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The economic outlook for real estate - 1989.

The Economic Outlook for Real Estate - 1989

About one year after the great stock market crash, forecasts of a recession in 1988 have proved erroneous. Some economists are now predicting a recession in 1989. However, I believe that the U.S. economy will continue to expand throughout 1989 at roughly the same 3 percent rate of real GNP growth that it has had during 1988. Growth in 1988 was fueled by an export-led boom in manufacturing, continued consumer spending, strong business investment, and continued pressure from a large federal deficit. These same forces will remain in effect throughout 1989.

Only certain unusual factors would cause a recession in 1989. All post-World War II recessions have been caused by some external shock, such as skyrocketing oil prices, or by a strong tightening of the money supply by the Federal Reserve. Though the federal government may raise rates somewhat, neither of these two conditions seems imminent in 1989.

True, unemployment is quite low, and industrial capacity usage is high. But the economy has not been driven into such high capacity utilization as to cause bottlenecks and rapidly rising wages. Wages are still rising at moderate rates in all areas, partially because the labor bargaining power has been tremendously weakened by the impact of foreign competition. Therefore, I do not believe inflation will rise enough in 1989 to cause the Federal Reserve to increase interest rates sufficiently to bring on a recession.

Inflation in 1988 was under 5 percent, with some of the increase caused by rising import prices. This source of higher prices is a one-time phenomenon that will not necessarily repeat itself in 1989, especially if the dollar does not fall any lower. These domestic factors are reinforced by a moderate expansion in both the Japanese and European economies.

Whether this record-length expansion will go through its seventh year (1989) and into 1990 cannot be foreseen yet. Precedents indicate that since 1948, real GNP has risen an average of 0.0 percent in the second year after a Republican president has been elected!

Even President Bush's own economists do not really believe he can balance the budget without raising taxes at all. My own view is that taxes should be raised on consumption. The economy would benefit from some slowdown or a shift from consumption to investment. If consumer spending is reduced, interest rates could be lowered, which in turn would lower the value of the dollar and further stimulate U.S. manufacturing exports. Lower interest rates would also stimulate investment because capital would be more affordable. So this is a great time to raise taxes on consumption - if there is such a thing as a great time to do that!

Taxes should also be increased because the United States as a society needs to expand its domestic spending significantly in order to meet some of the country's basic needs. Roads and highways need to be repaired and expanded. Health care and early childhood training need to be provided for deprived children. Big-city schools must also be greatly improved. Affordable housing should be built to help end homelessness. Research and development must be funded to keep the U.S. competitive in world markets. More federal money needs to be spent on these programs, not less.

At the same time, the deficit must be reduced and something closer to a balanced budget achieved. A combination of tax increases and reductions in some existing programs could achieve this goal. However, Bush does not seem ready to address the situation, if he still insists on no tax increases.

The American electorate still wants to live beyond its means by consuming and investing more than it is producing and saving, making up for the deficiency by borrowing from abroad. Most Americans seem to think that, because economists have been warning them about the deficit for many years and nothing drastic has happened yet, the deficit poses no real problems. But the United States' shift from being a net creditor nation to a debtor nation is reducing our control over our own destiny and piling up financial burdens on our children.

Democracy's greatest weakness is its unwillingness to pay short-term costs in order to produce long-term benefits. Our attitude toward the deficit is a perfect example. The American people want to consume more than they are producing and saving, and they do not want to pay the cost of doing so. Thus, the failure to address the deficit is as much the fault of the voters as of the government.

Money market factors

affecting real estate

The most striking thing about money markets today, over one year after the largest stock market crash in history, is that there is still so much money available for investment. As of January 1989, the Dow Jones Industrial Average is about 18 percent below its high in August 1987, but it is also about 28 percent above its low point on October 9.

The boom in buyouts and takeovers in 1988 surpassed that in 1987; so there is a great deal of capital available to stimulate these activities. Much of this capital is based on record levels of debt in the private sector to match the record levels of public debt. But the capital is there. And as has happened in real estate over the past 10 years, an abundance of capital can greatly influence levels of activity in the whole industry.

In looking at money markets today, it is important to take a global view. Globally, the world's major economies, as a whole, are much more in balance than each part is individually. For example, although people in the United States are living beyond their means, the Japanese are not living up to their means. Japanese households save about 16 percent of their incomes, while Americans save between 2 and 4 percent. The Japanese are saving so much that they do not consume all they produce. The United States, in turn, is borrowing their excess from them, helping to balance their economy.

Globalization also means that money markets are now based on an integration of previously separate national capital markets into one huge financial market. This integration is also true of the markets for goods and services, but to a lesser degree. Such integration causes many capital markets to become more alike and has enormous implications that few Americans have yet realized.

Not all parts of each national financial market have been made completely identical. Differences in legal regulations, in institutions, and in cultural behavior may prevent these markets from ever being perfectly integrated. Thus, opportunities exist for making profits by moving capital from one market to another. For example, Japanese interest rates are much lower than American rates. Japanese P/E ratios for stocks are much higher than in the U.S., even after correcting for accounting differences. As a result, the Japanese can borrow cheaply and shift their money to the United States where it will earn higher interest. The same phenomenon has occurred in real estate.

A second implication of global capital markets is that recent exchange-rate changes make U.S. assets look like a bargain to many foreigners - in terms of their currencies. At the same time, our deficit borrowing is giving other countries large amounts of American dollars to spend. As a result, foreign countries are buying our assets, including real estate, in huge amounts.

Globalization's impact

on real estate

This activity has several important impacts on U.S. real estate markets. First, the willingness of foreign buyers to pay what seem to be high prices for our properties has created a "premier" tier of properties in the income property market. Particularly in office space, a three-tier market exists. Because of foreign buying, prices for the best quality properties in the best markets have been increasing, even though the rental incomes have been stable or falling.

Another reason foreign real estate investors have been willing to pay high prices for U.S. real estate is that they believe that, as global integration proceeds, there will be a convergence of yields across the world. Currently, yields on U.S. real estate are twice as high as in Europe and about four times as high as in Japan. The current cash-on-cash yield on an office building in Tokyo is 1 to 2 percent. If yields do converge and U.S. yields decrease, the prices of American real estate will rise across the board. This is why many Japanese are willing to pay higher current prices for American real estate than many Americans.

I think that this convergence effect will be less than many foreign buyers think. As foreign buyers spread out their interests over more property types, the upward pressure on each property's price will be diluted.

Americans who have sold property to foreign investors at high prices believe that the invasion of foreign capital is a major benefit. And it has been to those who made big profits.

However, this capital influx also has some significant costs harmful to the United States. When ownership of U.S. assets shifts abroad, owners no longer have a proprietary attitude toward the cities in which the assets are located.

Foreign involvement in U.S. real estate has still another implication for real estate construction and management. Real estate has been fairly immune from foreign competition because buildings and land cannot be imported. But Japanese owners particularly will import their own executives, their own architects, their own managers, and their own construction firms as they buy up more U.S. property. This shift will mean rising competition for many U.S. real estate firms.

Our response to these negative impacts of foreign capital in real estate markets should not be to prevent the inflow of capital through protectionist measures. The United States has gained from the free flow of capital abroad. If the United States is able to control its budget deficit and trade deficit, U.S. real estate will no longer be bought up as fast by foreign buyers.

Because of global financial markets, every real estate transaction is now schizophrenic - requiring two very different kinds of knowledge. On the one hand, the owner must have access to local market knowledge to run the property itself. On the other hand, financing the same property requires an equally thorough knowledge of global financial markets. The funding of every deal is influenced by world financial conditions.

Even single-family mortgages are influenced by world bond prices because mortgages are converted to mortgage-backed rewrites sold in competition with highly volatile world bond markets. This dependence increases the volatility of real estate mortgage rates and thus the cost of real estate development. This unpredictability makes real estate transactions far riskier than they have been in the past.

Few firms in the United States have both types of knowledge: local market knowledge and global financial knowledge. Therefore, most transactions will now require a coalition of firms with different types of knowledge.

The final impact of globalization is that transactions are becoming more complex. As Wall Street firms have entered into financing real estate deals, they have created some very complex financing instruments. The Rockefeller Center deal, for example, required a week of study before you could follow all the nuances.

Failing S&Ls

The last aspect of money markets to consider is the virtual collapse of the savings and loan industry. The Federal Home Loan Bank Board now estimates in its weekly update that the current bailouts of the S&Ls will cost over $45 billion. This situation results from a combination of several factors.

First, there is a basic contradiction between deregulating the asset side of the business, as was done in the early 1970s, and maintaining deposit insurance on the liability side. If the government is willing to take all the risk of a default, then the people operating a S&L can offer high returns on deposits and make very risky loans. They and their depositors know that in spite of any mismanagement on their parts the federal government will bail them out. This is a fundamentally irrational policy. Only a re-regulation of the S&Ls will solve this problem in the long run.

Another major factor causing the decline of S&Ls has been a regional depression in oil-producing states. The thrift industry alone cannot be expected to bear the cost of this major disaster. Fraud and reckless management have also contributed to the thrift industry's problems, especially in Texas.

The industry will eventually have to be bailed out by huge appropriations from Congress, although Congress has been reluctant to face this fact.

Conditions in real estate markets

The dominant factor in most nonresidential markets across the country over the last few years has been overbuilding. Because of the resulting excess supply, these markets, especially office space, should have been experiencing a recession in new development to return to equilibrium. This equilibrium will not mean a return to 5-percent vacancies, but rather to a 10-to-15-percent vacancy level.

Eight of the 10 years since 1978 have been boom years in commercial development, with very high levels of nonresidential construction. This has caused current overbuilding, and it cannot continue. Nor will developers enjoy the growth and prosperity over the next five years that they have enjoyed for most of the 1980s.

The second dominant market factor, which operates in the opposite direction from the forces of oversupply, is financial deregulation and the globalization of finance. Financial deregulation has created an almost permanent availability of capital. This drives developers into continued building, almost regardless of market conditions. While it has become more difficult to build a building that is not at least partially preleased, in some cities, office properties of over 1 million square feet are still being built without any tenants secured in advance.

In the tug-of-war between these two factors, financial availability has continued to dominate more than I believe it should. There was very little drop off in new construction from 1987 to 1988, although both years were somewhat lower than 1985. In fall 1988, the Office Network reported that space under construction in the 40 markets it tracks equalled about 5.5 percent of existing inventory in suburban areas and 6.7 percent in downtown areas. These were exactly the same percentages as in fall 1987. The vacancy rates were also almost identical in those two years.

While many markets, such as Los Angeles, have absorbed office space faster than it was built, vacancy rates are still high, even though a bit lower than they were a year ago. And in any market where the office vacancy rate falls below 10 percent, developers are going to start financing and building new buildings, almost regardless of other market conditions. As a result, overbuilding continues to dominate office markets.

Overbuilding has weakened somewhat in hotel space during 1988. A drop off in new hotel construction has allowed for increased occupancy rates. Apartment construction has also fallen dramatically in 1988 as a result of higher vacancies and the impacts of the 1986 Tax Reform Act.

This overbuilding has dramatically changed the nature of real estate as an investment. Because of overbuilding, it has been almost impossible to raise rents in hotels or office buildings for several years. As a results, on an income basis, real estate is no longer a hedge against inflation.

The net profit from a property in current dollars was supposed to rise along with the general price level so that its real net income would remain the same. Since 1983, consumer prices have gone up 19 percent, but rents have hardly risen at all. So most commercial properties are no longer an inflation hedge. They will not be a hedge again until the excess supply of money is dried up by very high interest rates. Properties in the premier tier have experienced increases in market prices, so they may be a hedge on a price basis, but the average building is not.

In spite of that fact, the supply of capital looking for real estate has risen during the past year. Why? Real estate is attractive because the fear of stock volatility has kept people out of the stock market and the fear of rising interest rates has kept many buyers out of the bond market. This has fueled continued new real estate development, especially in industrial and small retail.

The anti-inflation motive for buying real estate among financial institutions has been replaced by a diversification motive. They are afraid to buy only other assets. It is amazing that such institutions have continued to buy real estate even though since 1982, real estate yields have lagged significantly behind those for financial assets, even taking into account the fall in stock prices since October 1987.

These conditions have prompted real estate investors to search for higher yields. Investors are more likely to buy specialized properties than to put money into pooled general funds offered by insurance companies.

Investors have also been attracted by to-be-built properties because their apparent yields are higher than those on most existing properties. Such investors often fail to consider that risks are greater for to-be-built properties; so actual risk-adjusted yields may not be higher than for existing properties.

There are still immense regional variations in the U.S. concerning economic strengths and real estate absorption rates. Although financial factors are roughly the same throughout the country, regional variations in other conditions remain striking.

Most energy-producing areas are still in a recession, although total employment has started to rise again in major Texas metropolitan areas. The Midwest is enjoying an export boom, as its industries benefit from the lower value of the dollar. Midwest agricultural states are suffering from the 1987 drought and a decline in farm prices. California is very strong; it has a surprisingly low dependence on defense spending because of its highly diversified economy. The Northeast is also strong, but is more dependent on defense.

In addition, for the first time in over 30 years, housing costs are influencing regional growth prospects, mainly negatively. Certain metropolitan areas have such high housing prices that people are unwilling to move to those areas to accept jobs, if they now live in lower priced areas. The exception to this might be in southern California.

In 10 large metropolitan areas, the median price of existing single-family homes sold in the second quarter of 1988 was over $130,000. In much of the Northeast, there are acute labor shortages, but few people are moving there because of high housing prices. In addition, because incomes across the country do not vary as much as housing prices, the ratio of housing costs to median incomes is much higher in these high-priced areas. In these top 10 markets, the ratio of median housing prices to median incomes is 5.27 to 1; in the bottom tier of metropolitan areas, this ratio is half that size.

There has been a great deal of speculation recently, sparked by an article in Barron's, that housing prices will collapse nationwide. I disagree with this view, although the prices of the very biggest housing units may decline by as much as 15 percent. Unless there is a massive withdrawal of demand, as there was nationwide in the 1930s, or recently in Houston where jobs fell by 200,000, housing prices in general will not fall dramatically.

On the other hand, where prices are far out of line with incomes, housing prices will probably not continue to rise very rapidly either. In Boston, the latest year-to-year increase in median home prices was 36 percent, compared to over 30 percent just two years ago.

Another major trend affecting real estate is the intensifying anti-growth movement in many prosperous suburban areas. Anti-growth sentiments are primarily caused by rising traffic congestion, which the residents blame on new commercial and retail development. While there is no doubt that suburban traffic congestion has gotten worse, most of the problem is the result of three deliberate behavior pattern's among the very residents who are complaining the most.

Suburban residents want to live at low densities, so people have to drive farther to get places. That also makes mass transportation unworkable. Suburban dwellers also want a wide combination of choices of where to live and where to work. Finally, everyone wants to commute by private car because of the greater convenience and privacy it provides. In America, public transportation is something everyone wants other people to ride so they will get off the highway and make more room!

Pursuit of these three goals by most Americans makes suburban traffic congestion inevitable, no matter how much or how little commercial development occurs. This congestion is aggravated by the tremendous growth in the number of automobiles relative to population. Between 1970 and 1986, the number of people in the U.S. went up by 37 million; whereas the number of cars and trucks in use rose by 65 million in the same period. Very few new roads were built during this period. Thus, there is no easy cure to this suburban congestion in fast-growth areas.

There are some short-term remedial policies for lowering congestion, including building more roads, staggering work hours, and so forth. But they will not offer long-term solutions.

The only long-term solution is for people to live closer to where they work, thus shortening their commutes. This, in turn, means moving more jobs to suburban areas. Moving people closer into town would meet opposition in urban neighborhoods because it would require higher residential densities there. Of course, this long-term solution locks us into the automobile as a mode of transportation, which in the very long run generates even more congestion.

Another result of the anti-growth movement is to make all suburban development more expensive. Developers will have to bear more of the cost of creating suburban infrastructure, which will be passed on to consumers in the form of higher prices. This, in turn, will aggravate the current problem of insufficient low-cost housing.

There is an acute shortage of low-rent housing in the nation as a whole. In 1983, the number of households who could afford to spend only $250 per month for rent (30 percent of their income) was about 12 million. The number of housing units for rent at that price or less was 8.25 million; hence there was a "gap" of over 3.5 million low-rent units. This situation has gotten worse since 1983.

This shortage is a principal cause of homelessness. The best estimates of homelessness nationwide are between 500,000 and 750,000 people. Yet without a radical change in federal policies, including higher taxes to pay for more domestic programs, this situation will remain unchanged.

The United States now has 20 percent of its children growing up in poverty. In contrast we have reduced poverty among the elderly population to about 3 percent by spending federal money. Our failure to deal with such acute poverty, along with our failure to educate our children well, will undermine our future competitiveness as a nation.

Poor schooling is very important to real estate because it affects the quality of the local labor force, particularly in big cities. Many of our big cities are not training young people well enough to staff and operate downtown office properties in the future. This will undermine the long-run viability of those properties.


In the United States, 1989 should be a year of general prosperity, so real estate space absorption should continue at high levels. But the problem of overbuilding driven by money availability is still very much with us. So are some other serious problems. Even so, the investment community will continue to consider real estate a viable choice, primarily because of negative reactions to the major alternatives.

However, we cannot continue to look at real estate markets in the same old traditional ways. The globalization of finance has radically changed the forces that influence even the most local real estate transactions. We have to adapt our thinking to global perspectives. We also need to place more emphasis on long-term factors that affect the prosperity of our nation as well as that of real estate, such as combatting poverty and improving the education and welfare of the nation's children.

Anthony Downs is a senior fellow at the Brookings Institution in Washington, D.C., a private non-profit research organization specializing in public policy studies. Before that he was for 18 years a member and then chairman of Real Estate Research Corporation, a nationwide consulting firm advising private and public decision-makers on real estate investment, housing policies, and urban affairs.

Dr. Downs has served as a consultant to many of the nation's largest corporations, to major developers, to government agencies at local, state, and national levels (including the Department of Housing and Urban Development and the White House), and to private foundations. Among those with whom he currently consults are Aetna Life and Casualty, Pacific Mutual Life Insurance, and the Federal National Mortgage Association.

Dr. Downs received a Ph.D. degree in economics from Stanford University and is the author or co-author of 15 books and over 300 articles. He recently finished The Revolution in Real Estate Finance (published by Brookings) and is working on a study of democracy.
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Author:Downs, Anthony
Publication:Journal of Property Management
Date:Mar 1, 1989
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