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Real estate and the economy - 1990 and beyond.

Real Estate and the Economy--1990 and Beyond In some ways, the state of the real estate markets has seemed relatively unchanged for several years; everything is overbuilt and the Oil Belt is bleeding. We say the same things every year.

But there is a very important evolution taking place. When a larger number of developers and owners in the Oil Belt went under at once, it attracted a great deal of public attention. But today you see a whole series of unpublicized mini-Texases, all over the country. The pain and suffering that began in the Oil Belt five years ago has now spread to every market segment in almost every part of the country. Today we are seeing foreclosures, deeds in lieu of foreclosure, wealth destroyed, people living on the edge in every geographic region.

The pain in the real estate industry will continue into the near future. There are still quite a few office buildings coming out of the ground. Tenants have become more sophisticated and aggressive at pursuing their own interests. That being the case, some people in real estate will continue to suffer.

Eventually real estate returns will begin to rise, but it will not be in 1990. It is hard to tell when the corner will be turned, but it is definitely measured in terms of years. If you have bad cash flow for a year or two, you may have the reserves to weather it. But only the institutions and "hold money" can survive several years of negative cash flow.

A continued

institutional presence

Institutions will continue to expand in real estate, despite these negative cash flows and low, short-term yields. The smarter institutions are in real estate more for diversification than for immediate returns. There has been no new evidence that real estate returns are correlated with stock market returns. In fact it is just the opposite; the stock market has been booming over the last two years and real estate has been doing badly. As a diversifier, real estate still holds its place.

ERISA requires pension funds to diversify, and diversification means seeking a low variance of portfolio returns. Some institutions may pull back because of lower short-term real estate returns, but large institutions that have to commit large sums of money over a long period of time will remain active in real estate. Some will even become more active as they see targets of opportunity.

The impact of regulation

Regulation is the other factor in today's real estate market. As regulatory controls get tighter, higher costs will reduce supply and eventually improve rental rates. This restrictiveness will probably take the form of a much more encompassing impact fee for all developments. Communities in all parts of the country who do not think they have other ready sources of revenue to fund infrastructure will try to get everything possible from developers. (In addition, heightened environmental concerns are going to drive up costs and slow down the development process.)

The voter sentiment nationwide is clearly behind higher impact fees; most people feel that added speculative development is wasteful and has a negative effect on lifestyles. Insufficient infrastructure is a great excuse for people who want no growth. Only the poor and the developers want growth because it increases their opportunities. Almost everyone else wants no growth.

Concern over the environment will also contribute to the no-growth trend. The pollutants in the ground are a very serious problem today, so water quality will be a growing concern in the next decade.

Long-term, a clean environment is going to become a consumable good that the American public buys.

We are a very affluent society for the 80 percent of the population who have any money at all. In the next decade, many consumers will be willing to pay higher prices to clean up our environment. After all, how many Sony Walkmans can anyone buy; everyone already has three. Clean air and water will become more desired, and hence more valuable, commodities.

This commitment to a clean environment may come about gradually, but eventually the ecological disasters will begin to wear away resistance. Love Canal, which was a terrible incident at the time, is not in the top 100 (worst) sites on the Superfund cleanup list today.

Further shakeups in development

The combination of weak markets and increased regulation will eventually slow development even more. To survive, more developers will turn into "fix-it" people.

In a boom period, a plumber becomes a plumbing subcontractor; in a slow period, he or she repairs your sink. The developers who want to be around when the next cycle comes will have to adapt in the same way.

Of course, this "fix-it" job is really a more intensive form of property management, including not just operations, leasing, and repair, but renovation, repositioning, and perhaps completing buildings that are only partially built. The developer will have to carve out a new job that is somewhere between property management and development. To compete with this new intensive development/management, property managers will have to become more versatile and inventive.

The properties held by the Resolution Trust Corporation are examples of this type of opportunity. But it has always been more profitable for fee managers to work for the private sector, and there are a great many buildings in private hands that need this intensive management.

These opportunities are definitely in the B buildings. Of course, by my definition, most buildings fall into this category. The true A buildings, the trophy properties that cannot be duplicated, are very few. These trophy properties will always be well loved. However, because there is a limited number of truly trophy properties, institutions will have to become more expansive in their views of acceptable properties for investment. While institutions have moved more heavily into non-trophy investments, e.g., apartments, in the last three or four years, they have generally limited their interest to only certain special properties in certain cities.

One place you may see this institutional expansion have a major impact is in housing for the elderly. In discussing the elderly, it is essential to talk about lifestyle rather than age. Age is not relevant; lifestyle is what segments the market of people over 55.

Clearly in the long term, we need some older people to stay in the work force part time, to offset the dwindling supply of younger workers. This being the case, these healthy older people, the "I'm still going" elderly, will need shelter consistent with this part-time worker lifestyle. Too much of the product currently being developed is for the "I've quit" elderly, whose health or inclination prompts them to chose a very supportive environment.

The needs of this active elderly market may not yet be evident, but it will be an important market force in the year 2000. This segment will present development opportunities and attract investor involvement. And in all forms of housing for the elderly, property management is the key.

Management with

a long-term view

The new development/property management which is evolving is a swing away from technological sophistication toward intuition and long-term market forecasting.

In the last few years, the industry has been filled with good technical analysts, who can scrutinize every detail and work out complex transactions flawlessly (usually). Unfortunately, this type of analysis does not tell us if certain space with certain services will provide what tenants want over time. That knowledge is more of an intuitive feeling than a mathematical wizardry. It requires different skills than finance.

The rest of the world takes a much longer term view of real estate investment than we do. When you have a longer view, the last bell and whistle on a transaction is not nearly as important as trying to understand where the market is going to be in five or ten years.

Achieving the long-term view will require a combination of a global focus and local expertise. Of course, no one has exactly figured out how to structure his or her company to fulfill this objective. But the general consensus is that firms now need a global perspective. Financing is global, and tenants may come from all over the world. At the same time, companies need the ability to execute this global strategy on a local basis.

Peripherally, the best real estate investment in the next few years, in my judgement, will be the partially completed, currently bankrupt, residential land development. Of course, finding the right one is the hard part. You can judge an office building much more easily than a land development. Selecting the right property is where intuition comes into play.

We are getting less and less able to understand our economy as it becomes more global and less dominated by giant corporations. In the last decade, job growth has not been in the Fortune 500, it has been in smaller companies. Similarly, big-league finance is no longer controlled by money-center banks. It is controlled by more regional banks and corporate finance companies. This dispersion makes it much more difficult to monitor what is going on in the economy. This lack of information is one of the reasons why economists keep forecasting things that do not happen, and why even the most sophisticated financial analysis of a property is not enough to ensure success.

The long-term predictions, 2000 and beyond, are really the relevant ones, the ones you do not want to give away. If you are trying to decide what to buy today, predicting what will happen in 10 or 15 years is what is important.

You can tell the world if you have just created a great, new way to do a swap in Asia; you have already executed the strategy and you are not giving anything away. But the correct long-term analysis is much more valuable, and more difficult.

To even begin thinking in long-range terms, people need to appreciate urban history and learn from it. They also must become more interdisciplinary. Long-term changes come about not because of one element, but through a combination of elements. Understanding those interfaces is vital for long-term predictions and long-term real estate success.

Michael E. Miles, Ph.D. is the Foundation Professor of Urban Development at the Graduate School of Business, University of North Carolina--Chapel Hill. He held the position as director of the North Carolina Real Estate Research Center from 1979 to 1983, as director of the M.B.A. program from 1981 to 1983, and as associate dean from 1987 to 1988.

Dr. Miles has published widely in the real estate field and serves on the editorial review board of the Journal of the American Real Estate and Urban Economics Association and the Appraisal Journal. He holds a Ph.D. degree from the University of Texas at Austin and an M.B.A. degree from Stanford University, and is a Certified Public Accountant and a Senior Real Property Analyst.
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Author:Miles, Michael E.
Publication:Journal of Property Management
Date:Jan 1, 1990
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