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Dan Rose: 'Where do we go from here?' (analysis of foreign capital investment)

Following are excerpts from an address at a meeting of the Foreign Investors in U.S. Real Estate held at The Plaza Hotel, New York City.

As one who believes strongly in the benefits to everyone of the international free flow of ideas and of capital, I am delighted to speak before a group that puts those concepts into effective practice. Your members, we are told, own over $15 billion in U.S. real estate and $55 billion worldwide; and I have one word for you, "Welcome!"

Many Americans forget the crucial role foreign capital has played in our economic history -- the building of our railroads and our steel mills, the opening up of the American West, and so forth. And they forget that when our own internal savings are insufficient for our investment needs, foreign capital fills the gap; it promotes our economic growth and helps hold down our interest rates, while giving our consumers the benefit of wider choices and lower prices. And the multiplier effect being what it is, the end result is greater domestic investment, more jobs, greater tax revenues and greater well-being for all concerned.

If that is true of foreign capital investment in general, it is especially so of real estate investment, which literally builds up our economy's physical assets; so we clearly come out ahead.

This audience is more concerned, however, about what this signifies for the foreign investor; that means what should be done, first, with assets already acquired; and second, whether to acquire more, and if so, what, where and when. The short answer to the first question is that in a demoralized and capital-short market with many would-be sellers and few eager buyers, disappointed owners should probably, if at all possible, hold on, manage imaginatively and skillfully, and await the better days that I think are likely to come sooner than today's conventional wisdom anticipates.

The answer to the second question, on acquisitions, follows the same reasoning; and I think that the next 12 to 18 months may well present one of the great buying opportunities of our professional lifetimes.

Today, the name Reichman brings to mind the heartache of London's Canary Wharf; but only a short time ago it would have recalled their $320 million purchase in 1977 of eight Uris Brothers Manhattan office towers that the Reichmans refinanced for $1.5 billion in the mid-1980's.

A decade from now, the Bertelsman purchase of 1540 Broadway for $119 million, a "state of the art" structure which cost over $350 million to build, will look like a tremendous coup, especially since Bertelsman itself will occupy about half of the 1 million-square-foot structure.

But let's begin our discussion where we should, at the start of the current cycle that has caused so much anguish. The 1980's began with our major cities like New York, Chicago and Los Angeles living with office vacancy rates of 3 percent to 4 percent. Rents were rising, and buildings purchased in the late 1970's were showing cash-on-cash returns far better than those of stocks and bonds. By the end of the 1980-82 recession a "normal" cyclical boom could have been expected, based on routine supply-and-demand factors.

Then, an inflationary surge, due in part to O.P.E.C.-induced "oil shocks," focused attention on real estate as a widely perceived inflation hedge, and the boom went into over-drive."

When the Economic Reform and Tax Act of 1981 dramatically increased the tax incentives for real estate investment, shortening the depreciation "write-off" time as well as cutting the capital gains tax, real estate development exploded.

At precisely this moment, our nation's banks and Savings and Loans were permitted to pay more for deposits and to reach for higher returns. The S&L's, which previously had focused on one-family homes, went wild; and the fact that Congress raised the federal deposit insurance ceilings from $40,000 to $100,000 served to calm any depositors who might otherwise have become nervous.

Commercial banks, too, began over-extending themselves in real estate exposures, as they sought to replace diminishing larger customers with smaller ones, at higher fees but also higher risks.

An estimated I trillion dollars poured into new real estate development in the 1980's; and across the nation, office towers, motels, strip shopping centers and office parks sprouted like mushrooms after a heavy forest rain.

In all fairness, the decade also witnessed a dramatic economic boom that created 18 million new jobs; and the conventional wisdom of the time, extrapolating the future from the past, forecast the boom would continue indefinitely.

New York City, for example, added some 300,000 white collar jobs from 1982 to 1987. At 200 square feet per office worker, that translated into the need for 60 million square feet of office space, which is almost exactly the amount of new space produced since 1982.

Unfortunately, since 1987, New York has lost all of those 300,000 jobs; but the 60 million square feet of office space remain; and that is just about the amount of vacant space currently available in Manhattan at this moment.

Today, as everyone knows, the national office vacancy rate is at an horrendous 20 percent, the industrial vacancy rate in some areas is over 13 percent, hotel occupancies have plummeted, apartment vacancies nationally are near their highest points, and the real estate scene generally -- with values having dropped precipitously -- can only be described as disastrous.

It is no consolation for Americans to hear that their real estate problems mirror worldwide conditions, and that, for example, over 10 percent of all British private homes have mortgages greater than their value, or that Tokyo hotel occupancy today is at 71 percent, down from 82 percent a year ago (75 percent is needed there for profitability). Our problems are our problems, and they hurt us here and now.

But what of the period we are entering?

First of all, new construction has come to a screeching halt; because of a total lack of mortgage money, it is unlikely to resume in the immediately foreseeable future. The current poor cash-on-cash performance of real estate due to the immense oversupply, as well as current low inflation expectations and the 1986 change in the tax laws, removing real estate's preferential tax treatment, have all conspired to plunge the real estate field into severe investor disfavor. Real estate's relative illiquidity has also proved painfully apparent to some would-be sellers who suddenly wanted to liquidate positions but found that they could not.

Since potential institutional lenders now require developers to achieve substantial pre-leasing, and demand really significant owner equity investment, and even enforceable personal guarantees, it is highly likely that new product will not flow again soon.

Environmental concerns, increasingly severe impact fees, and widespread anti-development sentiment will also tend to dampen new construction prospects even when other economic factors become more favorable.

So much for the supply side, which will, in all probability, remain at a very, very low level for several years.

The demand side of the equation is more difficult to determine, and here we each must become our own judge, because painful experience has shown that there are no infallible experts"!

In an age where our Central Intelligence Agency had nothing to do but study the Communists, we experienced the national embarrassment of discovering that the C.I.A. had not the foggiest idea of what was taking place behind the Iron Curtain or the Berlin Wall; and the picture that our military experts had of Saddam Hussein's military capability was equally wide of the mark.

Our economists' forecasts have not been much better; and George Bush's 1988 promise of creating 18 million new jobs in his first term seems now like a bad joke. Instead of growing at the 3 percent annual rate Bush predicted, our economy grew at a rate of 0.7 percent per annum. Instead of a balanced budget by 1992, our deficit will be some 5.7 percent of our economy, up from 3 percent of G.O.P. in 1988.

The heart of the forecasting problem is that most forecasters merely extrapolate forward from experience of the recent past, where, in the real world, life itself tends to run in cycles.

It is true that today, in many economic areas such as employment and job creation, we are not sure how much of our problem is structural and how much is cyclical; but the majority of prominent real estate forecasters seem still to rely on simple extrapolation.

They take the current high vacancy rates, assume what would historically be a fairly high amount of new construction, apply for years to come recent recession-level demand rates, and then assume a return to a "normal" 5 percent vacancy rate. Then they say that the nation has an 8.3 year supply of office space, or an 11.8 year supply, or in one extreme case, a 20-plus year supply.

It is possible, of course, that they are right; but it seems highly improbable.

Another view, one that seems more realistic, posits a very low level of new development; some 2 percent a year of the inventory being removed by demolition. obsolescence or conversion to other uses; a new "normal" vacancy rate of, say, 8 percent to 10 percent; and, when the current recession eventually phases out, a continuing increase in demand of 2 percent to 3 percent per annum. If one applies these factors, life would look very different in just a few years.

Cash-on-cash returns based on today's acquisition costs will look impressive when compared to the returns on stocks and bonds. At what point will the 30-year government bond today yielding 7.22 percent not look so good as a well-designed, well-built, well-located -- and, most importantly, fully-leased office building selling on an inflation-hedged cash-on-cash return of 10 percent or more? And those increasing cash flows will be applied to the lower capitalization rates that are likely to prevail in the face of an increase in the inflation that will occur when the economy starts to move again.

In Business Week's Outlook issue for 1992, the consensus of the 50 economists polled was for a recession recovery weaker than normal but with inflation rising rather than falling.

Higher cash flows and lower capitalization rates. I believe. likely to prevail from the middle to latter part of this decade. and they are likely to be reflected in real estate values substantially higher than today's.

And for foreign investors, the current "free fall" of the dollar gives added impetus for timely purchases. Many professional money managers feel that the dollar is already too low; and that, in time, adjustments will be made.

Some observers call the present low value of the dollar "protectionism in its most elegant form," acting as a de facto tariff on our imports and a stimulus to our exports. For how long will the international "powers that be" permit this to continue? And just a the fall of the dollar has been painful for foreign investors, so its rise will be agreeable. But to return to the bricks and mortar. Of course, all real estate is local; and in the real world, some cities or regions will boom and some will stagnate; some types of real estate product, such as multi-family housing, will recover fairly quickly; some, like older, asbestos-laden office buildings in secondary downtown locations, may not recover at all. And that is a problem we will be agonizing over for years.

Given new development at rates less than the increase in demand, housing values are likely to rise in most markets, as they are currently doing in cities like Phoenix, Denver and Houston. In most markets, the substantial drops of 20 percent or 30 percent in value seem to have bottomed out.

Today's dismal hotel occupancy rates probably have another couple of years to go, but they, too, in time are likely to rebound from their recession dampened lows; and warehouse vacancy rates will start to move soon. The better-located, better-managed retail facilities will rebound when the economy does; and the others should not have been built in the first place.

The office problem is a thornier one. We just do not now know the full impact on our center city office buildings of factors like the emerging changes in communications technology, or the internationalization of white collar labor output. We do not know if the older center cities will continue to be saddled with the crushing costs of supporting the nation's underclass, with the resulting pressure on business to seek locations with lower taxes, lower crime rates, better schools and better value for the housing dollar.

We do not know if the trend to "edge city" development will continue unabated, or if the American back office, white collar labor force will prefer to work, live, play and shop away from the old downtowns.

But those office towers do exist, and if past experience is repeated, the newer, better buildings will eventually rent up, although not at rentals that please their owners. If those owners can, they should now strive for shorter, rather than longer, leases, so as not to find themselves locked into unfavorable rent levels far into the future.

Vacancies will tend to be concentrated in older, less desirable buildings which will require fresh capital, patience, energy, imagination and first-rate professional skills to tide them over a difficult period. For some, demolition or conversion to other uses may be the eventual answer. The time has come for tough-minded calculations on the true cost and "time value" of any fresh funds committed, and in some cases it just will not pay to commit "good money after bad."

No one claims that the period we are going through is easy or pleasant. Some analysts estimate that the total drop in our national real estate values is approaching $1 trillion (a 20 percent diminution on $5 trillion of property) and that the bottom has not yet been reached.

My point today is not an effort to minimize the pain and economic hardship that exist. It is to restore a sense of longrange perspective, to point out that those who can afford to wait will see better days, and that those with fresh capital available will soon face historic opportunities. May we all survive to enjoy the turn of the cycle.
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Author:Rose, Daniel
Publication:Real Estate Weekly
Date:Sep 23, 1992
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