Why Real Estate Is Strong Even In A Weak Economy

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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 Samuel Zell and Robert Lurie Real Estate Center. In a discussion about "Pressure Points in the Economy: Risks and Opportunities in Real Estate," participants discussed the economy' s future direction as well as strategies that real estate companies should adopt during the coming months. The panelists included Jeremy J. Siegel, a professor of finance at Wharton; Anthony Downs, a senior fellow at the Brookings Institution; and Samuel Zell, chairman of Equity Group Investments.

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.

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