When the U.S. economy went through a recession during the late 1980s and early 1990s, commercial real estate hit the pits. An explosion of construction during the property boom of the 1980s gave way to high vacancy rates, pitifully low rents and poor demand for office and industrial space. Back then, the downturn was so severe that it took years for real estate to return to normal. How times change. Today, a decade or so later, although the U.S. economy again stands at the brink of a recession – some, in fact, believe that it has already arrived – real estate is in a stronger position than it has ever been. Gluts of vacant office, industrial and retail space – a visible symptom of past downturns – have failed to appear. Rents are still high – especially in upscale buildings. And while the stocks of real estate investment trusts (REITs) haven’t performed spectacularly, they look like bedrocks of strength vis-à-vis sectors such as technology, which were star performers during most of the 1990s but are now down in the dumps. All this means that real estate has entered an “unusual period,” according to participants at the Spring Members Meeting organized recently by the Wharton School’s
Siegel believes that real estate has been “very strong throughout this downturn,” which is “probably the only thing keeping us from a recession.” Although the GDP numbers announced recently for the first quarter of 2001 put the growth figure at 2%, which was higher than expected, Siegel adds that “the key to whether we have a recession or not is in the hands of the consumer.” Consumer spending was strong during the first quarter of 2001, but Siegel notes that he is concerned about consumers spending more than they are earning. “We have a negative savings rate, and that is understandable considering that we have had tremendous capital gains in the stock market,” Siegel explains. “But now those capital gains are not going to be easy to come by, and consumers should be going back to saving the old-fashioned way. They should be cutting back on consumption and adding to savings.”
Consumption cutbacks, however, could hasten the slide toward a recession, especially in the short run. Siegel points out that while the average savings rate of the American household during the 1970s, 1980s and 1990s was 10%, now it is zero. This means an increase in the household savings rate even to 5% – which would be among the lowest in the world – would require a cutback in consumption by 5%. This would pose a problem for the economy, since consumer spending accounts for two-thirds of GDP. “If consumers really started saving the old-fashioned way, in the long run it would be very good for the economy but in the short run it would be a potential problem,” Siegel notes.
Siegel expects that 2001 will “not be a great year for stocks. There are going to be more earnings disappointments.” He also believes that the U.S. Federal Reserve will continue to lower interest rates “maybe down to 3.5% by the end of the summer or the beginning of the fall.” Siegel says investors will be disappointed with the performance of their stocks – which will probably see neither significant gains nor losses. “In my opinion, this spells good news for yield-oriented stocks such as REITs,” Siegel notes. “The tremendous movement we have seen during the past nine months back to value stocks and away from growth stocks is likely to continue. In fact, it is likely to go towards yield-producing stocks, especially with short-term interest rates going down dramatically. There are going to be some dividend yields, especially among REITs, that will be higher than a shareholder can earn in a money market fund.”
Another factor that could drive investors towards REITs and other yield-producing securities relates to what Siegel calls the “earnings shenanigans” going on with some tech stocks. In an effort to meet the estimates of Wall Street analysts, some technology companies lately have been taking writeoffs and writedowns instead of operating losses. “We are going to hear more about such manipulations, and it’s going to cause investors to move away from stocks and firms that are engaged in such practices,” Siegel predicts. “People will move towards stocks they can trust, and where the earnings really are there.”
Downs agreed with Siegel that real estate is strongly positioned for the future, though the development boom that began in 1997 is drawing to an end. “The ending of a development boom is normally brought about by a slowdown in the overall economy or such a large amount of overbuilding that development gets out of kilter with demand,” he says. Massive overbuilding took place during the 1980s property boom. In contrast, “this time, it’s a slowdown in the overall economy rather than a large surplus of new construction that is ending the building boom. This slowdown in space demand has been unusually sudden. The economy moved from strong prosperity to a near recession in a short time,” Downs adds.
Why is real estate less overbuilt today than it was during past booms? Downs believes three factors are responsible. First, he explains, the “free, unconstrained sources of capital investment, which were present during the 1980s, were not present during the recent past.” While savings & loans and international investors made large investments in construction during the 1980s, the so-called dumb money during the 1990s went to dot-coms and high-tech companies. “The stock market is loaded with irrationality,” Downs notes. “There is always dumb money somewhere in the market.”
During the 1990s – and especially after 1998 – REITs and other real estate stocks appeared to be performing poorly. The reason had little to do with the companies or the properties they owned, which were doing very well; it was just that the rest of the market, buoyed by tech stocks, was doing much better – even spectacularly so. “I said at that time that REIT shares would not do well until the Nasdaq took a nosedive,” Downs points out. “Now it has – and that has allowed REIT shares to come to the fore. The comparative advantages of REIT shares have become obvious.”
The second reason why overbuilding did not occur during the current real estate cycle is that “after a slow start, the prosperity of the 1990s was especially strong and prolonged, which kept stimulating the demand for space.” This meant that new office space was absorbed almost as fast as it could be created, Downs maintains.
And thirdly, capital markets were more disciplined in making loans and equity investments in real estate during the 1990s than they were during the decade before. “This was not true of the capital markets in general, because they exerted less discipline in the Internet sector, but in real estate they did,” Downs says.
Downs believes that the current slowdown will probably have a minor impact on real estate unless “the overall economy moves into a lengthy recession. Even then, things will not be all that bad, because the REITs and other owners of property today are not as leveraged with debt as developers were during the 1980s. Even if cash flows slow down, rents fall and occupancy rates decline, very few REITs are likely to become bankrupt because they have a very large cushion in their cash flows,” Downs says. “They can stand a lot of decline without having to go out of business.”
Zell shared Downs’ and Siegel’s concern about the economy. “I believe that we are in a recession,” he says with characteristic bluntness. “The historical definition of a recession is two quarters of negative growth. I would ask you to reflect on a rhetorical question: What is the difference between two quarters when you go from plus two to minus one, and from plus five to plus one? If anything, the drop is more significant” in the second case.
Zell believes that the U.S. business environment today is like a deer caught in a car’s headlights. “Everybody has stopped doing anything,” he says. “Space decisions and moving decisions have been put on hold, M&A activity has dramatically been reduced, and everyone is questioning the definition of the future.” While some optimists may argue that a recovery is just around the corner, “I don’t necessarily agree,” Zell says. “We have dropped off a cliff and now we’re walking in the valley. Maybe we are walking at a slightly up angle, but I assure you we aren’t on a pogo stick.”
Zell points out that the economy has a lot to overcome, because “the last three or four years saw a significant misallocation of resources.” He argues that this misallocation involved not just the capital that went to what he calls “the dot-bomb world,” but also the people. “There’s this idea that someone would say, ‘It’s over,’ and everyone would be able to move back from San Francisco to the rest of the world and become part of it. Nothing could be further from the truth,” Zell says. Dreams are hard to give up, and a lot of former dot-commers are still unwilling to face reality. “A lot of them are going from one failed dot-com to another. They are trying to figure out that if they were entitled to be billionaires at 23, why didn’t it happen? These are challenging issues. Having gone through this extraordinary speculative boom, we as a country will take a number of years to get back in balance,” he says.
Zell disagrees with those who believe that lowering interest rates will solve the problems that beset the U.S. economy. “Interest rates in Japan today are zero, but that isn’t helping the Japanese. While interest rates going down may reduce the pressure in some areas, to a large extent lower interest payments will not make up for the fact that your sales are down by 40%. It will take a while before things are back on track,” Zell says.
Even so, the good news is that real estate is exceptionally strong, Zell points out. “Our supply-demand scenario is in equilibrium,” he says. “It is fabulous on high-demand real estate, and marginal on the marginal ends. The problems, to the extent that they will occur, will be in the marginal areas.” The office and multi-family housing markets are moving back to focus on location, and the re-gentrification of cities is changing the risk factors involved in owning real estate, Zell adds.
Zell believes that the next three years will see a shakeout among REITs. Of the 216 REITs that exist today, he sees little need for more than 20 or 30 at the most. He says: “Companies that understand the economic environment, those that stick to their knitting, focus on their operations and take advantage of scale will come out of this period stronger, better and more dominant.”
