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Prospecting in the real estate rubble.

The realestate market is comatose. After a prolonged illness attributed to an overdose of euphoria, it slid into a coma in mid-1990. Signs of the developing crises were visible as far back 1982: money cost more than lenders were earning on deposits, wholesale blocks of real estate were being securitized, and developers were starting projects all over the country with little demonstrable demand for the space. By 1986, the looming trauma was obvious; but the market, driven by new money from institutions and pension funds, continued to boom until early in 1990 when, abruptly, everything stopped.

The history of past cyclical downturns suggests that the present market conditions offer cautious investors a profit opportunity that comes around only once about every five to ten years.


Regional pockets of distress notwithstanding, national real estate prices climbed vigorously through about the second quarter of 1989. They then began to flatten in all sectors except apartments, and by the first quarter of 1990 prices for retail and office properties were tending downward. These first-quarter declines were more than offset by continued strength in the apartment sector, so the composite property index reported by the National Real Estate Index continued to climb slowly until the second quarter of 1990.

During the second quarter the apartment sector also sagged, and the composite index edged downward. By mid1990, real estate markets were comatose. The real message being delivered by the market was not in modestly declining prices, but in the virtual absence of transactions.

Because major real estate transactions are episodic and are negotiated in an imperfect market, downturns are signalled first by shrinking volume rather than by price declines. Property owners discover that values have slipped below purchase prices-indeed, in many cases, below remaining mortgage loan balances-and they simply refuse to sell during the early phases of a decline.

Receding transaction volume was painfully obvious in the real estate brokerage community by the middle of last year. Many commercial and industrial brokers were consolidating their operations to reduce overhead and protect their market positions, while others were aggressively seeking salaried jobs. In an open letter to members, the president of the Society of Industrial and Office Realtors reported that " . . . the institutional investment real estate market has basically come to a screeching halt. It is almost nonfunctioning." Foreign capital which had been a major factor buoying U.S. real estate markets, he said, contracted sharply in 1990, and mortgage lending activity in this end of the market virtually ceased.


The transition to a new calendar year finds the economy of the Mid-South and much of the U.S. sloshing through a periodic purge of excess real estate inventory and unneeded development capacity. Because our inventory-land and buildings-has a long "shelf life," elimination of the excess depends on growth in market demand for the product. During recessions or even periods of relatively slow economic growth, this correction can take from several months to several years.

Pick randomly from contemporary business periodicals and you get the same message, real estate is the wrong game to be playing. With high-profile projects and big-name developers forced through the financial wringer, and with major mortgage lenders bumping into each other in the crowded corridors of bankruptcy courts, pessimism has become chic.

Yet, in the previously-mentioned letter to members, the president of the Society of Industrial and Office Realtors concluded by observing that this may be "the finest opportunity for real estate investment since the Depression ..... In a similar vein, Barnard Mendik, who has an equity position in 14 large Manhattan office buildings and thousands of New York area apartments, recently told Forbes magazine:Did you know that [most of the] fortunes made by New York city guys on the Forbes Four Hundred [list of the country's wealthiest people] were made in about two years? It was from mid-1979 to the end of 1981.... We bought 8 million square feet [of real estate] right in that period."

To grasp the logic of these comments at a time when the popular press is consuming whole forests to report the news of unfolding real estate calamities, you have to remember what it is that investors are looking for. They want earning capacity, and the right time to buy is when earning capacity (not necessarily square footage) is being sold cheaply; the time to sell is when it is dear.


Few investors really care about the sticks and bricks, the mud and the mortar aspects of their real estate. What we buy when we make a real estate commitment is a set of assumptions about the property's future ability to generate income. As a general rule, moreover, the single best indicator of how well a rental property will perform in the future is how well it has done in the past.

A useful measure of the link between past performance and the market's assessment of a property's future prospects is the relationship between recent earnings and market price: the price/earnings ratio. (If you are more comfortable with capitalization rates, simply invert the price/earnings ratio.) This concept is depicted in the following graph which shows the relationship between current (or recent) net operating income and a property's current market value. The steeper the slope of the line relating these two variables, the higher the price/earnings ratio.

Every property is, of course, unique in at least one respect-its location. Thus, there will be a somewhat different set of prospects for each property and, therefore, a different price/earnings ratio. Even so, ratios for similar properties tend to cluster about a central value. Note also that the ratios tend to shift through time. Thus, the "low P/ E" line in Figure 1 might accurately depict a particular set of properties during one period and the "high P/E" line more accurately depict it in another.



The level of prevailing price/earnings ratios might best be thought of as a measure of market confidence in real estate's ability to generate operating income in the near future. To see why the ratio is subject to rapid and sometimes violent shifts, turn it upside down, thus generating a capitalization rate:

Price = Income / k - g) Where Income is the most recent year's operating results, k is the target rate of return on invested capital, and g is the expected rate of growth in a property's income stream. (Note that g can be a negative number depicting expected declines in operating income. This is a widely employed model for evaluating growth stocks. It is also used implicitly in most real estate valuation problems.) The dynamic element in the above equation is the factor g, the expected growth rate of income. Current property income tends to change only gradually over time with alterations in supply and demand for usable space, and k is determined by the long-term cost of capital.


When the market consensus about future revenue prospects shifts, it is usually because prevailing income has been disappointingly poor or surprisingly robust. Prices react both to altered operating results and to the consequent shift in expectations. This phenomenon, for a period when shrinking net operating incomes are fueling pessimism among investors and causing a shift from a higher to a lower price/earnings ratio for a particular class of real estate, is depicted in the graph "Declining Price/Earnings Ratio."

As net operating income declines from NOI to NOI', property prices drop from [P.sub.1] to [P.sub.2], based on the old price/ earnings relationship. But, declining prospects cause a move toward greater investor pessimism and a consequent shift from the higher to the lower price/earnings ratio, with a further decline in price per unit of property to [P.sub.3].

When generally improving operating results generate renewed enthusiasm, the consequences are reversed. This is depicted on the graph "Increasing Price/Earnings Ratio." An increase in operating income per unit from NOI to NOI' drives the price from [P.sub.1] to [P.sub.2]. The consequent reflowering of investor enthusiasm causes property to sell at higher earnings multiples, depicted by the shift from the lower "low P/E" to the "high P/E" function. This in turn prompts prevailing prices to jump from [P.sub.2],to [P.sub.3].

The dynamic role played by investor expectations explains the comment of a prominent real estate developer, quoted earlier, that so many investors made their money in two years-1980 and 1981. Mat was a period when real estate price/earnings ratios were at their lowest level in recent history. A glance at the final chart, "Composite Price/Earning Ratios," reveals that the ratio actually touched bottom in the second quarter of 1981.

By the first quarter of 1985, the average price/earnings ratio had broken through its long- term average level for the period charted in Figure 4, depicted by the broken line across the chart. To quote Barnard Mendik again, "we paid $40 per foot [in 1980 and 1981], and by 1982 [the property] was worth $200."

At this point you might want to look again at Figure 3. For one Manhattan office building Mendik cites, revenue appears to have increased about 190 percent, while market value grew about 400 percent.


The irregular price/earnings ratio pattern in Figure 4 suggests that the ratios move in a long-term cycle of unpredictable duration. There is a tendency to regress to the mean, but the degree of deviation from that level before the movement reverses direction varies greatly from cycle to cycle.

This presents a dilemma for investors who wish to exploit the pattern. When the ratio movement changes direction, there is no way to tell whether the event is a fluctuation around the long-term trend or a reversal of the trend.

A promising strategy is to identify variables that signal approaching market bottoms, and to take these as signals to begin buying additional property. One such signal is quarterly changes in Gross National Product (GNP). When real (that is, inflation-adjusted) GNP drops for two consecutive quarters, the economy is officially declared to be in a recession. Real estate price/earnings ratios tend to bottom out about half way through each recession.

There have been four such periods in the United States since 1966 (not counting the one we are widely predicted to be currently experiencing). For our purposes, however, it makes sense to lump the abortive disruption of 1980 and the more severe experience in 1981-82 as a single event. Using this convenient simplification, the recessions experienced during the period examined are indicated by the shaded areas on Figure 4.

In each case, the price/earnings ratio turned decisively down and was either near or below the long-term average for the period, before the economy was officially declared to be in recession. In each case the ratio bottomed out shortly past the recession's half-way mark and turned decisively up well before the recession was officially over.


Declining real estate markets are reflected first by a drying up of transaction volume, because owners resist the evidence that their properties are worth less than they were a short time before. Eventually, prices do decline somewhat, and price/earnings ratios tumble. In both up and down markets, investors tend to over-react, driving prices and price/earnings ratios further than sober analysis of the facts would suggest is appropriate. Dr. Greer holds the Fogelman Chair of Excellence in Real Estate at Memphis State University and is Director of the Graduate Program in real estate development. He has written eight books on real estate topics. His latest book The New Dow Jones-Irwin Guide to Real Estate Investing, was published in 1989.
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Title Annotation:present crisis in the real estate business
Author:Greer, Gaylon
Publication:Business Perspectives
Date:Dec 22, 1990
Previous Article:The mid-south economic outlook.
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