The Real Estate Industry Paradox
Muldavin, Scott R., Real Estate Issues
The real estate industry is a paradox. Just as property markets achieve their most stable equilibrium in recent history, real estate investors, lenders, and service providers must scramble to meet today's unprecedented challenges.
With real estate property markets in their most stable condition in 20 years, it would seemingly be logical to heed age old advice such as "sticking to the knitting" or focus on "blocking and tackling" in order to maintain market position and returns as overall market growth moderates. However, given structural changes in market cycles, the growth of the public real estate securities markets, and the surge of successful "applications" of technology to real estate, such strategies are unlikely to succeed.
Real estate companies of all types and sizes need to carefully reflect on their investment choices; take a more sophisticated look at their customers, products, and alliance partners; and adopt strategic decision-making frameworks similar to those that have driven the success of many corporations in America that have adapted themselves to the new global economy.
WHY IS CHANGE REQUIRED WHEN MARKETS ARE SO STABLE?
Stable markets themselves are at the root of much of the change necessary in the real estate industry. Most important, the more stable equilibrium in the real estate property markets today is not just a passing phase, but the beginning of a much less volatile market than has been experienced during the last 15 years.
As shown in Exhibit 1, the last 15 years have seen a dramatic period of excess capital and overbuilding in the mid-to-late 1980s, followed by an equally dramatic decline in capital and property values during the early 1990s. Capital flows since 1996 have been strong, but fairly close to the average of the last 18 years on an inflation-adjusted basis. Furthermore, construction levels for all property types on a national basis remain well within long-term norms; early signs of overbuilding in 1998 led to a strong corrective reaction by the industry.
Given structural changes in the finance system, the tax system, information availability, and the ownership of real estate, the likelihood of highly volatile market cycles on a national basis over the next 10 years is remote. This does not mean that there will not be overbuilding and/or capital shortages in certain property types or geographic regions, but overall, the volatility of market cycles should be much reduced over recent history.
Since most of the major real estate businesses today either started or grew dramatically during the last 15 years, and their cultures and businesses reflect an entrepreneurial orientation built around market volatility, reduced market volatility will require investors and lenders to change risk management systems and return goals and force service providers to focus on their customers, products, and potential merger and acquisition candidates to improve their productivity, pricing, and service.
Public Securities Market Growth
A second key change forcing greater sophistication by real estate companies is the development of the public securities industry during the last 10 years. The REIT and CMBS markets have grown from $27 billion in 1990 to nearly $360 billion today. For certain properties and mortgages, REITs and mortgage conduits have become the dominant providers of new capital.
The real estate securities markets are particularly important to monitor because they react so strongly to non-real estate related investment issues. For example, due to concerns over Russian credit, the Brazilian economy, and a few other non-real estate related issues, the CMBS market collapsed in late summer of 1998, pushing mortgage spreads up over 100 basis points, and closing down the mortgage market for many lenders and borrowers.
Similarly, the REIT industry began a steep decline in the summer of 1998 finishing the year with a negative 18 percent return and experiencing market value declines of 20 percent to 50 percent from their peak in October of 1997. …