A Decade Later . . .
A bumper sticker seen around Southern California lately goes something like this: “God, just give me one more good real estate market. I promise not to ruin it this time.”
Inherent in that plea is the admission that overbuilding and overpaying in the 1980s helped provoke a collapse that left the region’s commercial real estate business a shambles.
The message in the mock prayer is especially timely as 1997 winds to a close, because today’s recovering office and industrial real estate markets invite comparisons to 1987, when those markets were approaching their pre-crash peaks.
“People are already asking if we’re headed for an overvalued market again, even though this recovery is probably less than 2 years old,” said longtime developer Edward D. “Ned” Fox, managing partner of Los Angeles-based Commonwealth Partners.
The speed with which the markets have bounced back from their early-’90s lows is making some observers nervous.
“The acceleration in the recovery of property values is unbelievable,” Fox said. “People are starting to ask if we are getting into a speculative market again.”
At first glance, several conditions seem to mirror those of the 1980s. Then, as now, Southern California enjoyed a strong and growing economy. As with today, a seemingly endless supply of money was pouring into the markets. A spirit of optimism prevailed, and property prices were rising with each passing week.
Although these similarities might suggest another crash in the making, industry observers see significant differences they say should prevent any such deep collapse.
*
For one thing, Southern California’s economy is much more diverse today than it was in the 1980s, said Tom Lieser, director of the UCLA Anderson Forecast. The region was more vulnerable then because it was so dependent on the defense industry, he said, whose cutbacks helped cause the crash.
But other factors also laid the groundwork for a slump. Savings and loan associations lent money with little restraint, and many S&Ls; tried to cash in further on the building boom by forming subsidiaries to earn development fees through their own building projects. Investors bought properties that earned little or no return, expecting either to sell them at a profit or raise rents in the future. Foreign investors, especially the Japanese, added fuel to the fire as they bid property prices even higher.
Today’s market is decidedly more conservative, real estate executives say. Developers have been more restrained in building, and relatively few projects are being built on a speculative basis--that is, before any tenants have signed leases. S&Ls; have disappeared as lenders, and the sources of capital that replaced them are more cautious about new projects.
Today’s money is coming from Wall Street firms and real estate investment trusts, which can raise capital through stock offerings and take on corporate debt at interest rates considerably lower than those paid by the S&Ls.; That means REITs can earn relatively lower rates of return on their investments and still remain profitable.
*
Conventional wisdom also says the REITs are acting more responsibly than did the S&Ls.;
“In the late 1980s, there was a real lapse in judgment on many different sides, including the S&Ls;,” said John B. Kilroy Jr., president and chief executive of El Segundo-based Kilroy Realty Corp., a REIT that went public in January.
Kilroy said that in the last cycle, “rents were already lofty, but developers were still assuming that rents would increase very substantially every year.”
Today, he said, rents are rising, but developers aren’t making such pie-in-the-sky assumptions.
“There is much more discipline in the market today,” Kilroy said. Besides, he added, REITs that don’t display restraint face the prospect of having their stocks punished on Wall Street.
Kilroy said another measure by which 1997 looks saner than 1987 is that even with property values rising, buying an existing building is still generally cheaper than building a new one. This difference between “replacement cost” and the price for an existing building is an important barometer of whether properties are reasonably valued. If a standing building is selling for far more than the cost of building a new one, it may be a sign that prices are unrealistically high.
*
Real estate executives aren’t saying the market here won’t slump again--just that a crash like the last one is unlikely.
“Ten years ago, Los Angeles County still had plenty of land that was relatively cheaply priced. Now there is less land and it is priced considerably higher, so the capital sources have to be much more careful,” said Jim Center, a Grubb & Ellis senior vice president.
And though rents are rising, they haven’t been going through the roof like they did in the 1980s, said David Mgrublian, managing director of Los Angeles-based Investment Development Services.
Mgrublian added that developers are being more careful in general and are especially cautious about building more retail space this time around because “there is a lot of uncertainty about which retail concepts are going to survive and which are going to fail.”
Concern about the market overheating is understandable, said Robert Lowe, founder of Los Angeles-based Lowe Enterprises, a developer and owner of industrial buildings. “Capital has come back into the industry at a greater rate than most people would have expected.”
But the market is still in balance, Lowe said, and real estate types who remember the crash aren’t likely to make the same mistakes.
“I believe there is going to be more attention paid to keeping supply and demand in balance as we begin to increase supply through new construction,” he said. “I believe more attention is going to be paid to putting on the brakes than there was in the 1980s.”
*
Still, the current market does have its dangers, Lowe said, including the possibility that REITs’ need to grow will lead to excess.
“There is some risk that their appetite . . . could produce an oversupply of space,” he said. “The stock market is pricing the REITs as growth stocks, and the only way they can grow is by expanding the assets they control.”
REITs have been able to add to their assets so far by buying existing buildings, but once those run out, they will move more into financing and building, Lowe said.
Despite the potential for the REITs to overbuild, he said, “I don’t believe there is any structural reason why we couldn’t have a market that stays in balance, in which we are building new space to meet growth in demand.”
Lowe pointed out, however, that keeping supply and demand in balance is “a very hard target to hit,” and the industry traditionally tends to overshoot or undershoot it. That results in periodic downturns, though the slumps usually are nothing like the crash of the early ‘90s.
According to Lieser of UCLA, that’s because the last slump was accompanied by what he calls “once-in-a-lifetime events.” The end of the Cold War, the breakup of the Soviet Union, the tearing down of the Berlin Wall and the subsequent downsizing of the U.S. defense industry added up to a tremendous blow to the Southern California economy. Demand for office and industrial space shrank at the same time a glut of new space came on the market.
No one could have predicted that combination of events, Lieser said.
“If you would have asked anybody in 1985 to speculate on the possibility that the Soviet Union would collapse within five years, I don’t think many people would have gotten it right,” he said.
Economists say another recession is inevitable sooner or later, and unpredictable world events are always a potential factor, said Lieser. But barring such dramatic developments, Lieser believes that the next recession will have a much more moderate impact on Southern California’s commercial real estate markets.
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Then and Now--Lessons Learned
How the commercial real estate market in 1997 compares with the 1987 market:
ECONOMY
1987: Southern California’s economy was strong and growing--but vulnerable because it relied heavily on the defense industry.
1997: The region’s economy is strong and growing, but it is more broadly based and diversified.
PROPERTY PRICES
1987: Properties often sold for prices significantly higher than the cost of new construction--a risky style of investment.
1997: Properties are selling for less than or only slightly more than the cost of new construction, suggesting that pricing is still sensible.
THE MONEY
1987: Much of the capital was coming from savings and loan associations, which needed to earn relatively high rates of return in order to make a profit.
1997: Much of the capital is coming from real estate investment trusts. In general, REITs can accept lower rates of return and still remain profitable, in part because they can borrow at relatively low interest rates.
THE LENDERS
1987: Lenders were swept up in the market euphoria and advanced huge sums on ill-advised projects. Many savings and loans formed their own development companies in what turned out to be doomed efforts to earn money on development fees as well as interest on loans.
1997: Lenders have become much more conservative, insisting that developers demonstrate a strong demand for a new project.
THE BUILDING BINGE
1987: Developers embarked on a years-long building boom driven by a desire to earn money on development fees and a foolish optimism rather than a proven demand for new office and industrial space. The result was such a huge glut of space--especially offices--that some markets remain overbuilt today.
1997: Developers are proceeding more carefully, in part because of the lessons of the last cycle and in part because lenders are much more conservative. Development so far has been driven by demand, so new projects are being built only in markets where demand justifies new construction.
THE TENANTS
1987: Banks, accounting and law firms, and other big office tenants were leasing larger and larger spaces to accommodate growth. Many overestimated their needs because of overly optimistic growth projections and later abandoned much of the space when they were forced to downsize.
1997: After downsizing, traditional users of office space have started to expand again, but the demand for space is growing at a more moderate rate because of industry consolidations and other factors.
WILD CARD FACTORS
1987: The end of the Cold War, the fall of the Berlin Wall and the breakup of the Soviet Union led to a drastic downsizing of the U.S. defense industry, causing a deep recession in Southern California at the same time as the real estate cycle turned downward.
1997: No one knows what “X” factors may be at work, because such factors can rarely be anticipated. One of the most important questions today is whether the commercial real estate industry can avoid the excesses of the past and not overbuild again.
