Why Real Estate Is Strong Even In A Weak Economy

 

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."

All materials copyright © 2001 of the Wharton School of the University of Pennsylvania.

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