“In any crash there are winners and losers (hence “the best of times, the worst of times”),” Linneman states in his recent White Paper, “The Tale of Two Cycles.” In both 1990 and 2009 crashes, developers and many owners lost projects. In the 1990s crash, life companies and most major banks suffered serious loses, which sidelined them for at least five years or in some cases, permanently. At the same time, newly formed REITs and investment firms picked up multiple assets from distressed owners and lenders at bargain prices. At a comparison, life companies and Freddie/Fannie broke through the most recent crash with almost no loses from income producing real estate loans.
“Qualitative differences between the two crashes are interesting. The effects of the earlier recession were initially concentrated primarily in speculative new buildings. Only as the new, empty properties were bought at low bases and stole tenants from older properties did the pain widen. Thus, developers and lenders of new properties were quickly crushed, while the majority of existing properties felt little impact initially. This time, the recession’s deep job losses affected occupancy across almost all properties. As a result, the vacancy was spread much more evenly and was felt more rapidly across buildings,” as indicated in the White Paper.
Linneman continued to explain the differences between the crashes in his paper by describing the opportunities that were found buying privately owned distressed properties in the early 1990s as well as after the 2009 crash, how the opportunities abounded in REIT bonds and shares. He explains, “This difference primarily reflects the differential response of government as well as the evolution of REITs. The first Bush administration took an aggressive approach to resolving debt problems. Regulators rapidly took over lenders and forced lenders to foreclose, creating a flood of private assets for sale. In marked contrast, the second Bush and the Obama administrations were far less aggressive. Instead of shutting down insolvent insured depositors and letting markets find bottom, regulators systematically bailed out major lenders and encouraged lenders to work with borrowers. As a result, there was never the flood of distressed properties for sale which was widely expected. Meanwhile, the panicked withdrawal of capital from REITs provided widespread opportunities to buy real estate at distressed prices via REIT debt and shares.”
Dr. Peter Linneman closes his White Paper, “The Tale of Two Cycles,” with, “Every real estate crash is due to dissonance between supply and demand, and the rapid deleveraging after a prolonged period of easy money. But while each crash is similar, each offers new lessons for the future.”
The Linneman Real Estate Index (LREI) quantifies “easy money” by monitoring debt for commercial real estate relative to the size of the economy. The LREI compares the supply of real estate capital, as proxied by the aggregate flow of commercial real estate debt, with the fundamental demand for space, as measured by nominal GDP. Excluding the net real estate equity flows from the aggregate flow of commercial real estate debt; this modestly understates capital over-supply situations and overstates an undersupplied market.
In his latest White Paper, Linneman describes the LREI and its results between 1982 and 2009. The paper says, “The index is set at 100 in 1982. The index rises if mortgage debt rises more rapidly than the economy grows (“easy money”), and declines when money is tight relative to economic growth. The Linneman Index grew from 100 in 1982 to a peak of 138 in 1988, and it stayed at that peak through 1989.” It is explained that this means in just six years, mortgages grew 38% faster than the economy. As the crash set in, the LREI decreased dramatically hitting a low of 91 in 1997. This shows a 34% delivering in eight years. Easy money returned, with the LREI growing from 121 in 2003 to 172 2009. This shows us a 42% growth in leverage in just six years which was uncannily similar to the before environment of the crash in the early 1990s. Linneman explained in his paper that, “…the crash then reverberated, the LREI fell in each quarter, and it now stands at 134, a 22% delivering, with perhaps another 10% decline yet to come.”
“Why is there eventually too much supply?” Linneman and asks and explains in his recent White Paper, “The Tale of Two Cycles,” that the answer is that when given capital, developers will build. In the periods prior to both crashes, capital was plentiful resulting in ample private development. His research found that “Real total private construction rose by 43% between 1982-1986, and declined from this lofty height by just 3.4% through 1989, in spite of sustained high vacancy rates.”
There was a development boom seen adding up to the recent crash; however, not nearly to the degree of the earlier period. Real total private construction spending increased by 12% between 2002 and 2007.
“Real construction subsequently declined by 30% through 2012 as the crash crushed development. Multifamily starts averaged 260,000 leading up to the recession (1998-2008), peaking at 423,000 units in 2006. They then plummeted to a mere 53,000 units in October of 2009,” Linneman explains.
“They were the best of times, they were the worst of times; each with too much supply in the face of cyclically low demand. Just as in Dickens’ Tale of Two Cities, every real estate cycle is the same, yet every cycle is different,” Dr. Peter Linneman stated in his recent White Paper, “The Tale of Two Cycles.” Linneman explains that in the crashes of the early 1990s and 2009, there was an abundance of supply for too little demand yet both offer distinctive features and lessons for the future.
Both crashes were not only caused by a much greater supply of space than demand but also due to a retreat of real estate capital. Linneman explains that the crashes evolved into this enigma very differently. Dr. Peter Linneman states, “The recent crash was caused by a sharp decline in space demand meeting modest overbuilding. Thus, the second quarter of 2007 registered a healthy CBD vacancy rate of 9.7%, and most observers (we were among the minority which foresaw a recession) felt that due to the so-called Great Moderation, the demand boom would never end. In marked contrast, the 1990s real estate crisis was the result of out of control development meeting a modest cyclical demand decline.”
In his latest White Paper, Linneman illuminates on the late 1980s. The economy was booming during this time but the supply was increasing so vividly that vacancy rates stayed dangerously high. He states an example on the matter, “Even as the CBD office vacancy rate was 15.6% in 1989, developers refused to stop building, assuming that their new speculative buildings were immune to the forces of supply and demand. Hence the recessionary decline in demand in 1990 caused a complete real estate collapse due to the already existing excess supply and a burgeoning pipeline of new supply.”
Global Economic Briefing: Featuring Dr. Peter Linneman, NAI’s Chief Economist & Jay Olshonsky, NAI Global President
Executives and Researchers from around the globe joined together on July 11th at 12:00 PM, Eastern for an Economic Briefing as facilitated by NAI Global’s President, Jay Olshonsky and presented by NAI’s Chief Economist, Dr. Peter Linneman. This Web conference hosted more than 1,000 people who benefited from insights offered which touched upon where we are in the recovery and drilled into:
Real Rent Analysis: Which markets are below historical averages?
A comparison between this cycle and the 1990s
More reasons the Euro will fail
How we are repeating Japan’s mistakes
An update of capital markets
Social Security implications as the boomers retire
A recording of the event will be made available on naiglobal.com on or before July 20th. Our next Economic Briefing is scheduled for October.