Jury Out on the Real Estate Hangover

by Kevin K. Nunnink

The U.S. economy has been caught speeding and the fine is going to bepretty steep. The price tag will be paid through a process called deleveraging, and it will cost us trillions of dollars to unwind.

 

That is trillions with a “t,” not billions.

Several segments of the economy simultaneously moved to a point of near maximum leverage and, consequently, maximum risk exposure. Any of these risky actions in isolation could have been absorbed by the rest of the economy; collectively they have caused a cascade of weakness.

History has shown that in periods of declining residential real estate investment, the economy has headed into a recession. Valued at nearly $19 trillion, residential real estate is a key component to our economy. It is tied to manufacturing and production and is a huge employer of workers. Additionally, residential real estate is often a consumer’s primary source of personal wealth. While homes may not provide the best returns, they are an avenue for wealth accumulation for many.

However, the advent of 103 percent home loans, home equity lines of credit and refinancing at 100 percent loan to value changed this. The home became a money tree rather than an instrument of savings. As indicated by the fact that savings rates fell to 0.56 percent in 2007, Americans were already living on the edge of insolvency even when home prices were stable. As prices dropped and residential real estate investment fell with it, the American consumer found itself upside down.

While consumers were speeding on a track of borrowing so was the residential home building industry. Builders and developers of all sizes were aggressively building far too many “spec” houses without an indentified buyer and sinking huge sums into land acquisitions to open up the next subdivi-sion for building. With record numbers of first-time home buyers entering the market, builders and developers were taking advantage of the market. Home ownership rose from 63.8 percent in 1994 to 69.2 percent in 2004. The amount of debt to equity was only tenable when houses and lots sold quickly after completion. As soon as the residential markets started to seize in mid 2007 many developers and builders were caught holding the bag. It was not long before the burden of interest expense caused them to topple, bringing those reliant on their activity down with them.

Now, let’s turn to commercial real estate. While there were no predatory lending practices to blame, the underlying issues are similar. Property owners were cashing in on 95 percent loan-to-value ratios and interest only debt. With the commercial mortgage backed securities (CMBS) market greasing the wheels of liquidity, commercial real estate lenders found that they could sell loans before they were even made by slicing the loan pool into numerous tiers of risk. Large amounts of institutional capital poured into these markets, mistakenly assuming the ratings from one of the top three rating agencies equated to due diligence.

Combine the huge amount of capital with persistent cap rate compression driving prices higher for the same property and income stream and the CRE sector was dangerously vulnerable. In 2003, the average cap rate for an office building was 9.2 percent and was 520 basis points above there turn one could get investingin 10-year treasuries. In early 2007, cap rates were averaging 7.4 percent and were only 280 basis points above the 10-year treasury. It is hard to imagine, but billion dollar portfolios of real estate (a risky, illiquid asset) were trading hands for only 150 basis points above investing in debt from the US government. The returns on these investments were predicated on continually rising rents and sales prices.

Now, the consumer is weakened, the residential home building industry is in shambles, and com-mercial real estate is on the brink of destabilization due to lack of available financing.

The economy must deleverage. Consumers will need to improve their balance sheets and get rid of debt. Home prices and supply will have to even out as bankrupt home builders reorganize. Commercial real estate will continue to be challenged as tenants struggle with the economy, financing remainsscarce and cap rates return to sensible levels.

We are suffering from a real estate “hangover. The jury is still out on how long it will last.

Return to Ingram's February 2009

Kevin K. Nunnink Chairman, Integra Realty Resources 
E     |    knunnink@irr.com