by Stephen Chambers
United States real estate began to be of serious interest to UK investors in the early 1980s, probably as a result of the following factors:
- a relatively strong pound and weak dollar;
- property income yields in the US approaching twice that available in the UK;
- the abolition of exchange controls in the UK;
- a favourable US tax system; and
- the United States was perceived as the last bastion of capitalism at a time when much of Europe seemed to be drifting towards socialism.
In this climate several UK funds were set up to enable British investors to invest in US real estate.
What was probably not perceived at that time was just how cyclical the US real estate market can be, and the fact that the market was then probably close to the top of the cycle. Subsequently it has hit bottom and is now starting to recover; this, then, is an appropriate time to reassess investment in US real estate. However, it is useful to look back and see why the last cycle was so long and deep, and why real estate is now recovering.
During the late 1970s and early 1980s most major US real estate markets were experiencing increasing rents, high occupancy levels and strong demand from tenants. Real estate was out-performing both equities and bonds and both US and foreign investors were channelling funds into real estate, which provided a hedge against newly arrived inflation.
At that time, however, the north-east region of the US was suffering from serious problems in the “smoke stack” industries owing to rapidly rising energy costs, powerful trade unions and competition from abroad. These problems were compounded by the transition of the economy from manufacturing to an increasing reliance on the service and trade industries. As a result, business was expanded or relocated to the Sun Belt and significant population movements followed as workers were attracted to the job opportunities and pleasant working and living environments afforded by the rapid spread of efficient air-conditioning.
Massive development occurred in the Sun Belt, especially in the Dallas, Houston and Denver markets, where rapidly rising energy costs in the US fuelled the expansion of the oil and gas industries. (The price of oil rose from $10 a barrel to $40 a barrel in 1979 and most experts were predicting $60/$100 a barrel by the mid-1980s.) In these cities there was an unprecedented demand for new development and there seemed to be no end in sight to the boom economy that the regions were experiencing. The vacancy rate in downtown Houston was below 2%!
In addition to development encouraged by population shifts and demographic changes in the economy, a change in the American tax laws encouraged development still more. The Economic Recovery Tax Act of 1981 provided that real estate which was acquired or developed after 1980 could be depreciated over a 15-year period using an accelerated method of depreciation, instead of the expected life of the building. This enabled both profitable and unprofitable real estate to generate substantial tax losses which could be used not only to shelter real estate income but other forms of income as well.
For many property owners the performance of their real estate assets became secondary to the tax benefits that the property could generate. As a result, tax shelter syndication funds grew dramatically, and real estate investments were sometimes made without regard to the possible lack of demand to justify the developments concerned. During this same period money was also readily available to developers by lenders, particularly the nation’s savings and loans institutions which had just been deregulated, and there was little monitoring of their loan assessment procedures.
This combination of factors resulted in substantial over-development, particularly in the energy cities of the Sun Belt. The problem was further exacerbated when oil prices fell to $12 a barrel, thus causing the economies of the energy cities to collapse. Demand all but disappeared, vacancy levels rose to historically high rates (Houston over 30%) and capital values suffered. The tide of new developments began to decline, but projects which were already under construction when the market weakened added to the oversupply.
During this period aggressive property management became crucial to a property’s performance. Property owners lowered effective rents to keep tenants in their buildings and new tenants were offered very attractive rent concession packages, which included extensive periods of free rent, prestigious tenant finishes, moving expense allowances, and free parking. The power in lease negotiations shifted from the landlord to the tenant, and capital values generally fell. Help, however, was on the way in the shape of the Tax Reform Act 1986.
This long-awaited restructured tax law arrived in 1986 and it reduced significantly the tax shelter benefits of real estate ownership. The new legislation resulted in a drastic decline in real estate syndication funds and added some discipline to the market. Development began to be based on supply and demand, and since the new tax law came in there has been a marked decline in the number of speculative developments taking place.
Additional discipline has been forced on the market owing to the much more effective Federal regulation of the savings and loan industry and the implementation of more stringent loan assessment procedures. These two factors have arrived at a time when the US economy is sufficiently strong to cause an increase in occupancy rates in many markets.
Most observers view 1988 as a transition year for US real estate, with vacancies reducing in most markets. Although the strength and timing of recovery will vary from market to market, total returns and capital values are likely to improve in many areas for the following reasons:
(1) The market disciplines now imposed on development which result from the greatly reduced tax shelter aspects of real estate.
(2) The more prudent attitude and the Federal regulation of lenders.
(3) The stock market crash of October 19 1987 and the resulting upheaval of financial markets world-wide has led to a flight of capital out of the equity markets in the United States into tangible assets. The crash forced a comparison of the turbulence of the stock market to the more stable long-term values and yields of income-producing property. The US institutions are likely to invest more new money into real estate than before October 19.
(4) In many United States real estate markets there is a growing movement to protect the quality of life by restricting new development. This often arises in areas where residents of previously uncongested communities suffer from the traffic congestion stemming from population inflow and new building developments. This movement is increasing the value of existing properties because the construction of new buildings is limited.
(5) Most real estate markets, with the exception of the energy cities, have bottomed out. Property prices are now fully discounted and in most areas occupancy rates are now increasing, effective rents improving and capital values increasing. In many markets rents are rising from a base which would not show an adequate return on replacement cost, ie new development should not take place until rents reach a significantly higher level.
Conclusion
Although the US real estate market will remain cyclical the cycle is likely to be caused mainly by the general state of the economy rather than the other extraneous factors which exaggerated the last boom and slump. Future cycles are likely to be less deep and long and the outlook looks good for a steady improvement starting from a low base. In future the market should be more orderly as a result of the virtual abolition of the tax shelter aspects of real estate and the more prudent attitude of lenders. It looks as if the “real” is finally coming back into real estate.
Stephen Chambers BSC FRICS is a partner in Allsop & Co.