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Real estate 1991 - the party's over.

When even ever-optimistic real estate developers cannot find a positive word to say, the outlook for 1991 must be pretty grim. And as talk of recession, fighting in the Middle East, and plummeting real estate values fills the air, few will voice optimisim, at least for the immediate future.

John Tuccillo, chief economist for the NATIONAL ASSOCIATION OF REALTORS, [R] characterizes the year ahead as "a fairly perilous time for the economy." And three consecutive quarters of negligible GNP growth and rising unemployment rates have compelled even ardent boosters to say the word "recession."

According to Kenneth Rosen, chairman of the Center for Real Estate and Urban Economics at the University of California, Berkeley, uncertainty, both at home and abroad, is the single largest contributing factor to the current downturn.

Speaking before the November meeting of the Urban Land Institute in Chicago, Rosen cited several key factors contributing to current recessionary problems--the uncertainty in the Middle East and the resulting higher oil prices, policy uncertainty over budget reform and the S&L crisis, and the tremendous amount of debt throughout the economy, combined with very tight credit. Each of these key issues shakes the financial underpinnings of the economy.

The Middle East

"The question of the Middle East is the biggest foreign policy crisis facing the United States, today," says William Quandt, senior fellow in foreign policies at Washington's Brookings Institution. However, Quandt believes the immediate threat of higher oil prices is less significant than the long-term changes in the balance of power.

While economists agree that short-term increases in oil prices have dampened the economy and hurt consumer confidence, most believe that prices would fall to $22-to-$25-barrel levels if the current crisis is resolved. But with two-thirds of the world's oil reserves, the Middle East could continue to hold the United States, European, and Japanese economies hostage unless broader accords are reached.

And this may not be easy. Marvin Zonis of the University of Chicago believes that the Islamic fundamentalist countries of the Middle East are "opting out" of the economic concerns of the 1990s. "They are attempting to escape from history," Zonis continues. "If this trend is not reversed, the volatility in the Middle East will continue to plague the decade."

The budget

If the uncertainty in the Middle East is only partially under United States control, the same cannot be said of the second principal cause of economic uncertainty--the budget deficit. Even with the recent budget reductions, the budget is "out of control," says Kenneth Rosen. Despite recent agreements to increase taxes and cut some programs, federal deficit estimates for 1990 are still $250 billion, with the possibiity of recession pushing the figure still higher.

Even more frustrating is the government's seeming inability to act. "The unwillingness of the government to take decisive action is making a bad situation worse," says Jules Galanter, CPM, [R] of the Illinois Housing Development Authority in Chicago. "The way in which the budget crisis was handled exacerbated the belief that the government is wasteful and inept, further destroying confidence."

Craig Bayless, managing director of Tishman Speyer Properties, agrees. "Most people are willing to make sacrifices to lower the budget deficit if the government would act," he says. "Everyone knows a big tax bill is due, and most people want to begin paying it."

The unresolved deficit also poses the possibility of a return to the stagflation of the early 1980s, according to David Reilly of Aetna Realty Advisors, Boston. If stagflation does occur, he contends, "operating expenses could begin to rise much faster than rental rates, making the real estate situation worse. And if the government does loosen monetary controls to fight inflation, the question is how quickly and how long would it help real estate."

Worse yet for real estate

While most experts agree that the recession will last two years or less, assuming that oil prices stabilize and the deficit is brought under control, real estate faces a much longer downturn.

"Many people confuse hard economic times with hard development times," says Sol Rabin of TCW Realty Advisors in Los Angeles. "They assume that once the hard economic times are over, development will spring back. But we would be having hard development times whether or not we were having a recession."

Overbuilding in almost every property type in every market, driven by plentiful capital and lenient tax laws has created an unprecedented glut of product. Rabin points out that 38 percent of all existing office buildings, 33 percent of all shopping centers, and 25 percent of all industrial buildings were built in the last decade. Absorption projections range from an optimistic two years to as much as a decade in some southwestern and northeastern office markets.

"The supply is so vast that the result is more than just a down cycle," says Pamela Herbst of Copley Real Estate Advisors, Boston. "This is not just a matter of waiting a short time for demand equilibrium."

A whole new economy,

a whole new ball game

While some opportunities may remain--in build-to-suit, industrial renovation, and apartment construction--the question remains: Is this just another down cycle in real estate? Or is the industry undergoing some fundamental change?

"The problems facing real estate are more than just overbuilding," says Raymond Torto. "Aggregate demand and absorption are slowing."

The Coldwell Banker indices for the third quarter of 1990 shows industrial vacancies at 6.9 percent, up 1.1. percent over the last two years and downtown office vacancies at 17 percent, virtually unchanged since 1988. Suburban offices have made some gains, with vacancies dropping by 3 percentage points in the last two years.

This declining or stagnant demand is the direct result of demographics, says David Birch, president of Cognetics in Cambridge, Mass. Citing statistics from his study, America's Future Office Space Need--Preparing for the Year 2000, written for the National Association of Office and Industrial Parks, Birch noted that in 1980, the rate of growth of the work force actually began to decline.

While the actual size of the labor force grew by 17 percent in that period, according to American Demographics, much of this expansion was a unique phenomenon. The greatly increased entry of women into the job market, which accounted for 60 percent of the labor force growth gain, is unlikely to be repeated.

Nor will the labor force continue to grow from population increases, as the number of people in the entry-level 16 to 24 years age range fell by 13 percent from 1980 to 1990. Even more troubling for the office market is Birch's projections that white-collar workers will decline as a percentage of the work force during the 1990s, the first drop in this growth rate in 90 years.

"This is a new game," says Birch, "not a hiccup in the market."

The companies employing these workers are also changing, becoming smaller and more mobile.

"If the rest of the country follows Texas," says Ted C. Jones, senior research economist at the Real Estate Center at Texas A&M University, "we will see a massive diversification of tenants, with an increased emphasis on smaller companies.

"As Texas has begun to recover from its economic shock, we find that the big companies are gone. Instead we have smaller, more entrepreneurial tenants whoe are expanding rapidly. The growth in the 1990s will take place in smaller businesses."

David Birch's research supports this prediction. While the top 10 percent of firms by size account for 90 percent of the jobs in the economy, Birch estimates that 98 percent fo the firms that will constitute that group in five years now have fewer than 100 employees.

For the property manager, smaller tenants mean not only smaller space users, but ones that require different space configurations, parking allocations, and amenities. "People still pay lip srevice to the aggregate," says Ted C. Jones, "but the shift toward niche marketing of services and even of buildings geared to specialized tenants is already quietly underway."

The credit drought

If real estate is buried in a hole drug by overbuilding and declining demand, two other factors have added weight to the burden--the recent unavailability of credit and the ongoing market fallout created by the S&L disaster.

In defining the impact of the credit crunch on real estate, Sol Rabin points out that there are in fact two shortages--one of capital for new construction and another of investment capital to buy and refinance existing product. "The construction capital shortage will be with us for several years, but that is positive," comments Rabin. "On the other hand, the exodus of investment capital will be short-lived."

In the meantime, however, the Resolution Trust Corporation may be further exacerbating declining values in the South and Southwest. "As soon as the RTC takes over a property, it loses value because of the general market view," says Lawrence Jacimore, CPM, of Eagle Realty, Little Rock.

But the declining value of RTC properties are physical as well as psychological. "The RTC is slow," says Jo Anne Corbitt, CPM, of EDC Management, Nashville. "Under RTC control, properties are going into a dormant stage. And the deterioration that results may not be recoverable."

The slowness may be understandable, but it adds another weight to the burden. "We're trained to be problem solvers," says Michael Simmons, CPM, of Community Realty Management in Atlantic City. "It is frustrating to be forced to deal with layers of bureaucracy to accomplish anything."

Nor do most property managers see this situation improving. "The primary govrenmental focus seems to be shifting away from the resolution of the problems to prosecuting those who caused them," reflects John Bennett, CPM, of James S. Black and Company, Spokane.

While the RTC is a regional issue that does not affect all areas of the country, it is the strongest manifestation of the complete restructuring of financial institutions going on today. The overwhelming waves of capital that drove the real estate developments of the 1980s have abruptly dried up.

In hindsight, the current credit situation seems predictable. Ted C. Jones notes that "in the 1980s, we stripped off every law and regulation added after the Great Depression to ensure banking integrity. When you change the rules again, the shock is bound to create chaos."

A repricing of the market

And chaos seems to be just what happened. According to Kenneth Rosen, 64 percent of all assets created by commercial banks over the last five years were real estate. The wide availability of credit made 100- and 110-percent construction loans the norm.

But as the market faces up to the unrealistic projections of the last few years and the unlikelhood of a quick recovery, cap rates are rising and prices are falling.

"Fundamentally, there has to be a repricing of assets," says Charles Wurtzebach of Prudential Real Estate Advisors in Newark. "And as values decline, people are going to find that there is a lot more risk in their portfolios than they realized."

Raymond Torto of Wheaton-Torto Services, Coldwell Banker Commercial in Boston, estimates that buildings bought in 1987 have lost as much as 30 percent of their value already.

David Reilly concurs. "Real estate seems to be undergoing a structural pricing change," he says. "Property sales trends indicate that there is a decided difference of opinion between sellers and buyers as to what property values are.

"There is no doubt that cap rates and IRR expectations are higher than they were even six months ago. We are seeing pricing declines of 100 or 150 basis points. This has major ramifications for all property owners. But once we get over the hump in four or five years, with lower vacancies and construction at record lows, the reverse will occur, and prices may see a rapid rise."

George Myers, Jr., CPM, of Myers Management Company in New London, Conn., already sees the fallout. "I remember my grandfather telling me about the Great Depression," he recalls, "and I always imagined it was something from the past. But when we see certain buildings in the Northeast lose 50 percent of their appraised value in a one-year period, I think I may be seeing a depression."

"And the final question," says Jarvis Edwards, CPM, of Drucker & Falk, Newport News, Virginia, "is when or if these values will ever return."

But as real estate values declined, so did the banks's real estate portfolios. A recent Wall Street Journal article comparing the performance of 18 real estate stocks with the Dow found that while stocks overall had fallen 20 percent in value between July and October 1990, real estate stocks had declined by 31 percent.

At the same time, the S&L crisis brought on more stringent capital and underwriting requirements mandated by FIRREA. Faced with this double whammy, banks are struggling to stay afloat and frantically trying to get out of real estate.

For developers, this reluctance to lend trnaslates into severe difficulties getting permanent financing, even on well-leased buildings. "Banks and investors are worried about long-term effective rents, the stability of tenants in volatile industries, and falling values," says Pamela Herbst. "Because of this reluctance, there will be short-falls, and owners will have to come up with cash."

And if money is available, terms are probably more stringent, requiring lower loan-to-value ratios and developer equity. "Before 1975," says Jean Felts of Dupree, Felts and Young in New Orleans, speaking before the November meeting of the American Society of Real Estate Counselors, "you used to need real cash. Now we are hopefully seeing a return to that reality."

In some cases, this new push to recoup equity may force a property into default. "The banks have tunnel vision," says Jo Anne Corbitt. "They are not looking at the fact that a property is performing well in the market and may need only temporary abeyance to survive. Sometimes it seems as if the bank's loan department is only interested in foreclosing so that they can move the problem to antoher department and get it off their books."

Nor are commercial banks the only firancing source withdrawing from real estate. Pension funds and foreign investors--disappointed with the real estate return of the last few years--are lessening their market activity.

"There is still room for growth in pension plan involvement in real estate," says Charles Wurtzebach, "but growth in the next two years will not come close to what we have experienced in the last five."

Instead, he continues, "pension funds will devote most of their efforts to restructuring existing portfolios as best they can, not in increasing exposure." Wurtzebach also believes that plan sponsors will become aware of exactly what real estate products they need to complement a portfolio and will concentrate on specific requirements, rather than general allocations.

"If you go into a store and don't find what you want, you go down the street and look until you do," concludes Wurtzebach. "Likewise plan sponsors have to define their portfolio objectives and demand the particular product they need."

James DeLisle, of Equitbale Real Estate Investment Management, Inc. in Atlanta, sees a similar trend to more direct participation by plan sponsors, in the form of more single-client accounts to complement existing "core," commingled investments.

Light in the tunnel

But this light at the end of the tunnel shines only for existing properties. "Anyone doing new development today is making a grievous error," says David Reilly, "unless a property is very unusual. The risk-return ratio is just not there."

David Birch estimates that only 6 percent as much development needs to be done n the 1990s as was done in the 1980s. Even with obsolescence resulting from asbestos, limited computer capacities, and outmoded technology, Birch raises this percentage to only about 23 percent.

But that does not mean thta real estate will never recover. "Once we get over the hump, the reverse will occur," assures Reilly. "Buying demand will rise within the next 18 to 24 months as assets become more attractively priced."

What will it take to bring capital back into real estate? The unanimous answer is "higher yields." "Today, the only reason for owning property is for the cash flow," says Ted C. Jones.

Charles Wurtzebach agrees that the knowledgeable investors will probably re-enter the market in one to two years. "Basic economic fundamentals suggest that when everyone runs away from an asset, it gets repriced and becomes more attractive," he reflects. "Then the money will come back."

Jean Felts anticipates that IRRs will need to reach between 12 and 14 percent before investors will return to the market. Real Estate Research Corporation estimates that the current median real estate yields were in the 11.5 percent range and median cap rates were 7 percent.

But for the time being, real estate faces a period of financial gridlock, with few transactions. "Sellers are looking for yesterday's prices," says Raymond Torto, "while buyers are looking for tomorrow's. In investment, timing is everything, and the time is not right yet."

If it is a poor time to buy, it is an even worse time to sell, says Craig Bayless. "Those that don't have to sell in 1991, won't. Although there will be some grave dancers who will take advantage of the distress of others."

In many cases, these "others" are often entrepreneurial developers unable to refinance loans on properties or to come up with the cash needed to bridge the difference between new equity requirements and declining property values.

"Cash is definitely back," concurs Raymond Torto. "Real estate is no longer a deal business, and many of the old truisms just don't apply."

A scramble for a smaller pie

"You're going to see a big restructuring of the real estate industry over the next three years," predicts Pamela Herbst. "The traditional developer is going to have trouble going forward and finding financing. Political and environmental issues will also make development more difficult."

"This is a classic consolidation situation," concurs Charles Wurtzebach. "Over the years of rapid increase, investment managers have increased their staffs in anticipation of still greater demand. When demand failed to materialize, they are forced to downsize.

"The same situation exists for all real estate categories--developers, property managers, urban planners, and financial people," Wurtzebach continues. "If there are fewer buildings being built and bought, there is less need across the board."

For developers bent on survival, downsizing is only part of the answer. The second part is diversifying into fields such as property management. Most experts agree that if there is a growth area in the 1990s, that area is property management.

"If the 1970s was the decade of the developer and the 1980s was the decade of finance, the 1990s will be the decade of the property manager," says Alan Huffman, CPM, of Key Management Company in Wichita. "We will be trying to salvage whatever is left.

"At the same time," Huffman continues, "property managers will face increased competition from developers who no longer have anything to develop and financial people who no longer have anything to finance."

Ted C. Jones goes even further. "It is the property manager who controls the destiny of the property today," he states. "He or she is responsible not only for the property's tenants, but dictates the quality of life for those near the property. If a property becomes run down, it affects the entire area.

"The manager must be able to understand the needs of every layer of the real estate market--international, national, local, and site specific," continues Jones. "Of these the local is by far the most important. Even if you lease to national, low-credit tenants, if the local contact is dissatisfied, you are in trouble."

James DeLisle agrees. "While there is still a dichotomy between the bottom-down and the top-up approaches to management, the 1990s will see real estate managed 70 percent on the fundamentals and 30 percent at the portfolio level," he says. "The management will be the foundation of real estate success."

But even for the in-demand property manager of the 1990s, the next two or three years will be tough. "There will be a period of three or four years before we see any significant upturn," predicts Donald Creath, CPM, of EDC Management of Florida, Boca Raton.

And when recovery comes, it will not just be business as usual. "Managers are going to be dealing with a totally different kind of client," says Jarvis Edwards, "asset managers from institutions, from failed banks, or from the RTC. These managers will be demanding much more than ever before with specialized reporting requirements and shorter term contracts. But if you are willing to adapt, it could be a very good decade."

But the final word belongs to David Birch. "In five years, the hero will not be person who has built the tallest building in town," he concludes. "It will be the person with 98-percent occupancy."

Mariwyn Evans is the editor of the Journal of Property Management.
COPYRIGHT 1991 National Association of Realtors
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Evans, Mariwyn
Publication:Journal of Property Management
Date:Jan 1, 1991
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