FUTURE REAL ESTATE APPRAISAL PROBLEMS

Many real estate changes are now taking place, simultaneously, that might, singly or together, represent potential, major “game changers” (agents of change) to the future of real estate and thus real estate appraisal. The agents of change include, without being limited to: increasing homelessness, material decline in demand for “brick & mortar retail properties, globalization of real estate ownership, changes in the environment for office space and globalization of real estate ownership, to identify some major items. Despite these observable phenomena there does not seem to have been much major discussion as to how the appraisal profession may need to analyze and address these changes. Suffice it to say that, in over 50 years the study of real estate valuation has focused on improving methodology and professional standards. The integration of computers and innovative, interactive programs have facilitated material forward progress and the development of detailed, mandatory uniform standards have provided greatly enhanced credibility for the work product. However, there has been a complete absence of any new valuation theory discussion.  The profession is still working with the three approaches to value (Cost, Comparable Sales and Income) although the methodology has changed significantly and for the better.  The changes taking place may or may not suggest that an academic critique of present theory and methodology needs to take place to make sure that, moving into the future, the theories and methods in use are the right ones and provide a measurable level of reliability and relevance

The purpose of this paper is to examine the changes (causes and effects) taking place with the objective of stimulating the kind of thinking and research necessary to develop enhanced appraisal models, methods and theory needed to sustain the future of real estate valuation as a profession. For the active, practicing appraiser this paper probably doesn’t have much in it that they haven’t thought about, but thinking about and raising issues are two different things. As a biproduct an attempt will be made to examine some possible solutions to some problems.

HOMELESSNESS: In the last few years most people have become aware of the growing homeless problem but there is a lack of understanding as to the underlying reasons for the problem.  There are multiple related and/or unrelated causes. First, not all homeless people are victims of the same cause.

         LACK OF HOUSING ALTERNATIVES: Many counted as homeless are in that state because they can’t find any affordable housing.  In many jurisdictions this observed problem seems to be caused by a lack of enough building of new housing supplies.  A shortage of supply faced with rising demand leads to increasing rents and housing prices. At some point the potential renter or buyer is priced out of the market and living on the street becomes the housing alternative.

         MENTAL HEALTH PROBLEMS: Mentally ill people without support, resources or available treatment alternatives add to the homeless increase because there is no other alternative and they often require specialty housing in facilities that are different from conventional housing.

         DRUG ADDICTION: Part of the homeless population are substance abusers who may need specialized intervention and living facilities.

The same causes of being homeless do not apply to all of the homeless population.

         CAUSES:   The common cause of homelessness is a lack of housing supply. For the renter without enough money to consume a rental unit, a mentally ill person or a substance abuser it is the same cause albeit the mentally ill and substance abusers require different types of housing alternatives.

         Inadequate housing supply, in many jurisdictions, is the result of flawed land use and zoning policies.  In San Francisco, for example, the City down zoned properties in the late 1970’s resulting in a 50% reduction of previously allowable densities This was at a time when builders were eager to build and the change effectively discouraged development. In addition, the codes became more restrictive with the addition of requirements (like providing a percentage of affordable housing) that were unrelated to health and safety. The net result was a curtailment of potential, new supply. So, in effect, the leaders of the time reacted to citizen anti high-rise pressures instead of understanding the negative result on the future of what they were creating. Then, San Francisco, in 1978 created a strict residential rent control ordinance that effectively created two classes of renter. One class were the renters that were living in what became controlled rental units protecting the current occupant.  The other class were renters without protection such as those who occupied units built after the date of the ordinance. Finally, the City instituted a cumbersome, lengthy and very difficult permit process adding significant costs to project development. Despite what turned out to be the misguided belief of the Planners that the developer absorbed these costs the developer merely passed all of these added costs on to the consumer.

         SOLUTIONS: The only obvious solution, as things now stand, would seem to be for effected localities to induce, over time,  a massive increase in supply. Accomplishing this would necessitate a revision of land use and zoning policies designed to substantially increase height limits (wherever practical) and allowable densities. Modernize all codes to spell out what limits are permitted. At the same time all requirements having nothing to do with health or safety need to be reviewed with a removal of those requirements adding cost to the project but not enhancing the housing experience. Finally, remove all public hearings in the approval process unless a material variance from code is sought. The permit process needs to be expedited and taken out of politics. An example of the housing problem is the fact that many communities have experienced runaway price increases for single family housing. The result is that the price of a home has become so high that potential buyers can’t afford to buy yet the neighborhoods remain zoned for single family use. In terms of the future, the zoning must be changed to allow higher densities.  There appears to be only one major City studying that solution at the present time.

These steps might take years to resolve the supply problem but increasing supply is the only obvious solution.

         FUTURE: If the housing problem is not addressed aggressively the result may well be an extinction of the cities as we know them. Cities require an available of army of service workers, at every employment level and reasonable commute distances to the workplace. When workers can no longer find housing and commute problems become unacceptable cities will begin to die.  Signs of this are beginning to be evident in the hotel and restaurant sector where the availability of lower service level employees is forcing operating cost problems. The solution for hotels might be to devote some of their rooms to workweek housing for those employees.  Restaurants don’t have that option readily available and can only compete for employees through wages and the economic impact of that option may negatively impact economic viability.   

In order to solve these problems expert study roups should be appointed with the charge of providing detailed analysis of the observed problems along with developing a roadmap for solutions. Solutions will be long term involving a two year or longer development time so the appointed group might also be charged with developing interim solutions, in six months or less, designed to immediately induce major short term additions to the housing supply. Failure to take this step now could inevitably lead to the death of a City as those necessary service workers will no longer be able to live in or near the City and provide all their services.  What then? How will future appraisers deal with these problems?

RETAIL:  The retail revolution now taking place didn’t just happen.  The probable precursor may have been the emergence of “big box” stores consisting of huge, warehouse stores like Costco Walmart and single purpose retailers like Best Buy. These retailers not only changed the way business was done but also adopted the on-line sales strategies to increase their sales. The advent of widespread, on-line shopping has allowed consumers worldwide to shop any brand or product without leaving home. Retailers can quickly expose their products to consumers via well developed websites, print media and television advertising without needing a global network of brick and mortar stores.   The game probably began to change with the national and international expansion of retail brands either directly or via franchising. This change caused the diminution of the viability of small, local retailers.  Today there are few, small, independent retailers or family owned department stores remaining as most have been absorbed by major chains, gone out of business or bankrupt. The incursion of on-line shopping changed the dynamics of major department stores to the point that some are now struggling financially. Department stores and large “big box” retailers have been exiting business faster than new stores are opening with the most recent being the Sears announcement of store closures and Barneys going out of business.  Bankruptcy of a major retailer was a very infrequent occurrence but is now not unusual. This problem is negatively impacting both stores located in Central Business Districts as well as neighborhoods.  In many parts of the country retail vacancies are pervasive and present problems for their communities. The bottom line is that demand for retail store space has declined and continues to decline. These factors operate to change the risks of retail property ownership due to increased vacancy risk as well as the impact of this problem on capitalization rates.

         CHANGES:  Some of the changes have caused the creation of new models. It had been observed that young people like to “hang out” at the Mall and that adults like to “go out”.  The result of this is that specialty shopping centers focusing on the entertainment sector (like motion picture theaters) are enjoying success while other types of shopping centers are not. As available as movies are on TV, there is no substitute for the large screen. And there is no question that “eating out” is an increasing phenomenon with both fine dining, fast food and everything in between being popular.  Specialty centers with multi-screen motion picture facilities coupled with many restaurants have, so far, been successful in attracting tenants as well as customers.

Not all store types found in shopping centers can benefit from internet sales. Supermarkets, liquor stores, barbers, beauticians including a range of types like nail salons, spas, shoe repair etc. will still need brick and mortar space. In other words, if something is needed in less than 24 hours a store may be the best answer.

In many parts of the Country shopping centers may have been overbuilt with no infill tenants available to occupy vacancies. In shopping centers, the “in-line” stores depend on the “anchor” (most often a department store or big box store) and when the anchor vacates the in-line stores lose their customer draw. Some centers have leases where the in-line shops can opt for early lease termination if the anchor tenant vacates.

On-line shopping giants like Amazon create a new set of problems as their increasing sales lead to traffic and congestion problems resulting from the massive number of package deliveries. Whether this problem can be solved by an increase in drone deliveries (in place of surface street deliveries) or not remains to be seen. However, the increase of on-line shopping may increase the demand for expansion of distribution centers, either new or use for vacancy in-fill tenants, but proximity to transportation hubs may be a criterion.

It has been common for retailers to have clauses in their leases making the contract rent just a minimum to be moved higher by percentage rents if sales exceed the stated minimum level. Given the current retail environment one possible change could be the disappearance of percentage rents across the board. Retailers with internet sales do not need the store to generate more sales.

In the past, shopping centers and other retail in general were ranked based on tenant quality with those having the best balance sheets classified as a “credit tenant”. Years ago, major retail bankruptcy was unusual.  However, with the use of financial tools like “leveraged buyouts” and financed internal expansion few, if any, are free from bankruptcy risk. The reduction in credit ratings might be expected to impact capitalization rates.

CAUSES OF RETAIL PROBLEMS: Some Cities, like San Francisco, caused problems by flawed land use or zoning policies. San Francisco adopted measures intended to protect the small retailer such as tightly controlling the issuance of permits for chain stores in neighborhood commercial districts. Retailers with 11 or more stores nationwide were ineligible for permits. While perhaps, arguably rational as a protection for “mom and pop” stores this type of solution eliminated an entire spectrum of demand for brick and mortar retail space. Similarly, when banks, title companies and restaurants were driving space demand, rules were adopted that precluded their expansion. The Planners completely overlooked a study of the viability of “mom and pop” stores. Retail stores depend on supply chains, employees and operating capital as well as business operating acumen most of which the “mom and pop” operators lacked. This was the attraction of owning a franchise where the franchisor provided the operator with a business model that had everything except the operating capital. However, ruling out chain stores eliminated franchise operations from the demand group. A global change in buying habits and patterns away from brick and mortar stores to shopping on the internet may be the greatest cause of problems affecting retail real estate.

         DID THE LAND USE AND ZONING RESTRICTIONS SOLVE THE IDENTIFIED CONCERNS? Absolutely not In many communities across the Country retail vacancies are a major problem with no viable solution in sight. San Francisco, for example, is studying the idea of taxing vacancy under the misguided assumption that landlords are greedy and refusing to rent their vacant space unless they get the rent they want. Any experienced retail leasing agent will confirm that the rent a landlord can command is market driven and only mentally deficient landlords hold out for unrealistic numbers after reasonable exposure of the space to the market. Taxing vacancy will not induce a landlord to rent the space if there is no demand. Problematic vacancy is a sign of a shortage of demand.

SOLUTIONS: The obvious solution is to figure out how to increase demand. Developing a comprehensive list of neighborhood serving retail uses that do not need to be in shopping centers as well as those retailers that can compete in the existing competitive retail environment (businesses that are not impacted by on-line sales) might be a worthwhile exercise. One result of this type of study might be a refocusing of options in terms of identifying potential tenants. A solution to that problem may be to revisit the zoning ordinances and land use policies with a goal of eliminating or revising all that impede demand.  In other words, stimulate demand through increasing permissible uses. The urgency of this is forcefully demonstrated by a San Francisco case that was publicized as this paper was being completed: Trader Joes, a well-known and respected food market chain applied for a permit to open a store in a neighborhood that was not serviced by any food stores within close proximity. The Board of Supervisors had to override the prohibition of chain (formula) stores to allow the application to move forward. Despite this, the application is expected to consume an inordinate amount of time before final approval. A potential competing market tenant had reportedly abandoned its plans because of the difficulty in obtaining a permit. In a forward-looking planning environment this permit application should have received a rapid approval.  Instead, the tenant is penalized by having to spend unnecessary money because of a very flawed zoning rule.

 A Planning Department is not equipped to micro-manage uses or to interfere in any way with the law of supply and demand. The market must be the arbiter. The process of granting permits needs to be streamlined and expedited to eliminate the costly delays in permit issuance so that a potential merchant does not need to squander capital pursuing a lengthy permit process. Finally, where neighborhood commercial zoning may not permit upper floor residential uses the zoning should be changed to permit them as a means of expanding the surrounding customer base as well as housing supplies. These problems deserve extensive study with a goal of alleviating the problem long term.

OFFICE BUILDINGS Office properties have enjoyed an unprecedented rising rent trend to the point where only the largest and most secure firms financially can compete for space.  Small tenants and startup ups with limited capital are essentially priced out of the market.

The cause of this problem can, in San Francisco, be traced by the adoption of rules limiting the issuance of new permits to 950,000 square feet annually and many barriers to entry into the development market. The permit limitation had what, certainly was an unintended consequence, of providing a windfall in rental profits to existing building owners.  It wasn’t always so good.  During the “dot-com bust” and 2007-8 real estate recessions there was an office vacancy problem. However today the potential problems facing office building are quite different.

         TECHNOLOGY: The rapid rise of technological advances plus housing shortages combine to induce working from a home office instead of a central office. An escalation of this trend must be expected.  Also, business firms are recognizing the impact of office space rental on their annual budgets. Some firms are experimenting with the use of shared offices as opposed to assigned private offices.  This model was tried many years ago by major accounting firms who found that much of their staff was, daily, working outside of the central office. The technical ability to remotely “tap” into all needed files  greatly reduces the need to be present in the central office in order to work and the use of video conferences, via the internet and dial in meetings, substantially reduces the need for  face meetings in office conference rooms.  This change should be expected to accelerate as many types of office jobs may be adaptable to this model much in the same manner that firms have outsourced office functions to overseas contractors.

         ACCESS: The commute distances of today consume valuable travel time and workers who “tele-commute” tend to be more productive. The advantage of working in the central office seems to be more a matter of employee supervision than necessity in many instances. Technology is changing that.

         FUTURE PROBLEMS: It is possible that the advances in technology may, in the not too far distant future, reduce the role of office buildings as the workplace in favor of technology dominated models. When that takes place the office building may need to be re-invented.

SOLUTION: Future office building design may need to provide an exit path if office uses are no longer viable.   Such would include an original design that anticipates a probable conversion from office use to hotel or multi-family residential uses which, in turn, would necessitate zoning that anticipates that solution.

GLOBALIZATION: The major investments in real estate are now coming from all over the world.  The market for “investment grade” real estate is now international (global). Real Estate, for the most part should be divided into two categories (investment grade and locally owned).  Smaller properties tend to be owned by local investors and location tends to dominate value.  Homes priced for the average market are also locally owned.  However, super luxury homes tend to be, often, marketable in the international market. Utilizing locally generated capitalization rates for globally marketable properties tends to be a short sighted exercise. Rather, the search should be more global than local and include investor surveys that are nationally or internationally published.

The search for supporting data may need to be expanded to a national or international scope where that is the market for the property. The definition of a comparable sale may need to change.

CHANGES TO STUDY: Office buildings or shopping centers that are investment grade properties most probably can’t be valued based on the use of a sales comparison approach mainly for the lack of an adequately sized sample of sales of contemporary, comparable properties from which to draw the appropriate capitalization rate. Rather, the capitalization rate needs to reflective of the market in which the property would sell.

Appraisals may have to be much more informative.  While market value is a value at a specific moment in time, appraisals in the future may need to provide the client with information that will permit judging whether the concluded value will most probably be durable or subject to downward adjustment in the near future.  There is a saying that “perception is 90% of value” and the one perception that may be universal is that most humans, when taking financial risk, hate uncertainty. In the future, developing research that provides insight into “uncertainty” may help in reading markets.  Fortunately, the advance of technology has all manner of economic data available and it is now more a matter of selecting the best data than developing that data de novo. This means that appraisers may expect to have the availability of excellent sources of reliable data.

For professionals who regularly utilize DCF (Discount Cash Flow) models a daunting task will probably be deciding how, when and if the observed changes might impact the host of assumptions that go into the DCF study. For example, many practitioners have used the inflation rate as the rate of change in rent.  That may be supportable except when there are major changes taking place or projecting lease renewal probability may not find good support when demand is not reasonably predictable. The result of DCF studies may not be reliable when any material assumptions are not realistic or supported. This area most likely needs careful examination and revision of methodology where indicated.

CONCLUSION: All observed problems suggest many things.  First, land use policies and zoning must not be etched in stone and will need regular review to make changes that are needed to reflect what the market is telling the observer about the future. A jurist commented (in a case whose name is unimportant) something to the effect that “Planning and zoning are tools for use in planning for the future and should not be used to deny the future.” Planners should recognize that developers are not the enemy and promote “can do” attitudes instead of “can’t do”. Planners need to recognize the economic cost of protracted permitting processes and make sure that the process is defined to be expeditious instead of cumbersome and costly.  Planners have to consider that their plans can not control or change the laws of supply and demand as much as that may be desired. If there were a way to limit each family to one child (as China did) they would not need to struggle with the problems of growth.  However, that would not be realistic. Lastly, Planners and the political establishment behind them just can’t legislate design. Great design requires great architects and a bureaucratic attempt to control design will fail. Planners must begin with a visit to Cities like Hong Kong, Singapore, Shanghai, Dubai and Abu Dhabi to figure out what is necessary to induce the development of cutting edge and innovative architecture in our markets. Finally, appraisers may wish to be pro-active in planning for perceived changes rather than risking being consumed by them.

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POSSIBLE SOLUTIONS TO THE SAN FRANCISCO HOUSING CRISIS

©Lloyd D Hanford Jr., October 2019

There has been a serious homeless problem in San Francisco for many years. Unquestionably the problem has its root in sociological issues which must be left to the experts in that field to address. However, no matter why there is a homeless problem a key issue is the fact that there are no functioning housing alternatives to living on the street for people who can’t find affordable housing.

The common denominator to the housing problems is a SHORTAGE OF SUPPLY.  In other words, the demand for housing substantially exceeds the available supply. Economics 101 clearly teaches that when demand exceeds supply prices will rise and it is obvious that the greater the gap between supply and demand the faster prices will rise.  This explains why housing costs in San Francisco are so outrageously high that most potential consumers for housing just can’t afford them.. 

In searching for solutions, it is important to figure out how the City got into this position. It is suggested that the cause probably goes back to the 1970’s when anti-high-rise activists (1) made an attempt, via the ballot box, to limit the height of residential buildings to six stories. The ballot initiative failed but following that activity the City down zoned the vast majority of properties to permit a density that was, in many cases, substantially below the previously permitted densities. This decision had the effect of reducing the future, potential supply of housing by up to 50%. Add to that an increasingly difficult permitting process and the addition of new supply became even more problematic and expensive.

The growth of a NIMBY (not in my backyard) philosophy developed making any changes difficult if not impossible. The notion of preserving single family neighborhoods is, under any growth scenario, misguided. In a city like San Francisco with a very limited land area zoning criteria must advance with the times.  The City is now in a position where a cheap single family home costs well over $1,000,000 which means a property tax of over $10,000 per year. These costs keep single family housing well out of range for middle income people let along low-income people. The City can’t afford to preserve single family neighborhoods into the future if there is a desire to have adequate housing for the future population.

The solution to the present housing problems is to provide for a massive increase in housing into the future. In other words, dramatically increase supply to the point where hosing costs become competitive again. The planners need to comprehend that there is a “filtering up” process that comes with a building boom.  As people move into the new housing they vacate the older housing which older housing becomes the supply for the lower end of the economic spectrum.

Some steps to consider include:

  1.  Re-zone the City to permit mufti-family residential development in currently single family and lower density areas.
  2. Increase height limits and allowable densities to create room for major increases to supply.
  3. Change the building codes to eliminate all requirements that do not relate to health and safety such as the requirement to include a percentage of ‘affordable housing units” under the misguided notion that the developer is paying for that housing.  The housing consumer is the one that ends up paying.
  4. Review all architectural requirements that impact building costs such s bulk limits, shadow ordinances etc to make certain that they make a positive contribution to the users of housing and if not, change them.
  5. Remove any prohibitions against tearing down single family housing units.
  6. Reduce the time involved in the permitting process and unless permit application calls for a variance from the permissible criteria eliminate public discussion relative to granting the permit.
  7. Develop innovative zoning districts such as permitting high rise residential development along both streets bordering Golden Gate Park.  Such development would not block views of current housing. Permit high rise development along streets like Broadway (and tops of hills) where the development would not impair any existing view of the Bay from neighboring property etc.
  8. Develop a system for having developers pay the City (not the property seller) for any permit approved, increased density above the currently authorized density before the new zoning was created.  For example, if the old zoning would have permitted 50 housing units and the new zoning and issued permit would allow 100 housing units and he market price of land was (is) say $30,000 per unit the developer seeking a permit to build 100 units would pay the City $1,500,000 for the added 50 units permitted and built. There should be no windfall profit to either the developer buyer or the land seller as a result of increased density. The money received for these development rights could be earmarked for a fund to provide subsidized housing for those in need.
  9. Decontrol (from rent control) all covered housing units, on turnover within five years after turnover. Remove from rent control all remaining housing units covered fifty years from the date of the new zoning.

The foregoing is a broad brush approach to the problem. To devise a workable long term solution a “blue ribbon” committee consisting of architects, engineers, attorneys, developers, financiers, investment bankers, sociologists, economists etc. should be appointed and given a period of two years to study solutions to long term increases in housing supply and make recommendations to the City for the legislation necessary to implement the recommendations. The Committee should avoid any attempts to “dictate” architectural design because that should be left to the architects. One only needs to look at cities like Hong Kong, Singapore Shanghai, Dubai and Abu Dhabi to name a few and wonder why innovative architecture seen there doesn’t appear in San Francisco.

It has taken over forty years for the previous planning failures to bring the City to this point and no solution will bring immediate relief. But, a reasonable goal would be to have a resurgence of residential building within ten years with a goal of achieving a balanced supply/demand situation within the same forty years.

The current attempts to solve the problem by just throwing money at them will not work long term.  The only real solution is to provide for a dramatic increase in housing supply.

(1) See Alvin Duskin Biography (Wikipedia)

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HOUSING SHORTAGES AND OTHER PROBLEMS

Much has been written about serious shortages of affordable housing and other land use problems in Cities across America. President Trump has now taken up the California homeless problem and the State is enacting broad controls over rent increases in housing. The problems have been attributed to numerous causes but most of the causes seem to be descriptions of results and not the core problems. Using the City of San Francisco as the laboratory may be helpful in understanding causes that may be applicable in many jurisdictions.

A Jurist opined (the case is unimportant) in an old zoning case something to the effect that “the purpose of zoning is to plan for the future and should not be used to deny the future”. Unfortunately, for various and sundry reasons zoning became politicized, resulting in the rise of “NIMBY (Not in my back yard) political pressures. San Francisco provides an excellent example of this reaction.

In the 1970’s an activist caused a public vote on an initiative to limit the height of all buildings in residential areas to no more than 6 stories. The mantra was to prevent the Manhattanization of San Francisco. The public rejected the initiative at the ballot box but it didn’t stop the politicians from a massive re-zoning effort that resulted in effectively reducing most allowable densities by 50%. In a City with 36 square miles this had the effect of limiting the future supply of new housing by half of what would have been permitted under the previous densities. The Planners went on from there to adopt all manner of added problems for developers limiting the height and bulk of buildings to a requirement for each new building to contain a percentage of “affordable housing units”. In addition, a one for one parking requirement (one parking space for each residential unit) was put in place. Since zoning regulations impacted residential, office, commercial and industrial uses, each sector needs to be examined independently.

In the housing sector the theory was that developers would be happy to contribute the requisite “affordable housing” in return for the ability to develop. That was the most ridiculous theory ever concocted. Developers don’t contribute anything other than the completion of a building. All of the costs of production are built into the rents or prices charged resulting in the end user or consumer paying for everything. When the cost of production exceeds the anticipated recovery through rent or sales price the building just doesn’t get built.
Accordingly, the cost of the “affordable housing” element just gets passed on to the ultimate user and contributes to an unnecessary and limiting rent cost or purchase price. There is something wrong with this concept.

In a similar restrictive move, it became illegal to demolish a single family dwelling without replacing it. Thus, developers were unable to use the typical strategy of purchasing a group of adjacent houses for replacement by a high-rise apartment building in favor of maintaining an existing supply of single family housing. The result is a supply of bungalows now costing well over $1,000,000 each to purchase.

In addition to these issues, all older residential buildings (buildings with Certificates of occupancy dating to July 13, 1979 or earlier) are subject to rent control with rent increases limited to 2% per annum causing renters to give up too much if they voluntarily move out. Once a renter moves out the landlord is free to increase the rent to any level under current guidelines. This limits turnover in what might have been a rolling supply of less expensive rental units’ in older buildings where rent control prevailed.

It should be obvious that inept planning and the role of political pressure had a substantial limiting effect on assuring an adequate new housing supply. The situation requires a massive rewrite of all the rules to make sure that there are incentives to produce new housing at a pace unseen in eons. Mitigating against this ever happening is a large number of entrenched interest groups.

The problem causing the lack of affordable housing is, simply put, a lack of adequate supply. This problem, which was inevitable, began over 40 years ago with well-meaning but very flawed policies. The obvious solution to the housing shortage is to increase supply. Every other type of possible solution may have some positive impact but will not do anything to materially increase supply by a sufficient amount to solve the shortage problem on a long-term basis.

Limiting density and rent control may have been politically attractive but, in concert, they set the stage to reduce supply. Limiting densities seriously limits new supply and rent control is great for the current occupant but results in a lockout of newcomers to the market. The problems of both of these factors need critical restudy with a goal of causing an immediate resurgence of supply even though such may take years to resolve the current problems.

The citizens of San Francisco need to agree that when the City has policies designed to retain single family housing, that policy is not realistic in the current time. The only way the housing needs can be accommodated at affordable prices is to encourage high rise development and eliminate unnecessary design and construction requirements plus eliminating additions like providing affordable housing. Logic dictates that the modern city must gravitate toward tall buildings, particularly where there is no buildable land, in order to sustain population growth. Tampering with supply, as a policy, is very misguided.

In the office building sector, it became politically attractive to limit new office development. The land use rules were changed circa 1985 to limit new office development permits to a total of 950,000 square feet per year with any unused allotment carried over to the next year. All potential developers had to compete for a permit in what became referred to as a “beauty contest”. The prize became a permit to develop but the costs of that permit became an artificial financial burden due to the distinct possibility that unlimited added funds might need to be invested and substantial, costly time delays might be involved. In addition to these risks the “design criteria” included many difficult and sometimes questionable requirements such as bulk limits, shadow ordinances, pubic art, and other things that increased the cost of new development.

The result of limiting new permits, in and of itself, had the obvious impact of limiting supply based on wholly political considerations rather than on economic considerations which should be the sole determining factor on the question “to build or not to build”?
The result of the permit limitations was to artificially increase the rental value of all existing office space and make it an almost certain outcome that a developer with a permit would achieve the necessary lease up. Zoning and planning professionals should have absolutely no role in enacting rules designed to interfere the operation of the economic laws of supply and demand except by design where the goal is to increase supply for a valid reason (like making sure adequate space is available to keep the market in balance).

Expensive office space becomes a barrier to entry for small, start-up businesses and gives the large, financially strong corporations a marketplace advantage in competing for space. San Francisco (and other cities) now find themselves facing a shortage of office space because of misguided roadblocks to new development. Planners and politicians must grasp the obvious that limiting supply just causes rents to rise and eliminates a segment of potential users from the market. Limiting supply did not help the City but it provided windfall profits for owners of office buildings through rapidly rising rentals.

The retail sector (excluding the downtown CBD), relative to Neighborhood Commercial Districts experienced a different set of problems. At one point, banks, restaurants and title companies were seen as a threat to the “mom & pop” retail stores. The solution adopted by the planners was to limit those types of tenancies. The limitations were extended to rule out chain stores which were originally defined as any retailer with more than eleven (11) store units nationwide. This solution was not very well thought out as to what it accomplished and what unwanted consequences it might bring.

The planning experts did not recognize that the “mon & pop” stores already in business might have been able to survive for a few more years on their own strength but that the barriers to entry would prevent new start up retail businesses. Those barriers included much more than rent such as the need for adequate capital (the retail business is very capital intensive), labor cost, supply chain problems, necessary business expertise, competition from department stores, regulatory burdens, theft etc. The retail environment had moved away from a “mom & pop” business model. A wannabe independent retailer was able to acquire a franchise of a well-established merchant with the Franchisor providing all necessary business management acumen and systems including supply chain management and other operating expertise. However the operator still needed to provide the capital for operations. Yet, with the chain store limitation in place, franchise operators ran into the 11 store limitation.

To complicate the picture, the explosion of retail giants like Costco and the entry of on-line retailing giants like Amazon added a competitive force that increased the problems facing brick and mortar stores. Consider booksellers for a moment. Once bookstores were a staple of all mature shopping areas and now that is not the case. The growth of E Books completely changed that business model with major as well as local retailers disappearing from the scene with very few limited exceptions.

The retail environment experienced major changes that resulted in a substantial reduction in demand for brick and mortar store spaces. Most areas of the country are experiencing a significant rise in the vacancy of retail stores of all sizes. Many people believe that the retail vacancy now present is the result of “greedy landlords” who choose to keep their store space vacant until they can get the rent, they “want”. That is a completely preposterous thesis applicable only to a mentally deficient property owner.

Landlords are subject to market forces and can only hope to achieve the rent that the market will support. It may take time to get there but eventually the market wins out. But when vacancy is the result of a lack of demand there isn’t much a landlord can do to change things.

If the planners had resisted tampering with the demand for retail space it all may have turned out differently, but now there is a serious vacancy problem.  Again, the planners and politicians are jumping in to try to solve the problem.

A solution being discussed is to “tax” vacancy in the belief that a “tax” will force the landlords to lease vacant space. If anything is misguided that certainly is. The only program that will absorb vacant retail space is one that will increase demand.  To do that, the planner need to strike out all restrictions on space use such as prohibition of chain stores, limiting restaurants etc. and stimulate more potential retailers to step into the water.  In addition, the City must streamline the permit process so that a retailer does not need to spend all of its operating capital waiting for permit and complying with regulations that are unnecessary. For far too long the permitting process has operated with an attitude that the City is doing the retailer a favor by issuing a permit.  That Is just not the case.  If the Cities all look to jurisdictions where the permit process is fast, well spelled out and lacking roadblocks, vacancies might begin to be absorbed.  Punitive taxes will not do the trick.

Big Box retail may be running out of steam based on observation of the number of large stores that have gone out of business. Unwittingly, San Francisco may have dodged the bullet on big box retail by making it very difficult for those large retailers to enter the market. However, the rules did not consider what was best for the people.  The question needs to be addressed by Planners as to whether protecting or trying to protect small merchants from competition is better for the people than the competitive pricing resulting from the large retailers.

At the end of the day, Planner and politicians must wonder why there are very few, outstanding, architectural masterpieces among the new buildings built in the City. There was opposition to the Trans America Tower when it was proposed and now it, like the Eiffel Tower in Paris is an icon of San  Francisco. The Planners need to visit Dubai, Abu Dhabi, Hong Kong, Shanghai, Singapore and London to name a few and study the kinds of regulations that will cause great architecture to happen.  The “beauty contests” of the past failed to produce any great architecture with very few exceptions.  Something is wrong.

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A MESSAGE TO DONALD TRUMP

Mr. President, running the Country is very different from running the Trump organization because when you made poor decisions only you or your investors suffered the consequences.  But, when, as POTUS you make poor decisions they can, directly have negative impact on the populations of entire Countries.

You are probably not the “genius” of a business man you think you are. This is because of your “listening to your gut” instead of studying and listening to advisors. Unquestionably, you are a supremely persuasive and successful promoter of your own interests but managing a Country requires a “thinker” not a brazen Barnum like promoter.

When your Casinos went bankrupt the only ones to suffer the result of your folly were the lenders, junk bond holders and the people forced into unemployment.  But, those effects didn’t range far and wide. When you made losing investments in a major New York hotel and an airline, again the suffering was confined to a very few.  But, when you pull out of the Paris Climate Accord based on the flawed belief that climate change is a hoax denying the science behind climate change, your decision potentially impacts the entire world population now and in the future.  A decision like that mandates much more study and consultation with other world leaders than you gave it. There was no “showing” as to how that decision “made America Great Again” and seemed to be based on nothing more than a desire to reward the fossil fuel industry while maliciously trying to destroy any Obama legacy.

Pulling out of the Iran nuclear deal similarly not only impacts Iran but threatens the near term security of the region and possibly the security long term. You never disclosed the basis of your withdrawal other than to condemn it as a “bad deal”.  Why was it bad? And, why if it was so bad did other major countries so vigorously support the agreement. Was your rejection of the agreement based on just wanting to undo another Obama accomplishment? Please disclose which of your advisors convinced you that “pulling out” was good for the USA? And, tell us why engaging in a war of words with the leader of Iran is a good thing and more than just a diversion from your other failures.

Your reputation as a negotiator may be entirely contrived because you don’t exhibit the patience, preparation and style of a good negotiator.  Your penchant for name calling and denigrating others suggests that you are a negotiation bully.  Negotiating by “bullying” may get a deal occasionally but if the person on the other side is skilled you will walk away empty handed.

Why do you persist in continuing to attack the investigation of Russian interference in our elections as a “witch hunt” even after indictments and guilty pleas have resulted (even though so far nothing yet disclosed has pointed to any wrong doing by you)? Is it because you already know of things that, if they come out, would clearly point to your complicity? An innocent person, who has not been formally accused of wrongdoing would not go to such lengths to discredit an investigation. Your actions cry out GUILTY!.

Your zero tolerance policy was a clear blunder and looks like a knee jerk policy lacking a thorough prior study as to both probable effectiveness and possible unintended consequences.  Obviously, there was no PLAN in place before the policy was implemented. Despite the policy, most Americans are very decent, empathetic people who view the policy as contra to who Americans are.

You mistakenly announced that you had solved the nuclear crisis represented by North Korea only to later learn that you solved nothing.  Your announcement of success was designed by you to bolster your image. Your ego and self interest took over when a more measured announcement would have been appropriate.

There is nothing wrong with trying to engage other leaders in productive dialog even if those leaders are nasty dictators and thugs.  But, there is something very wrong with trusting them absent some act (not words) proving that trust is not misplaced. There is something very wrong with praising and trusting dictators while “blasting” allies and friends. Presidents just shouldn’t do that. Presidents who are statesmen would take up disagreements with other leaders through diplomatic channels rather than tweets and press comments If they really want to solve a perceived problem.

Playing the bully in the area of trade doesn’t stimulate cooperation from trading partners. Articulating a punch list of items needing to be improved through skilled trade negotiators is the way to accomplish the task. Threats of “pulling out” or imposing tariffs are just bullying strategies that will ultimately come back to hurt our economy. That fact has already been demonstrated by the harm done to certain U S producers. Promoting financial relief for certain sectors of the economy negatively impacted by your trade policies puts an unnecessary burden on taxpayers and could have been avoided by a coherent trade policy instead of knew jerk actions trying to pass as constructive policy.

Constantly attacking the media and calling every story you don’t like “FAKE NEWS” just demonstrates that you don’t know the difference between news reporting and the editorial page of a newspaper. The clear majority of print journalism scrumptiously vets news stories for accuracy before going to print and thus do not purposely print fake news. What appears on the editorial pages is intended to be opinion and is not, in any case, presented as NEWS. If your base believes your taunts, then they don’t understand either. Apparently, you never considered the unanticipated consequences of wrongly confronting the media on a constant basis.  You just provoke them into doing a better job of documenting your faults, mistakes, lies and dictator like reactions in ignoring or wishing to ignore rules of law

A President with a low regard for the truth would make a very poor witness on his own behalf in a court of law. Over 2,000 documented lies or distortions of the truth would convince any thinking jury that, as a witness, you were not believable.

You promised to drain the swamp but it is getting filled up with incompetent appointees who seem to toe the line of loyalty instead of providing what you really need – unadulterated, objective and truthful advice.

Keep it up and you will win the unchallenged title of the WORST PRESIDENT IN HISTORY.  That will be your legacy.

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TRUMP’S TAX BILL – BONANZA FOR REAL ESTATE

President Donald Trump has touted his proposed tax bill as a benefit to all taxpayers, particularly the middle income class.  He has also unequivocally stated that his taxes will increase as a result of the new tax bill.

 

Taking the latter statement first, since Donald Trump has not released his tax returns there is no way of knowing if that claim is true or just more of his usual bluster.  But, based on his penchant for deviation from truth, why should the public believe him unless and until he releases his tax returns and proves the point. The simple answer is the public shouldn’t believe him.

 

What Donald Trump doesn’t tell the public is that one of the biggest gifts to large real estate owners (and small ones too) but excluding homeowners,  is the ability to depreciate the cost of their physical asset (the building but not the land) This is a “phantom” loss as no out of pocket cash is involved like in the case of real cash expenses and the amount of depreciation charged in a given year is a direct deduction from income in arriving at taxable income.

 

Depreciation is a myth in the vast majority of instances because it is very rare that, at the end of a building’s “useful life” (the number of years over which tax code allows for depreciation) the building is demolished. What is more common is that at the end of the “useful life” under the tax code or in reality a building is renovated and/or its use is changed or both and it goes on.  On the down side, when buildings are demolished because they have passed their usefulness, the value of the underlying land has often risen by a sufficient amount to offset any loss in value for the demolished improvements.

 

Depreciation is a gigantic gift to the real estate industry and serves to provide a chunk of tax free income to the property owner. One of the arguments in favor of depreciation was that it induced greater investment and created jobs.  That may have been true once but in an expanding and/or inflating economy, such as the economy today, it is probably not true. And, to make things worse it appears that the Senate version would shorten the depreciable life of improvements which will just increase the benefit to the real estate owners.

 

To argue that the economy needs the incentive of “quick write off” to stimulate investment (development) and employment doesn’t make sense at a time when the U S is at almost full employment.  As long as there is demand for the end product developers will build and would do so without the incentive of tax free cash from depreciation. However, if “stimulus” is the raison d’être for the depreciation allowance then it might be confined to only new construction not to be passed on to subsequent buyers.  An offset could be the allowance of a 100% write off, in the year incurred, for any tenant improvements and a depreciation allowance for the cost of major renovations or changes of use.

 

Depreciation of buildings is not like depletion allowances in the natural resource industries.  When oil is pumped out of the ground it is gone and the amount in the well is “depleted”.

 

There is nothing in the proposed tax bill that even hints at considering eliminating the bonanza of depreciation and, under his tax bill, Donald Trump’s income will still be greatly enhanced by the depreciation tax shelter he and his company receives. Eliminating charging depreciation in real estate as an income deduction in arriving at taxable income should be considered for elimination under the proposed code. The reason it is not proposed is most probably that, outside of the  special  interest groups, the subject is not on the public radar no is it likely to be on the radar of less affluent lawmakers.

 

It would be interesting to see a study as to the total amount of income tax collected on 100% of the net income before depreciation and the tax collected on the revenue after the deduction of depreciation. The amount would probably be more than enough to make some of the other eliminated tax deductions unnecessary.

 

Now to the first point, the proposed tax bill does not appear to be a huge WIN for the middle class.  In fact, for a large part of the middle class, it appears, they will pay more taxes. The elimination of medical cost deductions will hit the elderly very hard and will be negative for many real people who will have an increased problem trying to afford their medical bills, even after the more expensive insurance pays its part. The average homeowner could be disadvantaged by possible limitations on mortgage interest and property taxes. Meanwhile real estate developers and investors would potentially receive greater gifts than currently enjoyed. There are other problems but they are minor in terms of public impact assuming that the proposed elimination of State income and property taxes do not survive.

 

The elected officials should move cautiously and avoid quickly enacting legislation just to prove to the public that they did something that achieved a campaign promise. The elected officials, to protect the public, should insist that each provision of the new tax code does, on balance, accomplish a beneficial result and that all arguments in favor of the legislation are proven out by facts as opposed to rhetoric. As things now stand, the proposed tax bills do not appear to bring any major benefits to the middle income taxpayers that are commensurate with the benefits to the wealthy. The lawmakers they should be diligent in understanding all of the possible, unintended consequences of their legislation.

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THE TRUMP EFFECT

When I wrote this several months ago the Trump tax bill had not been written or passed. But, now it is a fait accompli.  To my great surprise the Congress wrote a tax bill that rewarded the rich and particularly real estate owners. Instead of removing the depreciation provisions that provided big time tax benefits, which should have been revisited, the Congress actually increased the benefit. So, until the next round don’t worry about that aspect of the Trump effect. However, since Trump’s inauguration more has changed.

Real estate prices, particular homes, residential properties, industrials and office buildings have continued to rise in many markets.  This is good news and bad news. The rise in residential prices has hit many economic segments with serious affordability problems. Where this will end up no one really knows but in Cities like San Francisco the working class is literally forced out of the market and will have to live further and further from their employment.  At some point business dependent on support staffs will find their pool of potential employees to be far less than needed and will either be forced to raise salaries, provide housing subsidies or move out to lower cost areas where their staff’s can find affordable housing. In Cities like San Francisco,  rigid zoning and building codes raise the cost of construction and the lack of building sites is very limited making it difficult to produce affordable housing. This set of problems will hit many cities.

A danger point is approaching in the retail sector where competition from on-line merchants are eating into once healthy store sales.  Many retailers, like department stores (except apparently Macy’s) are struggling and may become dinosaurs. In the major cities traffic and unreliable public transit are inducing people to use on-line purchasing rather than going to the store.  This is not good for retail.

So far, interest rates have not made a material jump but that is probably temporary.  If and when interest rates rise there should be downward pressure on values. Further rising costs of doing business in major cities could cause cracks to appear in the rental markets as the number of willing and ready renters diminishes.

Add to the foregoing the possibility that Donald Trump’s trade policies could prove very disastrous for business in the U S..  This could result in lower demand for all types of real estate.  Sailing looks smooth but there are many potential bumps on the road. The problem is that when a major bump is hit it will be too late to run for the doors as it was in 2007 with the financial meltdown.

Commercial real estate prices seem to be inflating and rates of return appear to be at all time lows. Could this suggest that real estate is in a “bubble”?

 

There are two factors circling around that could spell a meltdown in real estate values in the not too far distant future. The first is what might be called the Trump Effect which should lead to an overhaul of the tax laws while the second is the probability that interest rates will rise..

 

THE TRUMP EFFECT: The brouhaha over Trump’s tax returns and the apparent agreement between Trump and Clinton that the tax laws need overhaul are one reason that tax code changes may be in the offing under a new administration.  But another reason is the fact that Donald Trump has probably not paid any significant federal income taxes for several years at least.  He has gamed the system and bragged about it with statements like “I love depreciation” coupled by remarks of surrogates that the ability to avoid paying taxes shows how “smart” he is. Every real estate professional knows that the tax laws are very favorable to real estate but, until now, the general public did not realize how really favorable they were. Until the campaign induced focus on the Trump tax returns the general public may have thought the tax laws were unfair but now they are convinced of it. This sets the stage for probable, strong public support for a major overhaul of the tax laws to remove that favorability and create a more balanced system. This not to say that Donald Trump did anything that was remotely illegal because he absolutely did not do anything that was against any law.  He used the convoluted tax codes to his advantage.  That’s all.

 

Most people without real estate experience don’t realize how the tax codes help  investment real estate owner and developers.  There are many ways but, most importantly the depreciation allowance and the tax deferred exchange provisions are major “tax shelters”.  Looking at depreciation first, real estate owners can deduct, from taxable income annually, over the “useful life” of the building only (land is theoretically not depreciable) an amount that will “recapture” 100% over that “useful life”.  Useful life for commercial buildings is generally codified as 39 years but there are methods for accelerating that recapture. Theoretically, this depreciation schedule simulates the gradual loss in value as a building deteriorates. However, the notion that buildings depreciate in value by 100% over 39 years due to deterioration is just not supported by the facts. The theory completely ignores that, over a 39 year period the odds are that a building will increase in value. Just in case that happens there is a recapture provision in the tax code that claws back any charged depreciation in excess of that actually incurred at the time of sale.

 

Now the tax deferred exchange comes into play.  A property owner can “postpone” any taxable gain by just exchanging the property for another one of like kind with a greater value.  Theoretically, the tax on the gain is deferred until the new property is sold and may be further postponed by another exchange. When the owner dies and leaves the property to heirs the property gets a “stepped up” basis and this avoids any capital gains tax on the asset.

 

The foregoing is an over simplification as the tax code is full of twists and turns.  For example, property repairs are deductible in the year incurred but if the extent of repair is considered as a renovation for tax purposes, the cost may be required to be “capitalized” (added to the cost basis and depreciated over time).

 

Most people only experience real estate ownership through their homes.  Homes may not be depreciated which is one major difference from investment property. Accordingly, depreciation write-offs have not been a popular focus. For the individual homeowner, the only tax benefit is the ability to deduct local real estate taxes (ad valorem taxes) and the ability to deduct mortgage interest (with some limitations).

 

There are transaction structures that greatly improve the ability to shelter income from taxes.  And, it can’t be overlooked that investor/developers only invest a small percentage of the cost of an asset as they borrow the lions share from lenders.  Thus, they depreciate the borrowed funds as well. That may be OK because they must repay the loan and pay the lender interest (also deductible) over the life of the loan.

 

To make tings more complicated there are “loss carry forward” provisions in the tax code that permit any loss (like Trumps almost $1 billion) to be carried forward for multiple years, to the extent they are not already charged. There is no basis for assuming that the loss carry forward provisions will remained unchanged in the next round of income tax legislation.

 

Years ago, syndicators tied up properties and sold them to investors who became limited partners in the property. Many of these transactions were so cleverly structured that no tax was incurred by the partnership with an excess “write off” available to the limited partners to apply to other otherwise taxable income for years to come. Many of these Master Limited Partnerships failed and the investors lost everything plus getting added tax problems. They were sold as “tax shelters” and were not always great investments.

 

INTEREST RATES:  It is not a matter of whether interest rates begin an upward climb.  It is only a matter of WHEN. When they do move upwards the spendable income from a property will diminish unless there is a corresponding rise in rents to offset interest cost.  However, rents in many urban areas are already at unaffordable and unsustainable levels particularly when one considers the potential cost of doing business add-on of an increase in the minimum wage.

 

CONCLUSION:  Donald Trump may think he knows more about our tax laws than anyone else and, thus is best equipped to fix them.  But, that is an unsubstantiated boast.  Real estate could be very vulnerable to a Trump Effect when the tax laws are redone as the overhaul will be designed to close all of the glaring loopholes which can only be a big problem for the very rich. Any material rise in interest rates should be expected to depress real estate values as such will increase the rates of return (capitalization rates) expected by investors unless there is a corresponding increase in rents to offset the effect of higher rates.  In many parts of the country, rents appear to be reaching unsustainable levels, particularly in multi-family residential, in view of economic change. Retail rents may come under pressure as retail stores face continuing heavy competition from alternative retailers selling on the internet without the need for a retail store (think Amazon) or big box retailers located outside the CBD (think Costco and Wal Mart). Escalating office rents in central business districts coupled with technological advances via computers may result in causing less need and demand for offices as tele-commuting (working from home via computer) increases. Accordingly, increasing rents is not necessarily something that can be depended on.  The bottom line is that there are reasons to worry about the current levels of value and price of investment real estate in the long term future.

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PRIVATE REITS – GOOD OR BAD??

The Wall Street Journal issue of March 25, 2015 had an article describing the reduction of returns and plight facing private REITs (REITs that are not publicly traded).  This article prompted the question as to whether or not private REITs were or are a good idea  as an alternative real estate investment alternative.

 

Starting at the end, it is suggested that for various and sundry reasons, private REITs probably were not and are not a good idea.

 

One of the major disadvantages of owning real estate is its relative lack of liquidity.  Investing in the traditional publically traded REIT security had and has investment attractiveness because the investor is able to sell his or her position, in the public market, in a matter of minutes, at a market driven price, with the cash proceeds delivered within days. This is not true of investments in private REITs.  Thus, the private REIT becomes somewhat similar to the old master limited partnerships but, without the MLP advantage of being able to pass through depreciation (tax shelter) directly to the investor on an annual basis.

 

As the article noted, there was a risk that private REITs overpaid for the portfolios that they acquired.  That risk is somewhat universal wherever the acquiring entity is essentially a money manager acting for a group of investors or stockholders. Two factors probably “drive that boat”.  First, there is a pressure to invest followed by a “herd mentality”.  Whenever attractive properties hit the market a competitive buying frenzy usually results when conditions are as they now are where there is substantially more demand (money) competing for very few qualified properties. The investing environment is very different than competition between individual buyers investing their own money. In the case of individual buyers there is a tendency to worry about the risks leading to a more conservative approach. As an individual investor once remarked “even when I lie to myself with the numbers they just don’t work. Aggressive purchasing is validated if, and only if, values rise over time but there is no certainty of that happening.

 

The article also pointed out that investors in private REITs were disappointed by the slow pace of selling off property. Where the portfolio is in the hands of someone who is essentially a money manager, selling off assets is tantamount to “selling yourself out of a job”.  Unless the money manager is a very major investor in the REIT his or her goals may not be the same as the investor’s goals. Because of this there is a potential conflict of interest risk between the investor and manager.

 

While the general conclusion is that investing in private REITs may not be the best idea there are transaction structures that could eliminate or ameliorate the observed negatives. As with any investment, there is no substitute for a thorough investigation and analysis as well as asking questions before becoming committed.

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IS ANOTHER REAL ESTATE RECESSION COMING?

An article in the Wall Street Journal this week suggested an increase in foreign investment in U S real estate.  While much of the investment reportedly comes in the forms of financing for U S projects rather than direct ownership or development, the move may suggest hitting the “warning gong”.  There is an old saying that goes something like “he who doesn’t read history is doomed to repeat it”. Those readers old enough to remember the 20th century will be reminded of the debacle of Investors Overseas Service (IOS) and the later invasion of Japanese investments in the U S real estate market.  Both of these investment moves preceded recessions in U S real estate values. Was this a freaky coincidence or was there a structural reason?  Are there parallels as to what might be expected in the foreseeable future? The short answer is that there are most probably parallels that should lead to caution but the opposite may be the case.

 

The current crop of foreign investors appears to be “institutionally” rather than individually driven.  The individual investor is not the real player. Thus, the investment decisions are in the hands of “money managers”. These foreign investors are reportedly using more liberal loan underwriting criteria than the U S financial institutions that were burned by the 2008 financial meltdown. That, in and of itself, translates into a gigantic risk factor for the lender and their pool of investors. Secondly, this increase in money from abroad comes at a time when the real estate market has undergone explosive value increases coming after the 2008 market collapse. So, there is a market timing risk. Some may say that it doesn’t make any difference if these foreign investors are wrong.  However, it may not be that simple.

 

If the foreign investors are financing high profile properties using liberal underwriting standards, then there is a market risk that failed projects individually or in the aggregate may induce a down trend in U S values.

 

Next, the currently low U S interest rates have contributed to the rising real estate prices.  If, as expected, domestic rates rise, the rise may dampen the U S values.

 

But, the most worrisome problem may be a lack of understanding real estate development and ownership risks by the investors.

 

In the second half of the 20th Century (1955) a gentleman named Bernie Cornfeld  started Investors Overseas Services (IOS) headquartered in Geneva (the money was held in Canada) with 25,000 salesmen covering Europe selling their real estate fund investments to ordinary people. In the 1960’s IOS started the Fund of Funds (which held the other funds previously marketed) and raised $2.5 billion with dividends guaranteed. To make a long story short, a “blip” in the market left the Fund without income sufficient to cover the dividends so capital (newly raised funds) had to be used.  This step made the Fund a Ponzi scheme (the funds from other investors used to pay dividends to current investors). The bottom line was that the investors lost all of their money.  Bernie Cornfeld probably never intended this result and started off with good intentions. However, the seeds of failure may have been the ease of raising money which put pressure on management of put the money out in the market resulting in chasing higher and higher prices as the pressure of their money met competition from domestic investors. In other words, IOS was paying premium prices to acquire assets. If they had not been able to buy assets the ability to raise more money would have been seriously constrained. Also, in this period, public syndication of real estate was underway making purchasing more competitive. If the pool of money had belonged to an experienced individual investor it is very doubtful that the prices paid for many of the assets would never have been paid. Along with their counterparts (the syndicators) IOS was under pressure to invest and a “herd mentality” may have taken over.

 

The Japanese investments in U S real estate during the 1980’s also demonstrated a competitive investment mentality.  The investors sought only prime assets at the start but later dipped into quality secondary assets.  Borrowing rates in Japan were lower than rates of return from U S real estate so it looked easy to borrow money in Japan and invest in the U S. The catch was that the Yen to Dollar exchange rate was very favorable at the time of asset purchase but, when it became necessary to liquidate that relationship had been completely reversed.  So, not only were U S real estate prices declining but the cost of converting sales dollars back into yen was steeply rising casing a loss of money not only on the sale but also on the exchange rates. The common denominator of IOS (& other syndicators) and the Japanese investors may well have been the role of the money managers making investment decisions rather than the end investor making the decisions.

 

In the period 2001-2008 the loose lending practices in the single family market ultimately led to the collapse of the entire domestic real estate market.  The common denominator was the fact that nobody in the transaction chain had any money at risk.  The real estate broker collected the sale commission; the mortgage arranger collected a commission; the lending institution collected a fee for originating the loan; the Wall Street investment banks saw a payday through the sale of loan product through mortgage backed securities; and the rating agencies had a substantial fee interest in rating the mortgage backed securities.  The only people at risk were those who purchased the securities. The originating lenders had come up with a foolproof method of transferring all of the risk of the transaction to the investor. Nice work if you can get it. 

 

The dominant real estate market makers (Institutions, Investment Banks, Banks, REIT’s, Fund Managers and related entities) all share a common element.  They are all using mostly OPM (Other Peoples Money) in the implementation of their investment strategies. They are all competing in the same markets and share the concern of being labeled “underperformers”. Leading up to 2008 prominent investment bankers, financial institutions, pension funds and others like themselves made some unbelievably ill timed, poorly analyzed, very costly investment decisions.

Included in the list of losers were the likes of State of California employee pension funds that lost $500 million in land investments, Morgan Stanley and other investment banks who lost billions in flawed real estate deals.  What happened then demonstrated that people investing other people’s money did not, necessarily make the same kind of wise decisions as they might have made if they had been investing their own money. 

 

In the 1990’s, easy money led to a commercial real estate collapse.  Savings and Loan Banks took in billions of dollars using “brokered deposits”. Investors desirous of diversifying to obtain optimum FDIC/FLIC insurance covering their wealth were easy clients for account brokers to land.  They earned a fee for leading a client to a financial institution.  The banks (mainly S & L’s) became over weighted with cash deposits that had to be invested in order to pay interest to the depositors.  Conveniently, the banks earned fees on the loans originated with the gathered funds. The weight of money to lend forced a serious compromise of lending criteria and standards as the loans became riskier and riskier as the loan frenzy progressed until it collapsed.  To say that the involved lenders made some terrible, high risk loans as well as falling prey to fraudsters gaming the system would be a great understatement. Again, a common denominator of lending other peoples money was at the root of the problem.

 

Real estate is very different from the other most favored investment vehicle of listed stocks.  Stocks traded on major exchanges are generally very liquid.  That is to say that they can be quickly sold on the exchange at a very low transaction cost. So, if an investor wakes up fearing that an investment was a mistake it takes only a moment to get out.  Further, a defensive strategy of using “stop loss” orders can be employed to limit loss exposure. Neither quick sale nor “stop loss” are available to real estate owners (as differentiated from investors in real estate securities). It can take 6 months or more from listing to sale closure on a major property. And, the real estate transaction costs can run 2% to 6% of the total sale price depending on a number of factors. When product and service companies operate under adverse circumstances they can substantially reduce their operating costs to offset the adversities. When real estate runs into trouble by virtue of vacancies some costs can be cut but the major costs keep on going.  A 100% vacant building still must pay debt service charges, property taxes and insurance as well maintaining equipment to avoid premature breakdown. Then when new tenants are signed a large leasing commission is paid to the leasing broker and the owner usually must pay for substantial tenant improvements.  Tenant turnover is expensive. All of this and more contributes to the reason behind a “liquidity premium” The fact that real estate is difficult to sell compared to securities is the reason behind the notion of a “liquidity” premium attached to real estate (for example, if stocks pay a dividend of, say 4% how much higher would the return on real estate need to be to offset the lack of liquidity? The answer is not the same for all properties. However, the greatest risk of all is the interest rate risk and most current investors don’t remember the days of 10% and higher mortgage rates.  The real estate rates of return are at current lows resulting in money being cheap.  But, if there is a progressive increase in money rates such could well trigger a recession.

 

The bottom line is that seeing major foreign money move into domestic real estate finance at what may be a cycle top creates an environment where another real estate recession could be triggered. What the trigger will be is impossible to predict just as it was impossible to predict the action of the Fed in 1979 in a surprise raising the discount rate that resulted in mortgage lending rates going to the stratosphere and causing a major real estate recession.

 

 

 

Stay tuned!

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MUSINGS ON THE MARKET

In recent weeks there have been several unrelated news articles that, taken in the aggregate, paint a picture of what might be expected in the future. These stories are discussed below and are not in any order of reporting date or importance.

The City of San Francisco is experiencing a crisis of growing shortages of residential rentals and rapidly escalating apartment rents.  Not only is there a serious shortage of affordable housing but a shortage of housing period.  There are many contributors to this problem.  One major contributor is the failure, years ago, of planners to adequately anticipate and accommodate growth in their planning codes. Instead, the planners and politicians followed the cries of anti-high rise activists and neighborhood preservationists resulting in more stringent land use codes which, among other thing, massively reducing allowable densities at a time when builders and developers were anxious to develop. The code changes resulted in disrupting new supply at a time when the best thing for the renters would have been the creation of a substantial over-supply of housing as that would have forced rents downward.  Couple the code changes with residential rent control which, while benefiting existing tenants greatly reduced normal levels of turnover. Those with “affordable” rents were economically dis-incentivised from moving unless absolutely necessary.

 There was a legal decision, many years ago, involving a zoning issue. The judge opined something along t following lines “Zoning is a tool to be used in planning for the future.  It should not be used to deny the future”.  However, restrictive land use codes and policies do just that – they deny the future.  As if the problems are not big enough, San Francisco has an entitlement process that uses up valuable time (12-18 months or more) and substantial money in going through the process. These factors cause a dramatic increase in rent as rent is related to project cost. One potential  solution might be to change codes to permit higher densities, streamlining the entitlement process to stimulate timely commencement of construction resulting in more rapid delivery of supply. This would apply to office buildings as well as apartments. The annual limitation of entitlements for offices is a classic example of governmental interference with the economic forces of supply and demand and result in artificially driving rental costs upwards at the point where shortages develop.

 The barriers to new construction help drive the prices of property upwards as investors adopt the notion that the downside risks of ownership in San Francisco are minimal.

 Single family home prices have risen to a point where the middle class is being driven out of the market and, coupled with runaway residential rents threatens to drive all classes of service and labor workers out of the City.  This is not good for the long term economic future of the City and the sustaining of growth in property values.

 Calpers (The California Public Employees Retirement System)) announced a new commitment to real estate investments by boosting its $26 billion in real estate investments by 27%.  This decision follows a loss of $10 billion or about 50% of the value of its real estate portfolio during the downturn in the market following the 2008 market meltdown as well as following an indicated increase in the value o high quality properties of over 80% in the past 5 years. Calpers will reportedly concentrate on fully leased office buildings and apartments. This type of investing is not opportunistic because it depends on increasing rents for long term growth rather than depending on value added management that can come from repositioning properties. One should question whether “buying in” after a 5 year period of explosive increases in prices is a sound investment decision.

 Nationwide, the prices of residential rentals and single family homes appear to be increasing, particularly in those markets where the excess supply has been worked off.

 Interest rates on mortgages remain relatively low.  However, the behavior of REIT stocks has recently underscored the sensitivity of values to borrowing rates.  The prices of REIT stocks declined in reaction to fears that the Fed would increase rates.

 These observations lead to the question of whether or not low borrowing rates may be a major contributor to the demand for and current increases in value of real estate?  Is the current real estate market a “bubble market” that could collapse if interest rates increase measurably? If interest rates increase, will business investment and growth decline?  If the answer is yes would it impact offices and residential rents? The answer would be yes.

 To some observers, there are more forward risks inherent in real estate ownership than are being built in to current offering and buying prices. Volume and price activity, in many sectors and many regional markets appear to some as exhibiting patterns like those in 2008 when a frothy market and cheap money drove frenzied activity

 

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ARE RISING INTEREST RATES THE ONLY REIT PROBLEM?

Much has been written recently about the decline in REIT share prices with most of the blame attributed to rising interest rates or the fear of rising interest rates. Some pundits see rising interest rates as a problem while some do not. Most of the analyses reviewed focus on whether or not rising interest rates are a problem for REITs but, that type of analysis may fall very short of identifying the real risks faced by REITs.

Most analysts would probably agree that the great advantage of REITs is liquidity followed by shelter from income taxation (the REIT pays no income tax if it distributes the statutory amount to shareholders). Neither of these advantages is impacted by interest rates and will survive regardless of whether rates are high or low. But, an analysis of the effect of rising interest rates must go further.

The very low interest rates in the last few years have caused capitalization rates to fall to a historically low level.  The capitalization rate (cap rate) is the rate of return that is used to convert net income into value by dividing that net income by the rate. Historically, as rates fall values rise and conversely as rates rise values rise.  Hence, rising interest rates can trigger a reduction of individual and portfolio property values. This, in turn can impact share prices. This effect can be immediate.

Rising interest rates will force debt service to increase at the time of re-finance which, in turn, may reduce the cash flow available for distribution? This is not an immediate problem and is often postponed until refinancing is necessary.

However, interest rates are not the only REIT problem and the lack of analytical research on other potential problems for REIT investors may result on causing the focus to be limited to a simple issue rather than seeing the range of potential issues.

Management:  One analyst observed the contribution of management as “acquisitions, dispositions and development” as well as “effective capital allocation”. There is no doubt of the importance of these skills.  However, much more important and rarely discussed is the “operating management” skill of the management team.  Properly managing the day to day operations of each individual property includes; effective tenant retention, effective leasing and rental programs, minimizing vacancy risk, strong preventive maintenance programs and rigid control over operating expenses to name a few. Most analysts fail to offer any analysis of these important functions as contributors to dividends and value. Unfortunately most REIT investors have no means for evaluating management and, thus face a risk that management shortcomings could negatively impact performance.

Portfolio Diversification: Many REITs are sector REITs (investing in one type of property like offices, apartments etc) rather than being diversified into different property types.  There are good arguments pro and con on this subject. However, the fact is that not all property types can be expected to perform in the same manner in all types of economic circumstances. For example, Power Centers (“big box” retailers) face consolidation problems like the merger of Office Max and Office Depot or failure. The preferred means of achieving diversification is to own REIT shares in the various sectors.

Local Nature: Individual real estate is locked into its location.  It can’t be moved to another part of town or to another city. Many REITs are geographically concentrated and not all geographic areas can be expected to perform in the same manner. REIT investors need to consider the potential positives or negatives of ny geographic concentration.

Vacancy Exposure: One of the greatest risks of real estate ownership is the constant exposure to vacancy by virtue of lease expiration, tenant bankruptcy or tenant failure. Many REIT report their lease expiration schedule but few, if any, disclose the renewal probabilities for specific large tenants until the tenant has made some form of public announcement.

All of the foregoing problems, in addition to the interest rate problem are things that should be of concern to REIT investors and the need for information may be an opportunity for some analysts to find an unfilled niche.

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