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The legacy of the 1980s.

Although real state is inextricably involved in the business cycle, it does have characteristics that differentiate it from other businesses. In most other segments of the economy, the supply side of the equation is relatively flexible and is able to adjust to reduced demand. For instance, a manufacturer can close down an assembly line or simply shorten hours. A law firm, an advertising agency, or any other service enterprise can cut staff. Such curtailed activity may lower or even eliminate profits and may cause some firms to go out of business. In any case, the limitation of supply moderates pressure on pricing.

This elementary adjustment mechanism, however, does not function in the case of investment real state. Once a building has been built, it becomes a permanent part of the marketplace and remains a competitor regardless of whether it is vacant or desirable. The availability of poorly designed or unsuitably located property has an impact on negotiations for other real state. For example, a tenant who has no desire or intention to move can nevertheless threaten his landlord with low-cost alternatives. Because all development money has been committed at the beginning of a commercial venture, an unsuccessful property may be foreclosed but is unlikely to be demolished. The effect of failed developments is to depress all rents. With an average of just under 20% vacancy nationwide for commercial properties, more than one billion square feet of primary office space is currently overhanging the marketplace.


Efforts by owners and developers to conceal the extent of the decline in commercial rents have only exacerbated the situation. On the surface, typical rent levels in 20-year-old, class A offices appear to be off by around 20%. However, a more realistic measure of decreased revenue is the area of "tenant inducements." The allowance for alternations and improvements, sometimes referred to as the "workletter," has dramatically increased, along with periods of free rent. These concessions frequently result in a further reduction in real gross rents of 20% to 30%.

The attempt to downplay the effects these concessions have on the rent roll in order to protect future financing or sale not only distorts the market, it also eliminates the normal compensatory function of lower costs during a period of economic decline. A tenant receives a large, one-time benefit in return for locking into the obligation to pay a full market rent in future years. This commitment is further aggregated by step-ups at five-year intervals. On the other side of the bargain, a landlord must absorb the full economic impact of a long-term concession concentrated in the first years of a lease. Under such an arrangement, a landlord advances substantial capital that may never be recovered if the tenant falls victim to softening business conditions. From any reasonable viewpoint, the best chance for mutual survival would be achieved by a straightforward recognition of the weak market through negotiation of a lower rent and elimination of the frills.

The dramatic decline in the rental market has not been matched by a parallel reduction in investment transactions. In terms of "effective rent," as distinguished from "contract rent," the net return on capital has fallen by more than half. In contrast, the "distress prices" current in most markets are close to the 1985-1986 market levels. Because investments are, at least in theory, predicated on either 1) what a willing buyer will pay, or 2) the present value of future benefits, it is appropriate to examine the phenomenon that profitability has declined by more than 50% and sale prices by only 20%, despite bleak prospects for short-term future enhancement.

The investment market has ground to a halt largely because title and control are vested in ownership, which has lost its economic equity. With debt exceeding free and clear value, an owner has nothing to sell, a condition that prevails because lenders are reluctant to add to their inventories of troubled property. Many lenders have found it expedient to work with defaulting borrowers by accepting partial interest payments, waiving amortization, and extending due dates for repayment. By so doing, lenders have helped their own balance sheets and have gained the benefit of the borrowers' entrepreneurial skills at no cost. Such a house of cards can maintain the appearance of stability until circumstances require the commitment of substantial new capital for tenant work on a major lease. While excessive debt and the inability to meet competition with matching tenant inducements create an obvious scenario for disaster, no one believes he or she will benefit by being realistic. Everybody suffers, however, when an investment property must operate in an economic vacuum. The process of decision making is paralyzed when the record owner of title, who is still in control, has no surviving economic interest to protect while the true equity is vested in the lender, who is unable to exercise authority. This vacuum of leadership becomes critical when the forces of a highly competitive market demand the investment of new funds for upgrading the property or for payment of leasing commissions and tenant inducements on a new lease. When the up-front cost of a 50,000-square-foot tenancy can easily exceed $3,000,000 to $4,000,000, someone must provide the funds and be willing to make the additional investment in an already troubled property.


Generally, the capital markets move in the same direction, though at different speeds depending on whether stocks, bonds, or real estate is most in favor. Currently, there is a sharply divergent movement, with stocks at a record high and real estate not only in decline but also with drastically reduced liquidity. A partial explanation may be found in the inexorable law of supply and demand. The explosion in the 1980s of mergers and acquisitions combined with the number of corporations that have gone "private" have resulted in a significant reduction in the supply of marketable stocks. In contrast, the development wave sparked by the availability of easy credit in the 1980s resulted in excessive inventory of investment property.

The liberal lending practices that produced the development excesses have now totally reversed. Consequently, the unwillingness of institutions to commit financing is a major obstacle to the orderly restructuring of problem real estate.

On a theoretical level, the stock exchange is a perfect market. Presumably at any given moment every buyer or seller will enjoy the benefit of the same stock price and will have equal access to the same information. In contrast, real estate, by its nature, operates in an imperfect market. Each property is unique (i.e., not fungible), and pricing will vary not only because of property differentials such as leases, physical condition, financing, and location but also as a result of the varying levels of knowledge and motivation of the principle parties to the transaction.

The old question of whether price and value are to be considered identical is pertinent. There is no easy answer; a well-conceived and-executed development in a suitable location that is priced substantially below reproduction cost because of general market conditions may reasonably be considered undervalued. In elementary economic terms, however, "time utility" is the factor that dictates that an air conditioner, for example, will sell for less during winter months. Logically, time utility reduces the value as well as the price for adding product to an overbuilt market.

In the recent past, when market price and value were both analyzed by 10-year computer projections and the ubiquitous internal rate of return (IRR), the underlying assumption was that inflation would be reflected in prevailing yearly rent levels. The increasing income would then be reflected in higher capital value and price. The basic fallacy in this assumption is that rents are determined by supply and demand like any other commodity. The idea that inflationary costs necessarily result in higher rents is equivalent to the notion that God has decreed that every investment will be profitable.

Over a long period of time, high reproduction costs will limit development activity and lead to a slowdown in competition, thus encouraging higher rents as demant eventually catches up with and pushes against the slow growth in supply. The theory is valid for the long run, but as Winston Churchill noted, "In the long run we will all be dead."



The impact of future inflation on current investment decisions should not be wholly discounte. Infaltion has seriously eroded buying power in recent history. Government figures, as might be expected, are carefully constructed to present the most favorable picture possible. However, even the Consumer Price Index (CPI), which measures spending based on the limited income of a low-middle income family (i.e., less than $20,000 per annum in 1982-1984), shows that any dollar-denominated investment has lost approximately 80% of its purchasing power in the last 25 years. In other words, it will now take $5 to purchase what $1 used to buy. For higher income groups, the inflarionary spiral has been relatively more dramatic as "discretionary spending" has escalated faster than "obligatory spending" (i.e., eating restaurant meals versus meals from the supermarket).

According to the Dow Jones, stocks at the present peak have kept more or less even with inflation. Good real estate that has the added advantage of being leveraged with long-term, fixed-cost financing has far outperformed inflation.

In light of the enormous burden of both public and private debt, the more business declines, the more certain long-term inflation becomes. Struggling borrowers, governments, corporations, and individuals are relieved of their obligations when the value of currency is reduced so that repayment can be made in "cheap" dollars. The more desperate the times are, the more certain the political manipulation. We have become indoctrinated to the belief that 4% or 5% per annum inflation is acceptable. Not too long age, a Republican president, Richard Nixon, felt that 2% inflation was so unacceptable that he imposed wage and price controls. In a different context, 5% per annum inflation means that prices double every 14 years, or stated otherwise, purchasing power is cut in half. With cash or government bonds almost sure to lose over time, it is prudent for investors to take another look at troubled real estate.

Historically, in a depressed market, an owner of multiple properties under pressure from declining rental income and reluctant lenders has had to raise cash. The only way this can be done is by offering for sale the choice properties, because there are no buyers for the weak ones. During the next few years, the shake-out of overleveraged properties along with lowered rental expectations, more conservative investment analysis, and the shortage of available capital can reasonably be expected to produce extraordinary opportunities for real estate professionals. Currently, cash is king, and as the cycle matures leasing skills and courage may become more critical.

Few investors will be smart or lucky enough to hit the bottom of the market, which is not especially crucial. Far more critical is property selection; nothing is a bargain unless an investor knows what to do with it. In a competitive market, it is essential to hold property that will be preferred because of its location, design, and condition. Quality can prove most important. There may never be an economically viable tenant for a poor building, but there will always be tenants for well-located, well-maintained structures even if lease rates fall below expectations. The expense of marketing vacant space, including rehabilitation and tenant inducements, can easily exceed the purchase price. An investment should be adequately funded to survive possible further decline and unbudgeted capital expenditures. It is important to remember that those who do not learn from the mistakes of the past are condemned to repeat them, to paraphrase the philosopher George Santayana.

Even if the immediate rate of return on capital is disappointing, if quality property can be held through the cycle, the eventual recovery will almost certainly prove profitable. The history of economic cycles is remarkably consistent--while booms end, recessions and depressions end as well. No matter how long or steep the decline, the recovery has always reached a new high that surpasses that of the preceding cycle. There is no doubt that eventually prices and values will rise above the 1989 highs. The only trick is to survive until such recovery occurs.

Given the excessive inventory particularly of office space, the recovery in real estate clearly depends on the expansion of business. The national supply of primary office space is estimated at 5,700,000,000 square feet, of which 1,000,000,000 square feet is now vacant. (1) Using a factor of 250 square feet per person, the economy must expand by 4,000,000 jobs to fill present availability. Allowing for a normal vacancy, rents should firm up and begin to rise with only half that number of hirings. With employment in the service industries estimated at 28,700,000 (assuming inaccurately that all are housed in primary space), an increase of less than 10% would more than restore the balance to the marketplace.

Even if business expands, the economy begins to recover, and real estate is restored to profitability, the price for investment property will still depend on the health of the financial system. The sheer magnitude of real estate investment requires the availability of credit. From homeowner to developer, the industry depends on mortgage financing. The financial institutions created on their own initiative the overdevelopments that now chokes the marketplace. Without the active participation of these same institutions or their successors, real estate is held captive. Restoring the health of real estate must necessarily follow the recovery of our credit system.

The very survival of financial institutions, let alone the capacity to extend new credit, depends on their ability to resolve their existing portfolios of troubled real estate. The result is a "which comes first, the chicken or the egg?" dilemma. Will the recovery of the real estate industry and of financial institutions come about simultaneously, one fueling the other, or will the recovery of one as a result of outside forces spur the recovery of the other?

(1) The total national inventory of office space including secondary and lesser grade is 16.1 billion square feet, of which 12.9 billion square feet is occupied.

Henry Hart Rice is chairman of James Felt Realty Services in New York City, a Grugg & Ellis company. He is a vice president of the Realty Foundation and is a member of the American Society of Real Estate Counselors. In addition to serving an an adjunct assistant professor in the School of Continuing Education, New York University, Mr. Rice is a frequent speaker before professional groups and has written articles for several real estate--related publications.
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Title Annotation:real estate industry
Author:Rice, Henry Hart
Publication:Appraisal Journal
Date:Jan 1, 1992
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