Southland Real Estate: Did We Learn Our Lesson?

The paralysis in Southern California real estate markets reminds me of a classic scene in Laurel and Hardy movies. After each new mishap, Ollie looks helplessly at Stanley, throws his hands in the air and says, “Well, this is another fine mess you’ve gotten me into.”

That same conversation might just as easily be had today by a real estate lender meeting with a hapless developer who once again finds himself struggling to stay afloat in falling markets.

The malaise hanging over the real estate industry nationally has touched even Southern California, once considered impermeable to recessions plaguing other parts of the country. While our population continues to grow rapidly in the Southland, new home building and other urgently needed development have come to a virtual standstill.

We face parallel dilemmas.

After years of banking industry deregulation, the pendulum has swung again to the opposite extreme. Federal regulators have levied rules of such strictness on banks and thrift institutions that capital for new development is virtually unavailable. Real estate lending is the financial community’s “bad boy.”

At the same time, we face a paralysis in regional leadership required to confront the reality of growing populations and declining public services in Southern California.

The LA 2000 Committee put forth an ambitious vision for the Los Angeles metropolitan area as a world finance and cultural center--a model city of the future.

Is that vision now threatened by our inability to provide for the growth needed to support economic health? Does Southern California face the same fate as New York, Texas or Arizona, where collapsing real estate markets were harbingers of wider economic problems?

I don’t think so. But to avoid repeating the past, we must understand how we arrived at our present difficulties. The roots can be easily traced. In fact, we are today paying penance for the sins of the last decade.

The genesis of our problems springs from events in the late 1970s, years of “stagflation.” Economic growth was flat, interest rates were high and inflation was running out of control.

As that decade ended, the government took two fateful steps intended to stimulate the economy. Congress passed the Economic Recovery Tax Act of 1981--a law which ushered in a flood of tax-sheltered real estate investments. Investors reaped 4-to-1 tax writeoffs. Real estate projects were financed regardless of whether they made economic sense.

At the same time, deregulation of financial institutions opened up vast new sources of funding for speculative real estate projects.

Savings and loans suddenly were able to form subsidiaries owning a smorgasbord of assets ranging from fast-food chains to real estate companies.

The world looked rosy for real estate in Southern California. The Reagan Administration’s kitchen cabinet had cooked up a host of initiatives intended to correct the legacy of the previous administration.

In the pendulum’s swing back, however, the most severe overbuilding in the country’s history took place. Syndications and limited partnerships went wild with tax-sheltered investment funds pouring into the marketplace. Wall Street was booming, and limited partnerships raised billions for new development.

The initial ripple of concern came with the collapse of oil prices in the early 1980s. The first savings and loans to go under were located in the country’s Energy Belt, auguring the financial hemorrhage of the thrift industry that would take place by the end of the decade.

In 1986, excessive abuses in tax shelters led to a new tax act, legislation dedicated to simplifying the tax code--a 954-page document that still defies complete understanding.

Tax shelters for real estate investment were eliminated. Syndications and limited partnerships died almost overnight. Declines in real estate in the Energy Belt spread to the Northeast by 1987.

And the multibillion-dollar bailout of the thrift industry was in full swing by the end of the decade.

Clearly, the sins of the past need correction. But we have now entered a period of over-regulation that may be offering a cure just as destructive as the illness.

Twin forces have forced financial institutions to curb real estate lending: shareholders and regulators.

Wall Street and other investment analysts who value bank stocks have generally concluded that real estate debt is an albatross around the neck of institutions. Banks have put as much distance between themselves and real estate lending as possible.

In addition, strict new capital requirements under the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) are forcing banks to limit real estate lending. Banks are fearful of triggering regulatory review with respect to outstanding real estate loans.

Capital for real estate markets has been squeezed to a standstill as a result. And some of Southern California’s oldest and most successful home builders, as a result, could go broke because banks will no longer make new loans or “roll over” existing loans.

Other sources of capital also are threatened.

Japanese investors have been largely responsible for maintaining liquidity in the U.S. real estate industry in the last two years with the demise of the thrifts.

A full 25% of home building in Southern California last year was financed by Japanese financial institutions or joint venture partners. Now that money is diminishing. The public reaction in the United States against Japanese real estate investment has caused them to look more carefully at Europe and other overseas markets.

Meanwhile, the trillion-dollar decline in the Tokyo Stock Exchange this year alone--which has been exacerbated by the Middle East crisis and rising oil prices--means there is less capital available from Japan than in the past.

And the rise in Japan’s discount rate brings their yields closer to those in the United States, thus making it more likely that Japanese investors will keep their funds onshore.

What we have in Southern California is a volatile situation that doesn’t lend itself to easy correction. In an area with a gross national product larger than all but 10 countries in the world, it’s not surprising that many diverse organizations and groups seek to serve the special interests of their constituents.

In a 60-mile radius from downtown Los Angeles, it is possible to cross five counties and 90 cities. Redistricting at the county level adds further confusion regarding these divisions. And, the federal government imposes an additional agenda in its oversight through the Air Quality Management District. Meanwhile, economic sanctions against new growth are forcing Southern California developers to leave the state for better-performing markets such as Las Vegas and Seattle.

In the midst of this diversity, what is urgently needed today is a more unified approach to planning that cross bipartisan lines and addresses the complex problems of overlapping jurisdictions. Strong political leadership is essential. We need a forum to deal with economic issues that affect not only Southern California cities and counties, but the welfare of the state as a whole.

While we have limited influence over federal regulatory policy, we do have some control of our destiny at the state and local level. With a new governor taking office, the early months of the new year are an excellent time to launch a state initiative evaluating growth policies.

“Summit” meetings involving mayors, local council members, state legislators and others offer an opportunity for a “meeting of the minds” on these issues. Cooperation and consensus must be sought to stave off further declines in the economy and job losses.

Job growth in all industries is required to absorb the oversupply of real estate in all sectors--office, industrial, manufacturing, and research and development.

But what tax incentives should be offered to attract new companies and keep others from relocating in areas with lower costs of living, particularly housing?

While home prices have dropped somewhat in the past few months, affordable housing continues to be one of Southern California’s most pressing problems. New policies relaxing growth controls to stimulate home building--not restrain it--are required. More bond issues are needed to pay for infrastructure such as roads and sewers.

And, we need to find a balance between assuring clean air under Air Quality Management District programs and maintaining the competitiveness of Southern California as a commercial center.

At the same time, cuts in the defense industry mean that a wealth of intellectual and technical capabilities must be redeployed. Grants to stimulate research and development may be one key in that deployment.

At issue is the vision of the LA 2000 Committee for the Los Angeles. Will we move toward this vision of Los Angeles as a center of the Pacific Rim, marshaling the intellectual and financial resources of the region? Or will we become snarled in our own debate over growth as the regional economy stagnates?

Recognizing the sins of the past should give us the tools to avoid repeating them. But it will also take cooperation at local, regional and state levels to put forth the policies needed to avoid the fate of cities such as Boston and Phoenix, where programs billed as economic “miracles” ended in disappointment.

Los Angeles has a superb position economically and geographically. It is this base that we must build on with a coherent effort to support job growth and new development so that our children’s future will be as promising as what we have enjoyed.