the city’s attempt to diversify itself and move away from a financial industry that has imploded. Anything that New York City and State do to prop up commercial prices thus will not only delay the industry’s recovery; it will injure the rest of the city’s economy, too.

Schick’s talk about attracting private dollars with public dollars is also worrisome. The public sector would probably take on much, if not most, of the financial risk in order to attract private-sector investors. The state and city pension funds—and taxpayers—therefore would face a risk of significant losses at exactly the wrong time, as the market forces pushing real estate prices down simply would overwhelm the government’s relatively paltry amount of cash.

One final problem: who will decide which real estate projects are “critical”? Schick notes loftily that “lobbying must be prohibited. . . . If pension funds are on the line, it must be all about the numbers, not who you know.” The state pension fund, though, has a history of allegedly choosing managers based on political contributions, as investigations into former New York State comptroller Alan Hevesi have shown. Plus, developer Bruce Ratner is lobbying heavily for federal “infrastructure” stimulus money for his Atlantic Yards condo and basketball-stadium project—a centrally planned Brooklyn boondoggle that already benefits from hundreds of millions of dollars in public subsidies.

Ironically, if Schick and his predecessors at Albany’s economic-development agencies had done a better job of overseeing reconstruction at the World Trade Center site, they’d have alleviated one bit of this “crisis.” Developer Larry Silverstein could have easily obtained generous private financing to complete the new World Trade Center towers four years ago—maybe even two years ago. But not in today’s post-meltdown Manhattan: if the site gets fully rebuilt, more public money is likely needed.

As it happens, Ground Zero is the only city site where it’s possible to argue with a straight face that the city and state governments should directly support construction, because it’s a matter of rebuilding a neighborhood that terrorists destroyed—an objective that goes beyond purely economic and financial considerations. But even there, the state and city certainly shouldn’t make such investments through the pension funds, confusing public policy with profit-seeking investments. And as state and city resources shrink, even public subsidies for Ground Zero are less justifiable. New York City needs working subways, not more vacant real estate.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst. She blogs at nyfiscalwatch.com.

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