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1992 economic forecast: no relief in sight.

There is a future, but many of us

won't be a part of it

David Shulman

Despite a small positive GNP gain of 2.4 percent during the third quarter of 1991, the U.S. economy is still teetering on the brink of a severe recession. Moreover, unlike previous recessions, the classic formulas for a recovery are not doing the trick.

According to Dr. Lawrence Chimerine, senior economic advisor to DRI/McGraw Hill, this recession is different than any since World War II. Speaking at the November American Soceity of Real Estate Counselors meeting in Las Vegas, Chimerine pointed out that strong GNP growth really stopped in 1989. Since then, government efforts to jump start the economy have largely failed.

"Most recessions since World War II have lasted about one year, followed by three or four years of growth," explains Chimerine, "but this recession reflects some fundamental long-term problems that traditional short-term solutions, such as cutting interests rates, will not remedy."

Nor is real estate in any better condition. "This is the worst environment for real estate since the Depression," says David Shulman of Salomon Brothers. "The 1973-75 correction was bad, but that only affected office and retail."

Chief among the causes of the current economic fall is an unprecedented level of debt, on the national, state, local, corporate, and personal levels. The $900 billion national debt of 1980 has reached $3.5 trillion in 1991.

Don Ratajczak, director of the Economic Forecast Center at Georgia State University, points out that in 1980 corporations held $3 of equity for every $2 of debt. By 1990, the equation had been reversed. Speaking at the fall meeting of the National Council of Real Estate Investment Fiduciaries, Ratajczak noted that 14 percent of all retail sales in 1991 are being conducted by stores in Chapter 11 and that service on personal debt has reached a historic high of 20 percent of disposable income.

"What we really saw in the 1980s was a leveraged buyout of the United States," comments J. McDonald (Don) Williams, president and CEO of Trammell Crow.

Corporations and individuals finally are beginning to reduce their debt, but many experts feel that the overhang of 1980s borrowing will limit recovery throughout the 1990s.

These aren't layoffs;

these are terminations

Larry Chimerine

Even for those few debt-free consumers, fear of unemployment has been sufficient to curtail new spending. U.S. unemployment reached 6.7 percent in September 1991, with an average of 14 weeks out of work for a job seeker. Perhaps more significantly, many service-sector jobs have been eliminated, not just temporarily suspended.

"The service sector grew incredibly in the 1980s to accommodate the baby boomers," explains Leanne Lachman, managing director of Schroder Real Estate Associates. "Boomers were entering the work force, buying houses, buying furniture, buying cars. In the baby bust of the '90s, there is simply no need for much of this capacity."

Wylie Grieg, director of research for RREEF concurs: "During the '80s, manufacturing firms were suffering and laying off workers, but they were making gains in productivity.

"At the same time, service firms--including those in real estate--were getting fat. Now they are going to have to cut the fat. These firms are undergoing a long-term structural shift to become less labor intensive."

Most have already seen the effects of this reduction in the real estate field. "I keep saying that by 1995 the size of the real estate industry will be reduced by one-third," says Leanne Lachman, "and people claim I'm conservative."

We can't count on

demand to lift us up

Paul Sack

It is not just real estate employment that is facing a cutback. The demographics of the baby bust will limit growth in the labor force during the 1990s to only half of that seen during the 1980s.

"For the next seven years or so, we will have a much smaller number of 20 to 25 years olds," says Susan Hudson-Wilson, director of research for Aldrich Eastman and Waltch. "That means fewer household formations, fewer workers needing office space, and fewer buyers for retail." Hudson-Wilson predicts that demand will not take a significant upturn until 2000-2015, when the children of the baby boom enter the workforce.

The economic downturn has added to this problem by producing its own short-term reduction in demand. "Until the economy is moving again and companies are encouraged to go and lease moe space, we really aren't going to see any improvement," predicts Wylie Grieg of RREEF. Grieg points out that the demand for office space typically lags the recovery by two to four quarters.

And because low rents have prompted businesses to increase average space per worker from 260 to 410 square feet in the last decade, according to an MIT study, absorption may take even longer.

On the other hand, industrial and retail demand may reverse much more rapidly. "Usually industrial demand picks up fairly quickly once inventories begin to grow," explains Grieg. "But so far, manufacturers have been reluctant to expand because of the slow recovery."

But demand is only one side of the equation. The relationship between demand and supply is what truly drives the market. And if demand is sluggish, supply is almost nonexistent.

We built for the

1990s in the 1980s

Dale Reiss

Lack of credit and concern over yields had virtually stopped construction and lending by 1991. "We just turned off the supply machine, which is phenomenal," says Hudson-Wilson. "Unfortunately there were a lot of people hurt as a result."

Yet even with the cut off of supply, inventories remain at unprecedented levels, especially in the office sector. "Half the office buildings in this country were built after 1988," says Grieg.

Don Ratajczak reports that in 1980 only two cities had office building vacancies of more than 10 percent. But by mid-1992, CB Commercial/Torto Wheaton estimates that average national office vacancies will reach 19 percent, up by 5 percentage points from 1990. Vacancy rates in industrial and retail are following similar, if less dramatic, patterns.

Apartment vacancies have shown some improvement, but only because the 1986 Tax Act cut off supply five years ago. "Demand for apartments is terrible," notes Hudson-Wilson, "but supply is even worse."

Most experts believe that existing overcapacity will be absorbed during the 1990s, but others are not as certain. "The real problem is that developers in the '80s anticipated where growth would be--downtown versus suburban, the Sunbelt versus the Midwest--by prebuilding the '90s," says Dale Reiss, managing partner, Chicago office, of Kenneth Leventhal & Company. "But demand does not always follow supply, and it may be the middle of the decade before we know if much of our oversupply is mislocated."

But if oversupply has been a problem in the past, it is not likely to be so in the near future--thanks to the credit crunch.

Real estate is facing a liquidity

problem that is probably the worst

since the Depression

Michael Herzberg

Over the last two years, a shortage of money for real estate has created a gridlock in development, sales, and refinancing. Nor does that situation appear likely to change in the near future.

"It isn't the cost of capital," says David Gialanella, director of marketing for Cushman and Wakefield, "that is the lowest it's been in years. The question is the ability to finance a deal."

"Bankers are rewarded for harshness," continues Don Williams of Trammell Crow, "so why should they lend?"

Hard-pressed banks and insurance companies already carry record levels of real estate debt. According to the 1992 Emerging Trends in Real Estate, published by Equitable Real Estate Investment and Real Estate Research Corporatin, the real estate exposure of commercial banks equals 29 percent of total assets; insurance companies average 24 percent of total assets in real estate.

Nor are these institutions likely to be able to significantly reduce their holdings in the near future--no matter how hard they try. The National Realty Committee estimates that banks will face a rollover of $197 billion in short-term loans between June 1991 and June 1993. Yet during the 1990-91 period only one-third of the short-term laons held by commercial banks were repaid. The remainder were extended or foreclosed.

Michael Herzberg, CEO of Ferguson Partners notes: "Banks are under tremendous pressure to reduce their real estate loans. The problem is they have very little choice but to renew."

Life companies face a similar problem, with an estimated $75 billion in bullet loans and guaranteed investment contracts coming due during the next two years. David Shulman estimates that 20 percent of these outstanding loans will be paid in cash; another 50 percent will be rolled over; and the remaining 30 percent will be delinquent. Shulman notes that defaults are already at 15 percent, an historic high.

"I don't think you are going to see many traditional real estate lenders who aren't struggling with their portfolios," says Wylie Grieg. Like the banks, life companies will need most of their capital alloations just to cover their own problems.

Yet, despite the exit of traditional lenders, there are still some sources to fill the void. Credit companies, long a lender for more speculative projects, are making substantial inroads into real estate lending.

Sol Rabin, director of research for TCW Realty Advisors, predicts that foreign banks also may increase their market share as capital requirements force domestic banks to withdraw further from real estate lending.

Securitization of commercial mortgages--long an idea tossed around on Wall Street--has once again attracted attention. Although commercial mortgage-backed securities have been rated since 1987, very little activity had occurred. But last fall's securitization of loans on real estate held in the RTC's portfolio has opened the door to this new capital source.

David Shulman predicts that it may be two to three years before securitization becomes widespread. Yet, eventually individuals, as well as institutions, may become new sources of funding for commercial real estate.

REITS are another securitized vehicle that is attracting more attention thanks to the credit crunch. "Figures are hard to come by, but I think that pension funds have invested over $1.3 billion of new money in REITs in the last year," reports Wylie Greig.

While pension funds have the money to alleviate the current credit freeze further, they are unlikely to do so. Poor performance by the asset class has eroded interest in additional real estate investment. "There is an enourmous disinterest in real estate as an asset class because of its performance in the marketplace," says Rabin. He notes that, far from allocating additional money to real estate, many pension funds are attempting to withdraw monies from commingled funds.

Get used to the volatility

because it is real

Susan Hudson-Wilson

In the 1980s, real estate often was sold to pension funds as an asset that only went up. However, the last few years have shown just how cyclical it can be. Over the past four years, performance of the unleveraged properties in the Russell/NCREIF Index have not performed as well as risk-free treasury bills, according to David Shulman. In June 1991, the Index posted its first annual negative return of -1.1 percent. While stronger segments such as retail (11.2 percent return) remained viable, widespread writedowns in value severely reduced performance.

"In actuality, total returns on real estate have been declining from a high of 21 percent in 1979 to something on the order of -2.2 percent today," says Sol Rabin. "The notion that real estate was booming was largely a fiction brought on by decreases in the capitalization rate."

Paul Sack, a principal with RREEF, is not quite as harsh. "The last viable year of real estate performance was 1983. After that credit drove the market. The banks couldn't lend to Brazil any more so they lent to developers," he explains.

But for conservative pension funds, value declines of 20, 30, or 40 percent can be frightening. "Real estate was sold as a non-volatile investment," explains Susan Hudson-Wilson. "And it is, in the long run. But that doesn't mean that there aren't cycles. All equity investments are volatile."

Hudson-Wilson believes that the dramatic reaction of some investors occurred because they have never experienced a down cycle before. "The stock market can drop 20 percent, and no one talks about selling out," she continues. "Why can't it be the same for the property market?"

FIRREA requirements for annual appraisals have forced pension funds to confront declining values, but other institutional owners--banks and insurance companies--are doing their best to avoid recognizing losses.

The market cannot be cleared

at current values, and the

banks won't take the hit

Don Williams

While many have predicted massive foreclosures and sell-offs of properties, so far there has been only limited activity. Says Leanne Lachman: "Most banks simply cannot afford to take the write downs on their loans that should be taken." Lachman predicts that banks will work to build up reserves against projected defaults and postpone foreclosures for as long as possible to spread out losses.

Nor are regulators forcing banks to foreclosure. Susan Hudson-Wilson explains: "The regulators learned their lesson in Boston. They forced several banks to foreclose, and those banks failed. As a result, the regulators have backed off significantly in the last twelve months."

Insurance companies are also postponing foreclosures to minimize their on-paper losses. The accounting guidelines of the National Association of Insurance Commissioners allow life companies to carry a mortgage at book value for five years, but require a foreclosed property to be written down to market.

"Life companies hope that, in five years, real estate values will have recovered and they will be in good shape," says Susan Hudson-Wilson. "But I think it is a delusion; it's not going to work."

Sol Rabin is more optimistic. "If repricing occurs in three or four years, as I think it will, many owners will be able to wait out the downturn and get full value for their properties," he predicts.

Yet the end result of this fiscal maneuvering is to extend the time it takes to readjust values. "It is likely to be two or three years before owners hanging on by their fingernails are foreclosed," predicts Leanne Lachman. "This will only prolong the process of restoring the market to equilibrium."

Eventually, however slowly and gradually, real estate prices will come down, presenting buying opportunities.

There is a price at which anything

is an attractive buy

Dale Reiss

When prices reach a low enough level, as they have in a few cases, savvy real estate investors may be able to make big money in the 1990s. "The key is to buy the appropriate property and to pay the right price," says Ray Torto, principal of CB Commercial/Torto Wheaton. "In the 1980s you made money when you sold real estate; in the 1990s, you will make money when you buy it."

"Value has to be based on current income levels," says Don Williams. Williams believes that reasonable levels for pricing are at 8 to 10 times cash flow.

Paul Sack of RREEF agrees: "Prices must come to 50 percent of replacement cost to make buying viable."

David Shulman also predicts that higher returns will be needed before institutional money returns to real estate. "Cap rates of 10 to 11 percent are needed to realize the return institutions expect," says Shulman, "but that will require substantial repricing."

Yet even at the right price, not every property is a bargain. Says TCW Realty Advisors' Sol Rabin: "There's no point in buying a distressed property if it takes 10 years for rents to increase."

While it may not take quite that long, Ray Torto anticipates that it may be 1995 or 1996 before yields rebound. "Vacancies will probably begin to drop this year," says Torto, "but it will take a year or two before rents move up. And because the real estate asset market lags the space market, it may take several years for values to recover."

Nevertheless, Rabin predicts that for the astute advisor it is a wonderful opportunity to provide investors with above average returns. "The key is to recognize these buying opportunities before it is too late," he concludes.

Wylie Grieg concurs: "Some of the more experienced funds will recognize that this is a good time to buy property at a good price."

Yet, even with some significant problems, news of real estate's demise may have been exaggerated. "There is a tendency to paint the whole industry with the same black brush," laments Sol Rabin. "But there are over 1,000 submarkets in the country, and some of them will recover very rapidly."

Leanne Lachman also feels that some have overstated the problems. "The bulk of real estate is still performing," she says. "It hasn't gone into default. The income stream may be a little lower, but the owners are running the building and paying the mortgage."

Paul Sack also believes that problems in real estate have been exaggerated. "Much of the fall in the NCREIF/Russell Index has been as a result of poor office performance," he points out. "Between 1985 and 1990, the Index showed compounded industrial property returns at 10.6 percent and retail at 11.7 percent."

Lachman explains that it generally is the newer properties that are not fully leased which stand the greatest chance of failure.

"Almost a third of the real estate built after 1988 is vacant," reports Ray Torto. "The only way new buildings can survive is to get sold with a debt service that allows their rents to compete with older buildings. That cycle may take a long time."

Nor is economic recovery likely to alter this situation. Larry Chimerine predicts that growth for 1992 will reach only 4 percent. Still, even weak markets offer prospects for some.

The glamour of acquisition is

being replaced by the drudgery

of asset management

David Shulman

Experts continue to predict that property and asset management will be more in demand in the '90s than ever before.

"Over the next few years, working the properties as intensely as you can will be the key to survival," predicts Leanne Lachman.

"More and more attention is being paid to cash yields," says Wylie Grieg. "As a result, managers are feeling increased pressure to keep the building full, keep earning money, and continue generating current income."

Development opportunities pose a more difficult question. "I think that the developer of the 1990s will be one who knows marketplace dynamics, not one who can calculate mezzanine financing," says Dave Gialanella. "It is ironic. We looked down on these guys in the 1980s because they didn't have the Wall Street savvy. But I think that a more fundamental approach will have an advantage in the 1990s."

Even within sluggish markets, opportunities exist. "Recreational real estate, especially near-in weekend homes, will be one attractive area in the next ten years," says Lachman. "Two-income families that have made compromises to stay in an urban area are going to put more emphasis than ever on their lifestyles." Lachman notes that this trend will bode well for home improvement retailers.

Susan Hudson-Wilson feels that the 1990s may be the decade when "we may finally get elderly housing right." She believes that past efforts have failed because developers did not understand where the elderly want to live and what types of services were really required. "Developers also did not understand how management intensive congregate care is," she says. "It is more like hotel management than apartments."

Dave Gialanella notes that the issue of financing must also be addressed before large-scale construction of elderly housing becomes viable. "The high cost of entry into elderly housing makes it difficult to build anything that is not either heavily subsidized or high end." He sees economic incentives to private developers as the most efficient way to produce needed moderate-cost housing.

Ways to fund mid-range homes are also a concern of Hudson-Wilson. "We are investigating ways of channeling pension fund money into the construction of moderate-income housing," she says. "That's where th bulk of Americans are, making it a deep, stable market."

But, for the majority of the real estate industry, the few opportunities available are overshadowed by the current problems.

The 1990s will be

like the 1950s

Paul Sack

"Even when the recession is over, real estate will experience the shock waves for several years," says Leventhal's Dale Reiss.

Nor will the glory days of the 1980s ever return. "We are returning to the days of one-third equity and preleasing," says Paul Sack.

Ray Torto predicts that construction levels in the 1990s will be similar to those in the 1950s, when very little office space was constructed. "It will start to edge up in 2000," he predicts, "but non-recourse, no-amortization financing is a thing of the past."

"Institutions have a long memory and big sensitivities," says Susan Hudson-Wilson.

Yet, every cycle--no matter how long--has an upswing. "At some point, the spread between treaury yields and available mortgage yields will become so wide that mortgages will become an attractive investment," says Dale Reiss. "Then institutions will re-enter the market."

In the end, the advice from real estate experts nationwide is simple to understand, if hard to execute: manage intensely and wait for the upswing. Or as the guru of real estate bad times states it so succinctly:

Stay alive 'til '95

Sam Zell

Mariwyn Evans is the managing editor of the Journal of Property Management.
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Title Annotation:includes related articles
Author:Evans, Mariwyn
Publication:Journal of Property Management
Article Type:Cover Story
Date:Jan 1, 1992
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