Forty Years in Commercial Real Estate: Weathering the Cycles of Boom, Bubble and Bust
Real estate is prone to cycles of strength and weakness, to periods of growth and decline. The ongoing challenge—particularly for businesses and individuals for whom real estate is a primary asset or investment—is to ensure that the solutions to any current problem do not also plant the seeds of the next crisis. Equally important, opportunities seized during times of prosperity should not set in motion a chain of events that lead to a subsequent collapse.
From the first day we opened our doors at Much Shelist, the firm has served the legal needs of the commercial real estate market in Chicago. Over the intervening four decades, we have seen the industry go through several cycles of boom, bubble and bust. Even a brief overview of this period reveals striking similarities between the challenges we face today and those we've faced in the past, and offers important insights into the solutions being debated right now.
In many ways, the modern commercial real estate market came into being during the early part of the 1970s. Despite oil shocks, the war in Vietnam, and the recessions of 1969-1970 and 1973-1975, demand for real estate outstripped supply.
The market was further driven by the rise of a new class of entrepreneurs with access to private capital sources. The first publicly owned funds dedicated to real estate came into being, and real estate syndicators developed the first public offerings. In fact, Much Shelist filed what we believe to have been only the second such public offering by a syndicator. From this point forward, developers and investors began to create increasingly sophisticated vehicles for financing, developing and marketing real estate projects.
During the early part of the 1980s, the United States experienced another pair of back-to-back recessions. Prime rates spiked to almost 20 percent, and bank lending all but disappeared since it was nearly impossible to structure a traditional deal under those terms. Creative buyers and sellers reverted to the use of Articles of Agreement for Deed (known more familiarly as installment sales), or the seller agreed to take back a loan at a much lower rate than the commercial lenders then charged. Motivated sellers could still find a way to sell.
In order to stimulate the economy, Congress enacted the Economic Recovery Tax Act of 1981 (ERTA), which included provisions designed to improve the rate of return on commercial real estate investments and acquisitions. For example, ERTA lowered ordinary income tax and capital gains tax rates, and implemented the accelerated cost recovery system (ACRS), which changed depreciation rules for commercial real estate and made such investments more attractive.
This new legislation had a significant, positive effect on the market. Real estate limited partnerships took immediate advantage of ERTA provisions and increased rapidly in size and number. Real estate syndicators began to package and sell tax losses, while the savings and loan (S&L) industry began to make increasingly risky loans in order to achieve higher returns. More and more, real estate activity moved from the hands of individual entrepreneurs and onto the books of institutional investors.
In the meantime, certain foreign economies were experiencing spectacular growth, and the wealth that resulted was ripe for investment. Japan, for example, had become the second-largest economy in the world, with an average growth rate of 10 percent annually over the previous four decades. Japanese and other foreign investors began to flood the U.S. real estate market, outbidding and outbuying domestic investors and snapping up trophy properties in major markets across the country.
All of these forces came together, resulting in a dramatic increase in new non-residential construction. At the same time, valuations increased rapidly and out of proportion to the broader economics. Exacerbating the problem was the growth of flawed and overly optimistic appraisals, which led to increased uncertainty about the underlying value of real estate assets. (Does this sound similar to the current uncertainty regarding market values?)
In response to this new set of pressures, Congress took action once again. The Tax Reform Act of 1986 lowered marginal tax rates, eliminated many existing tax benefits and repealed ERTA rules that had, during the previous five-year window, favored real estate investments. Following these tax changes, syndicated real estate deals with tax advantages all but evaporated.
During this period of economic expansion, interest rates also began to increase again. In 1986, the Federal Reserve gradually raised interest rates in order to slow growth. The S&L industry, which had helped propel the real estate boom by extending risky loans, began to suffer as borrowers started to default.
The 1989 Collapse
By 1989, S&L and other thrift insolvencies had accelerated at an alarming pace. In order to manage and dispose of the increasing volume of assets that were being liquidated, the Resolution Trust Corporation was formed. Across the industry, gross charge-offs on real estate loans rose dramatically. At the same time, the supply of new loans shrank as new risk-based capital standards were applied to the banking industry.
Falling values triggered a collapse of the real estate market. Hit particularly hard were California, the Southwest and the Northeast (in many ways, foreshadowing the effects of the 2008 financial crisis yet to come). However, no area of the country was immune—including Chicago.
Responses to the 1989 S&L and real estate collapses were once again almost immediate and, in some cases, overblown. For example, many real estate investment trust (REIT) lenders vowed publicly never to write another long-term fixed-rate loan. (Keeping their fingers crossed, a few added the qualifier "…unless we have to.")
Accompanied by another oil shock in 1990, the U.S. economy entered a brief recession. After the construction frenzy of the previous decade, vacancy rates soared. Congress rewrote the tax code, again putting tax-loss syndicators out of business. Asian and other foreign investors sold off a significant percentage of their U.S. properties at a loss and moved on to greener pastures.
Despite the significance of the 1989 collapse, in some ways its immediate ill effects were short-lived. By the mid-1990s, an improved economy had already begun to soften the memories of previous excesses, and confidence was once again in full rebound.
REITs took off, with more than 150 being launched between 1992 and 1997. Securitized debt found a new market through the creation of commercial mortgage-backed securities (CMBS), which were significantly more complex than traditional bundled and resold residential loans. By 2006, the CMBS market had grown to nearly $550 billion. Investment banks went shopping for loan portfolios; for example, Morgan Stanley skyrocketed from virtually no dollars under management in 1995 to nearly $40 billion by 2006.
Once again, the U.S. government stepped into the real estate market by promoting a policy of near-universal home ownership. Lenders began to develop the market for subprime loans, and rating agencies were more than willing to issue AAA credit ratings on these high-risk loans, which in turn spurred the growth of the collateralized subprime mortgage market.
Looking just over our shoulders, the early to mid-2000s are remarkable for the resiliency and optimism of the real estate marketplace. In fact, this renewed confidence was enough to lessen the impact of the burst of the tech bubble in 2000, the terrorist attacks of September 11, 2001, and the subsequent wars in Afghanistan and Iraq. Rather than tightening the purse strings, investors simply redirected their attention toward "real" assets and stable cash flow. As the decade progressed and positive growth in real estate prices seemed fixed in stone, many analysts acknowledged the excessive growth, but put it down to "overpricing" rather than "overbuilding." Some suggested that a minor correction was likely, but downplayed the possibility of another 1989-style crash. In the meantime, the band played on.
2008 and Beyond
Rising defaults on home mortgages insured by Fannie Mae and Freddie Mac started a panic, and in 2008, the real estate bubble burst again. This collapse can be tied to a range of additional factors, including the market for securitized residential subprime mortgages, the growth of speculative credit default swaps and other complex financial instruments, faulty credit agency ratings, and policies perpetuated by the U.S. government and the Federal Reserve. Without doubt, there has been no shortage of finger pointing.
While the exact cause of the crisis may be debatable, the negative impact is not. Financial scandals have swallowed up or entangled almost all of the world's major public and private financial players, including Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers and AIG. Multinational businesses (including companies in the automobile and transportation industries) and the economies of entire countries have been brought to the brink of collapse. Some, at least, have partially recovered. But the defaults in home mortgages insured by Fannie Mae and Freddie Mac continue to rise, and the U.S. government will incur many billions of dollars of additional losses.
Continuing bank failures and the write-down of values that further degrade the capital of remaining banks have resulted in a near freeze on commercial real estate loans. Reduced real estate values also have compelled insurance companies to shrink their real estate holdings to a smaller percentage of their total investment portfolio. As real estate values and stock markets have plunged, insurance companies have had to sell off loans, avoid renewing loans and encourage borrowers to prepay in order to bring their ratios back in balance. Some have even offered discounts of up to 10 percent as an incentive for borrowers to replace or buy the loans. This has effectively removed insurance companies as a source of new mortgage loans, further weakening an already fragile real estate market.
Congress is again plunging into the fray. On the heels of a number of recent financial reform packages, the Dodd-Frank Wall Street Reform and Consumer Protection Act (signed by President Obama on July 21, 2010) contains a host of new regulations, government oversight and controls, but virtually nothing to address the Fannie Mae and Freddie Mac lending policies that led to the collapse. Despite government intervention, we remain in a very tight market. Many loans will not be renewed, borrowers will not be able to replace their mortgages and still more properties will be lost.
But there is a silver lining. The experiences of the past four decades have shown us that the market always manages to bounce back. Innovative businesses and individuals are already coming up with solutions to the current challenges. Hedge funds and other astute investors with cash are buying troubled assets at bargain basement prices. Seeds for the next boom are being planted and, in time, will generate huge profits as markets inevitably recover again.