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The black hole of hype.


The present crisis in the real estate and banking industries prompts uninitiated outsiders to wonder how so many projects could have been financed and constructed, with no apparent awareness that oversupply would lead to non-existent investment returns.

Because apportioning blame is fruitless now when the crisis is upon us, the best we can do is learn from past errors. A better marriage between real estate financing and real estate market analysis is called for in the future. That development, plus lender's more critical review of market analyses submitted with applications for financing would be welcome outgrowths of these current troubled times.

Market analysis was the scorned stepchild of the real estate industry in the 1980s, when the financial whizzes dominated the field, in terms of both salary and approach to real estate. Oddly enough, following the last recession, a number of major commercial banks around the country sharply curtailed their real estate research groups. There were also instances where bank's real estate libraries opted to hire personnel in-experienced in research, or chose to cut library budgets. Thus, the resources available to investigate on the market background for a proposed real estate loan were more restricted, while real estate lending itself increased.

Market fundamentals

There is a lot of talk today about "market fundamentals." However, there is little in the way of instruction on how to recognize an appropriate analysis of market fundamentals. In its simplest form, market fundamentals for any property should entail an analysis of future supply, future demand, expected vacancy rates for the macro market and the market segment, as well as expected income growth due to the movement of those vacancy rates. But many interesting games have been played with market analysis concepts, and a better appreciation for the manipulation of market data may lead to better investment decision-making in the future.

Requests for financing on substantial, income-producing properties are usually accompanied by attractive brochures with colored photographs, maps, discounted cash flow analyses and market data. Theoretically, the income growth assumptions and operating expense assumptions for the future should have some relationship to the market analysis.

A first warning signal for any property submission is when the market analysis is tucked away in an obscure appendix. The location of the market analysis indicates whether or not it was considered important. If it's buried, that suggests there is something perhaps not entirely relevant about the market analysis. Typically, it is heard in the real estate industry that "no one reads the market analysis sections anyway," so the content and presentation do not matter. But, then again, it remains a given that the content must be as optimistic as possible.

The "place it in the appendix" approach is being used in tandem with another ploy for presenting, shall we say, an overly optimistic view of the market. Sometimes the market overview in the appendix is such a "macro" approach that it has very little to do with the subject property. It is certainly possible to write a substantive overview of market conditions, without zeroing-in on how the subject property and its market fit into the greater scheme of things.

Another sad industry truism from the last decade has been that if you don't "hype the market" you'll never get the deal done. One can only conclude that the whole real estate industry - borrowers and lenders alike - fell into some kind of black hole of hype for almost eight years. Clearly, the verbal hyperbole describing almost every location must have "sold." The national appetite for hype should be replaced by a balanced view of the market risks entailed in a potential investment. The market analyses should contain a reasoned discussion of those risks. These should include possibilities for over-building, potential weaknesses in the local economy and for corporations or households in the long and short term, as well as a solid analysis of the competition and its strengths.

When the market analysis section of a property submission reads like a tour guide or Chamber of Commerce promotional brochure, this should be a another warning sign. Although tour guides and brochures are often very well written and most useful, especially when doing driving tours of these markets, this type of market overview serves to obfuscate the reality of supply and demand.

Ignore the future

We have examined the overall tone of the market analysis report, but much more substantial, and more serious, are the actual economic projections included for any location. The reputable national and regional forecasting firms have all been doing conservative projections for the last five years - even more than politically motivated local entities. There were three, fairly common real estate industry approaches to economic forecasts being used: * Ignoring all references to national economic problems, and how those problems would affect the locality * Assuming past trends would be projected in a linear fashion for the next 10 years * Ignoring or dropping out recessions when averaging past years' performance

All of the above resulted in extremely rosy views of the future.

In the 1990s, as most of us know, population and labor force growth is expected to slow substantially. Future market reports should include a review of forecasts for a location. These forecasts should, in their analysis, indicate an awareness of national trends, and good arguments about why a location may do better than expected, if such seems to be the case. Equally, one should be wary about methodology that projects linear relationships for a decade. That methodology is only useful or realistic in the very short term.

Market niches

The real art of misleading market analysis comes in the determination of past and future demand, supply and pricing. Supply is quite intriguing, because all kinds of games can be played in the study of the market. One such gambit is the straightforward misrepresentation of future supply in the subject market, which is a variant of the "ignore the future" maneuver on the economic forecast side. This dearth of data (or misleading information) will probably not be seen much in the 1990s.

However, there are two ways of juggling supply data that will certainly be with us for the next 10 years. One is the "market niche" game. The other is the "disappearing sample." In the market niche game, the seeker of financing claims that he or she has discovered a segment of the market previously untapped, that is simply bursting with "pent-up demand" (another spurious concept). Since vacancy rates began to climb in the mid-1980s, most parties in real estate transactions have been counting heavily on the robust health of such market niches. Unfortunately, when vacancy rates climb above 12 percent, the immense amount of vacancy in a market begins to press income growth rates down to a negligible level.

The disappearing sample refers to what will be a new 1990s phenomenon. The careful observer of commercial real estate data will find that the inventory base for a market will be shrinking, not remaining stable as one might expect. The rationale that will be presented is that many buildings will have become obsolete - unwanted or unleasable. In the case of office buildings, these will be Class B, C, and D buildings unable to accommodate the modern computerized tenant. In the case of retail, it will be the unattractive, never-renovated strip center or older mall in a declining neighborhood.

There will be, in fact, excellent justification for the argument that the competitive inventory will be reduced. For five years, the older buildings have been losing out to the newer, more functional spaces. Nonetheless, it is still important to know what the total inventory is, and what tenant movements have occurred, so that the rationale for ignoring the obsolete competition can be made on solid evidence. (A variant of the disappearing sample, is the habit that careless market analysts have of not indicating that they are writing only about the top end of the market.)

Mysterious absorption

It is almost overwhelming to consider what has been done, and will continue to be done, to perplex financing sources about the real statistics on demand, as measured by the net change in occupied space, both commercial and residential. Admittedly, it is hard work for a developer or owner to come up with market information on net absorption. But a good market analysis should reveal the lack of data, and develop the next best proxy of information available. The lack of information or commentary of any kind is in itself, a serious warning about the project.

The favorite deceptive ploy on the demand front concerns the gradual redefinition of absorption. In the misty past of the 1970s, the common industry definition of absorption was the net change in occupied space. Leasing was just that - the amount of leasing activity in a market. Experienced and cynical market watchers noticed that around 1984, the real estate industry began using absorption as synonymous with leasing, which of course inflated "absorption" by 300 percent or more each year. The careful market analyst began to look for the term "net absorption," which denoted the real change in occupancy. We cannot predict what new terminology will arise in the 1990s, but the manipulation of definitions is always something to watch.

Vacancy rates and income growth

For years, the real estate market has been a puzzle to economists and forecasters. Starting in 1984, most real estate projections that were realistic about future demand and supply (or even optimistic about demand) showed steep upward movements in the vacancy rates - those elevated vacancy rates that are with us now in many office, retail and residential markets. But the lending community often did not have access to such projections, unless specific market studies were commissioned. And many market analyses do not go through the quantitative exercise of projecting vacancy rates and reasoning through the relationship between increasing vacancy rates and decreasing, property-income growth. This kind of exercise should be expected, or rather demanded, in the future. Furthermore, the projection of vacancy rates should be rigorously done; the mathematics should be explained both verbally and visually through tables, graphs and the like; with the assumptions clearly traceable to the sections on supply and demand.

The relationship between climbing vacancy rates and income growth is one that, on the basis of much of the superficial evidence of the real estate industry, contradicted most economic laws. Rents, or income, continued to climb in property presentations, while vacancy rates rose and the NCREIF/Russell Index of real estate returns fell.

The mystery seems to be explained by the tracking of "asking rents" or "prices" - that is the income asked by the owner. Probably everyone realizes, but it is worth noting again, that "asking rents" almost always rise, unless the market is so abysmal that decline cannot be concealed. There is every reason for lenders to demand in the future, estimates of net effective rental growth in the market and sub-market of the particular property. Even if the information cannot be obtained from a large, satisfactory sample, the lender should request an estimate of trends in concessions, tenant workletter and the impact on rents.

In the 1990s, there is every reason to believe that lenders will demand and actually receive much more realistic data on real estate markets and the prospects for specific properties. The decade for the sleight of hand market analysis is clearly over.

Helen R. Arnold is director of investment research for Jones Lang Wotton USA.
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Title Annotation:burying market research in loan application packages and deceptive tricks helped mask signs of overbuilding in the 1980s
Author:Arnold, Helen R.
Publication:Mortgage Banking
Date:Nov 1, 1990
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