Monday, April 19, 2010

A Clash of Cliches - "The Rules Have Changed", but "This Time It's Different"

Have you heard the saying "The Rules Have Changed" when discussing real estate development and investment? Have you heard what got us in to this mess of a recession is the thinking "This Time It's Different"? While the words are different, from my point of view, they really are saying the same thing. Both sayings are always true when taken out of context of the situation being referenced. It is true - the rules have changed in terms of development if you are talking about financing and investment expectations. It is also true that it is different "this" time in the context of the "last time" we have done anything. Every time I kiss my wife it is different.

Ahh, but the fundamentals really have not changed, just our perception of them. True, it is much harder to get a loan today, so that much has changed...since 2005. The pendulum had swung so far to the easy side of getting a loan that it had to swing in the other direction for a while. That does not mean there has been some cataclysmic change that will forever wipe out lending on commercial real estate and development loans. What it does mean is once banking capital has normalized, in terms of the ratio of deposits to performing loans, lending will return. More cash will be needed from borrowers. Shorter terms will prevail for a while. Rates will most certainly be higher. These changes are merely going to be a return to the norm and not a significant departure from standard lending practices 10-15 years ago.

Also true is there is little need for new commercial development for next few years. Vacancy rates in many parts of America are approaching or exceeding 20%. The retail and office vacancy trend will continue until job growth returns. There will always be special circumstances requiring new development (before vacancies are lower) and that is no reason to get excited when a new building or project goes up in your area. This is still America and we like new things.

What has not changed, in a meaningful way, is people. Specifically, investors have not changed as they still want to make money with their capital. There is not much of an appetite for a real estate investment that will yield less than 8% these days. If an investor can get a 10% return on the investment with some degree of continuity then they will generally take the risk of owning a property. Ten years ago, the rule of thumb for non-institutional investors was a target cap rate of 10%. From a 2005 buyer's perspective the world must look like it is crashing all around them with rental rates down and vacancies increasing especially when you consider a 2005 buyer was willing to live with a 6% cap rate. In real terms a cash buyer in 2005 has watched their investment decrease in value by at least half while at the same time had their cash flow also cut in half. For these people, the rules have most definitely changed! What is different this time is they are now broke.

As baby boomers and insurance companies need to put money to "work" and create a predictable cash flow, real estate investment and subsequently development of real estate will come back to sustainable levels. Land will be developed, buildings will be erected and investors will look for yield. The rules really have not changed and it really is not different this time when looking back over the last 50 years. I have a final cliche for you, the more things change the more they remain the same. That my friends, you can bank on.

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