The Five Drivers of Real Estate Recessions
By: Eric Cress, President & CEO, UD+P
In graduate school, my real estate development professor used to say, “You’ll be successful in this business as long as you survive the cold winters.” Since that time, I have always taken a defensive approach toward investment in development projects. For me, this meant becoming a bit of a meteorologist, watching for stormy weather like a deep-sea fisherman.
You can flawlessly execute the delivery of a building but fail miserably as an investor if unprepared for a frigid real estate recession. Broadly speaking, there are five categories of real estate recession risks to look out for:
Supply risk
Demand risk
Capital Market risk
Government Policy risk (including tax policy)
Force Majeure
Supply Risk
Supply and demand risks are closely related, and it’s sometimes hard, or pointless, to distinguish one from the other. In my 25 professional years, I have been through three recessions. Only one might be considered due to oversupply—the tech bubble in the late nineties and early aughts. When the bubble burst, apartment rents in the San Francisco Bay Area softened, but the office market is where the real carnage lay.
Real estate is particularly sensitive to supply risk due to the long production lag that occurs in development. In the late 90s and early 2000s, demand was so strong that a bunch of developers jumped into the game and started delivering buildings as quickly as they could get them built. Because delivery of a project can be three or more years from original site acquisition or even groundbreaking, they were unable to pivot when the tech bubble burst, and in fact, additional buildings were delivered long after demand dried up. The market suffered from the Bullwhip Effect, where multiple suppliers enter a market at the same time to meet demand, only to deliver a supply glut years later.
Fortunately, early supply data is usually easy to obtain by monitoring local permitting reports that signal the groundbreaking of projects. Matching those deliveries to the expected supply is the trick. Assets that have long product delivery timeframes, long lease durations, and high turnover costs—such as office and retail buildings—are particularly vulnerable to demand risk. Diversification among product types, including multifamily with its relatively short lease duration and industrial, which has shorter product delivery timeframes, can help mitigate supply risk.
Demand Risk
As we were recovering from the tech bubble in the mid-2000s, low interest rates and very loose lending practices led to an insatiable demand for residential real estate. The stories of people buying two, three, or more investment homes with no down payment are legendary now. The frenzy created an unsustainable demand, and the chickens eventually came home to roost when Lehman Brothers, founded in 1847, went bankrupt in the dramatic lead-up to the global financial crisis. The Big Short famously depicts Mark Baum, on the ground in Florida, uncovering the investment shenanigans that led to his uncovering of subprime lending gone amok.
Real estate demand is the function of many forces, so its risk is harder to forecast than supply risk. 2008 saw a global economic shock, but even in a global situation, keeping an eye on the local economy and local drivers of demand are key to mitigating demand risk. Apartments and industrial real estate have proven to be particularly sensitive to demand-side risk. When local economies fail and commerce slows, industrial (which generally serves the local economy) and apartments (which serve local workers) are the first affected. Tenants tend to be the first to anticipate demand risks that take the form of national and local recessions and economic obsolescence (shopping malls). Therefore, staying in communication with tenants is important.
Capital Market Risk
Supply of debt and equity capital for the acquisition and development of property can dry up quickly. In extreme cases, this can take the form of a global financial crisis. Capital market failures can be instigated by a number of causes including aggressive federal reserve policies, currency failures, or systematic bank failures due to lax underwriting or increased regulation. In many cases, capital market failures lead the economy into a recession, leading to a drop in GDP and a loss of demand. Therefore, recessions caused by capital market failures tend to be the most severe [Commercial Real Estate and the Banking Crisis]. This article, from The Cato Institute, argues that Federal Reserve-induced real estate cycles average about 18-years. Managing debt and maintaining modest leverage is the important mitigation here.
Government Policy Risk
A big part of a developer’s value proposition, and competitive advantage, is their understanding of local government policy and politics. When we first moved to Portland, Oregon in 2006, I immediately began studying the local planning code and attending the planning bureau’s community meetings. There, right in front of the public, the city outlined its plans to upzone SE Division Street and to make investments in the infrastructure there. They wanted to see more development on the street, which got my attention. I sent personal letters to every single property owner on the street—a few even called me back! Over the next six years, we proceeded to develop seven buildings on a 10-block stretch. No deals cut in smoke-filled rooms; the opportunity was there for everyone to see.
Policy at the national level can also be influential. National policies generally don’t lead directly to booms or busts, but they can overheat (and eventually overcool due to reforms) capital markets, ultimately leading to over-supply and then capital market failures.
For example, the boom and bust real estate market of the 1980s was largely caused/stimulated by government regulation. Favorable tax policies brought by the Economic Recovery Tax Act of 1981 led to high demand from investors (capital markets) for real estate. Later reforms in the Tax Reform Act of 1986 rolled back some of the favorable tax treatment, and over the course of the late 1980s and early 1990s, the country suffered from a severe real estate recession and the closure of many banking thrifts (capital market failure) [Commercial Real Estate and the Banking Crisis].
Experienced investors generally have a sense for when a government policy leads to windfall profits that are “too good to be true” and eventually lead to a bust. Keeping an eye on city, state and federal policy is important. Changes are often slow to be enacted and can be handled if you are paying attention.
Force Majeure
Low leverage, diversification, and insurance. When I was fresh out of business school, I would cringe at paying insurance premiums. Insurers are like a casino: they play the odds and they always have the edge. To me, that meant it was like giving away money. However, insurers are large and able to take on a tremendous amount of financial loss without folding. Unless you are a similarly sized financial institution, you do not have that luxury. So, you are paying them to hold that tremendous balance sheet so you can play the development game in a risky world without being too big to fail.
Insurers will not insure against everything. Therefore, and I am sounding like a broken record here, reasonably low leverage and diversification are vital. To learn more about how UD+P can build your real estate portfolio with a diversified, low-leverage strategy, visit us at https://www.udplp.com.