Real Estate Industry Poised for Recovery Despite Slowing EconomyPublished: November 21, 2001 in Knowledge@Wharton
The real estate industry, which triggered the last recession, comes into the current slowdown in a much stronger position than it was in the 1980s. That assessment, along with new opportunities in leasing and finance, suggest a basically sound and resilient real estate sector, according to participants at the November 6, 2001 meeting of Wharton’s Samuel Zell and Robert Lurie Real Estate Center.
But the industry is also vulnerable to a number of stresses, participants added, ranging from scaled-down activities on the part of tenants to a significant decline in cash flows and a softening at the high end of the retail market. "There’s no doubt we are in a slowing economy and we need to think about how to run our companies," said Center director and real estate professor Joseph Gyourko.
Michael Balaban, president of Lowe Enterprises Mid-Atlantic, Inc. offered his own outlook for the industry. Many projects and markets remain strong despite the recession and the Sept. 11 terrorist attacks, he said, while others, particularly hospitality, are under strain. At the same time, the situation has created new opportunities in leasing and finance.
And private investors, Balaban said, are looking for real estate. "Private capital endowments and foundations and high net-worth individuals are whispering in our ear about things they would like us to consider on their behalf," he noted.
Balaban’s company is also working with pension funds. "The difficulty in getting debt today leads us, in some cases, to build on relations with pension funds who don’t like debt anyway." Pension funds see opportunities, he said, and now don’t have to compete with developers dependent on conventional financial structures.
Ron Uretta, chief operating officer of Insignia Financial Group in New York, said tenants are more cautious and many have put space they had hoped to use for their own expansion onto the market as sublease space. "What we’re seeing now is a hesitance on the part of tenants or owners to make long-term decisions with regard to occupancy needs," he said.
Scott A. Wolstein, chairman of Developers Diversified Realty Corp., which specializes in retail space, pointed out that most of the retail softening has been at the top end of the market. Retailers are honoring commitments through next year, he added, but "as to 2003 there’s a great deal of uncertainty."
He pointed out that retailers were prepared for a lean Christmas and are not likely to be caught with huge inventories that will slice into profit margins or force them into bankruptcy.
The current low interest rates are a mixed blessing for developers, Wolstein added, because the economic conditions creating them are at the same time giving rise to tougher underwriting standards. "It’s a classic case of the rich get richer." Companies with strong balance sheets, he predicted, will be able to snap up available land or redevelopment projects even more cheaply.
David Marshall, chairman and chief executive of Amerimar Realty Co., is working through the slowdown at his hotel properties by cross-training employees. For example, an assistant restaurant manager may be trained to make sales calls to drum up new business that will allow him to return to his original position. "There is a lot to be said for loyalty. If you show loyalty to employees in tough times they’re going to bust it for you when times get good."
And times indeed are tough, according to Dean S. Adler, president of Lubert-Adler Partners in Philadelphia, who gave a grim assessment of the post-Sept. 11 markets. "We’re going to see a significant decline in cash flows, a significant decline in valuations and this is no short-term issue," he said. In addition, developers may be less able to negotiate their way out of a default in this recession because many of their properties are now financed with commercial mortgage-backed securities that spread across many owners rather than a single bank or institutional lender.
Poised for a Renaissance?
Eric Lindner, executive vice president of GMAC Commercial Mortgage, was somewhat more optimistic. His company has not seen an increase in defaults, he said, and is equipped to process them if necessary. "A lot of people are focused on this. It is complicated, but I think for those who use common sense and have good real estate skills there will be good opportunities."
The securitization of the industry and the transparency that has added, Lindner noted, may provide real estate with significant stability through this recession. "This is the first slowdown when real estate has not been in the lead," he pointed out. "This is the first time we have gone into a slowdown where there wasn’t a huge oversupply of real estate."
Cydney Donnell, managing director of European Investors Inc., agreed this downturn will not be as harsh as the last one that forced many developers to seek bankruptcy court protection for their projects. "I’m not as concerned as I was in the ‘80s. It was not fun to stand out on the courthouse steps. There are projects that are going to be dogs, but there are going to be other opportunities."
In her opinion, real estate may be poised for a renaissance. "I think that 10 years [from now] you are going to find that real estate has a new-found respect. One of the issues people are going to be concerned about is, ‘Where do you get income today?’ The only place I know of is real estate." She said baby boomers will begin to retire in 2004 and will be looking for steady income. "When you retire, you appreciate that bird in the hand a lot more."
Allen Sinai, chief economist and president of Decisions Economics, Inc., in New York, forecast a recession that could continue through 2002 and possibly stretch into the first quarter of 2003. But he said the economy has already absorbed six to nine months of the slowdown.
The current recession takes an unusual pattern, he noted, because it began in the industrial sector with a glut in technology, not in the real estate and consumer arenas which typically start a slowdown that spreads to industry. "In a complicated and difficult world filled with risk and potential for disappointment, my guess is that a year from now things will look relatively bright," he said. "At this moment in time, though, I can’t promise you a rose garden for the next 6 to 12 months."
In the aftermath of Sept. 11, Brendan O’Leary, an expert on terrorism at the London School of Economics who is teaching at the University of Pennsylvania this year, outlined the causes and costs of terror. "Number one, they hate you because you are number one," O’Leary said. But, he pointed out, the hatred is also there because the U.S. has supported repressive regimes from North Africa to Central Asia in order to safeguard its access to oil.
Aside from the straight-forward economic costs of providing additional security, O’Leary outlined other long-term costs to U.S. society. He said expansion of military and police power at home will dampen domestic spirits and tourism, while residential and office buildings will be secured but open space [will be sacrificed]. The loss of investor confidence will cost jobs and output, he said, and the hunt for terrorists could lead to greater government intrusion into banking and financial systems.
He cautioned against creating a central anti-terrorism czar, arguing that this creates an additional level of bureaucracy that can diminish coordination and effectiveness in stopping terror attacks. Traditional policing, with resources to support it, is the strongest weapon against domestic terror, he said.
O’Leary warned against three mistakes the United States could make going forward. One would be to wage war on all of Islam, a danger he said administration officials appear to have avoided. He also cautioned against the temptation to expand the war to Iraq or other nations where there may be legitimate links to the terror attacks. Such a move would only open a second front of the war that would benefit the prime suspect, Osama bin Laden. In addition, O’Leary warned against broadening the front into other countries and issues, such as the dispute over Kashmir in India.
And third, he urged the U.S. to avoid what he called the "surrender fallacy." That means the U.S. must make changes in its foreign policy even if they appear to satisfy bin Laden. For example, the U.S. needs to support a settlement for the Middle East that acknowledges Israel’s rights as well as those of the Arabs. "This would not be to surrender to bin Laden; it would be the right thing to do [even] if he did not exist," said O’Leary.
In Praise of Smart Growth
Despite the economic downturn, and the likelihood that some of the late-1990s development pressure might ease, the fall members’ meeting addressed the issue of smart growth.
J. Ronald Terwilliger, national managing partner for Trammell Crow Residential, said continued U.S. population growth, combined with a shift of offices to the suburbs, created additional demand for development into the exurbs which in turn set off environmental and traffic problems. "It seems that in the ‘90s it all caught up with us," he said.
Terwilliger, former president of the Urban Land Institute, noted that smart growth does not translate to "anti-growth" or "anti-suburban." The Urban Land Institute, he said, defines smart growth as development resulting from policies that are economically and environmentally sound and create sustainable communities.
In practice, he said, that generally means flexible zoning that mixes residential and commercial development in a higher density than is traditional for suburban markets. The automobile is inevitable today. But if homes, offices and shops are closer it might at least limit the amount of time spent on the road.
Terwilliger said developers who strive for smart growth are too often trumped by neighborhood opposition. Residents are empowered by a political system that gives local home rule precedence over land development issues. The result is usually a development of sprawling single-family homes and traffic congestion.
According to Gary Hack, dean of the Graduate School of Fine Arts at the University of Pennsylvania, one way to diminish pressure to develop suburban sprawl is to revitalize communities that already exist in the nation’s cities. He said that while city centers and some far-flung neighborhoods are doing well, many cities are filled with wide swaths of abandoned, or obsolete, working-class homes.
He proposed the idea of intermediate density, in which city parcels are redeveloped at a lower density with some suburban traits, such as on-site parking and small backyards.
Bradford Klatt, co-managing partner of the Roseland Property Company, a New Jersey firm specializing in redevelopment projects, laid out the complexities of redeveloping an urban site. He said in an urban setting there is likely to be a need for environmental remediation and attention to geo-technical conditions. For example, his firm is trying to redevelop a former General Motors facility in Tarrytown, N.Y., that will require demolishing the plant’s heavy foundations. These foundations rest on land that juts out partially into the Hudson River. Such complexities, he said, often overwhelm public officials with planning oversight. To overcome this, complex redevelopment projects should be approached in phases.
Stephen Ross, chairman and chief executive of The Related Companies, which is redeveloping the New York Coliseum site in Manhattan, said massive urban redevelopment projects require great input from public officials, both in planning and financial incentives. His most successful projects have been in cities that had a good idea of what they wanted. He described a small mixed-use project in a suburban Detroit town that took years to develop. It became a drain on the company, which had to carry the land during lengthy zoning approvals.
The 2.7-million–square-foot coliseum site, he said, has been easier because New York officials already had a clear idea of what they wanted. "They were really just looking for requests for qualifications. That’s what it’s all about."
Karen L. Martynick, vice chairman of the Board of Commissioners in Chester County, a rural county outside Philadelphia that is facing tremendous pressure to develop open land, gave the view of a public official. She said suburban residents are likely to object to any development – smart or not. "People look at a farm field and they think they can forever have that [space]," she said. "It is hard to convince people they can’t stop development." And if a developer goes to court and wins the right to develop, the community loses much of its say in the development.
The lack of a regional structure that would link the economic demands of a city and its suburbs inhibits smart growth, she added. "As a region we don’t speak to one another. There are no incentives to work together. So we continue to develop in a way that is unsatisfactory to everybody."