Nature of the Current Real Estate Recession
The four most deceptive words in real estate are: "This time it’s different." Well, this time it is and it isn’t. It is the same in that this "great recession" started as a bubble created by too much money chasing real estate deals that made no sense.
But this time it’s different, because, first of all, there is a necessity for all elements of the economy to "de-leverage" or reduce debt; the debt burden is too great for families, businesses, and real estate developers. De-leveraging has led to deflation unlike any seen since the Great Depression of the '30s . And like the experience of the Great Depression, Texas and Fort Worth are experiencing it somewhat later and maybe with less impact, given our diverse and more dynamic economy.
But deflation in real estate values is, in fact, here and will get worse. Residential prices have dropped 10% to15%. Overnight, commercial values dropped 25% to 40% after capitalization rates rose from 6% to 8% or 9%. Cap rates are now close to the historical norm, so, given the severity of this depression, will prolong the rise more and not revert to that experienced two years ago.
What does this mean? Sam Zell, one of the country's most astute real estate investors, stated recently that all commercial loans made since 2006 are “under water.” This could very well be true. But the fact that a deal or lease is under water doesn’t mean it won’t inevitably work out. Inflation will come back to the market at some time in the future, but this will take awhile; for instance, from the peak of the market in the mid '80s, land prices dropped, and it took 15 years, about until the year 2000, to get back to that level. The way land prices are dropping now, if the same holds true, it will be 2025 before the real estate market recovers to that of 2006. What does this mean? Sam Zell, one of the country's most astute real estate investors, stated recently that all commercial loans made since 2006 are “under water.” This could very well be true. But the fact that a deal or lease is under water doesn’t mean it won’t inevitably work out. The second reason that this downturn is different is the massive loss of jobs in the U.S. Not since the 1930s has such a double disaster of deflation and unemployment occurred. The loss of jobs this time appears to be structural, and it may be several years before the U.S. returns to full employment.
In the meantime, lenders are not under pressure from the FDIC and the Federal Reserve like they were 20 years ago, so they aren’t pushed to deal with all the bad loans on the books. The Feds don’t have the money to bail out the banks and are hoping a number of conditions will improve to help some banks stay afloat. Therefore, banks aren’t foreclosing on bad loans and aren’t realistically liquidating the real estate they own. There is no Resolution Trust Corporation today to deal with the problem.
Changes and Issues That Will Come Out of the Current Recession
What is in store for real estate for the next two to four years? No one knows for certain, of course, but here are some of my opinions.
• Except for governmental, school and medical facilities, there will be very little commercial building. For the next few years, the words "commercial developer" will be an oxymoron.
• Almost no “green field” subdivisions will be constructed until this over-abundance of lots on the ground are absorbed. New homes built in Dallas/Fort Worth, which hit a high of more than 50,000 three years ago, will be only about 13,500 this year and will eventually even out to about 35,000 in four years. Infill projects will increase.
• Homeownership will fall from a high of 68% to 64% nationally, a more historically normal number.
• After a several year shakeout through next year, multifamily construction will accelerate. Indeed, multifamily development will be one of the few development types that will prosper.
• Cap rates will return to historical norm of around 8%.
• Local governments that rely on property taxes will suffer for the next three to four years as all property values fall 20%-50%. The pain felt by cities during this year's budget process is only just the beginning. • As a consequence, cities will dramatically raise development fees and taxes to try to cover the decline in those revenues that have nourished them in recent years. Unfortunately, this will have a dampening effect on new developments.
• Cities will initiate fewer public developments but will continue to pursue public/private partnerships for projects that cannot be otherwise financed.
• Market analysis will make a comeback. Investors and bankers will again pay attention to the facts.
• Real equity will again become the norm when bankers look at new loans.
• When will we come out of this recession? When rents and prices stabilize and employers start hiring again in two to four years.