Real Estate Hazards.

Navigation: Main page

Author: Shilling, A. Gary

Financial Strategy

THE FEDERAL RESERVE AND MANY OTHERS FEAR A return of inflation, but I still foresee deflation. This is the good deflation driven by excess supply and high-tech productivity, not the demand-deficient deflation of the 1930s. That means real estate values will drop, which poses big challenges for successful property investing. A deflationary climate will start soon and last for years--until the next war spikes demand.

Real estate is the classic hedge against inflation, but property prices fall in deflation, even though class-A, well-located buildings with prime tenants may be the exception. Property was obviously a dog in the 1930s deflation but also in the good deflation of the late 1800s and the Roaring Twenties. This time will be no different.

Several special factors are also going to push real estate prices down. Cost-cutting businesses will curtail demand by shrinking office space and encouraging telecommuting. The hotel industry will suffer with the rise of teleconferencing and e-mail. Consumers will ease off their borrowing-and-spending binge and switch to saving. One result: They'll visit malls and resort hotels less often. Since the huge baby boom generation already has its homes and there are few in the next age cohort, housing demand will soften.

In addition, building costs will fall. Houses built in highly efficient factories are only half as expensive per square foot as site-built houses. Factory-assembled shelter now accounts for one-third of new single-family homes, big enough to pressure site-built housing contractors to improve efficiency and slash prices. Also contributing to the downward pressure: falling building-material prices, which will pull the cost of new commercial structures below those of older buildings.

The era of tenant supremacy is drawing near. Sinking rents and higher vacancy rates will give them the luxury of picking and choosing. Landlords will try to get longer leases on old office buildings, warehouses and malls--with scant success. Tenants will demand shorter commitments; that will allow them, once the lease is up, to renew at lower rents or move to less expensive, newer quarters.

Making money in real estate looks very dicey. In the inflation days of 10% mortgages, even when rent just covered costs, a landlord could put down one-fifth on a property that rose 15% a year in value and make a 35% annual return on capital. In a deflationary era, nominal mortgage rates may be 4% , but you'd lose 26% annually if the property price fell 2% per year. Leverage works both ways. If you want to make money on a building, make sure your rents will cover all costs, plus the decline in property value, and still leave you with an acceptable profit.

Time will no longer be on an owner's side. It used to be that a landlord could wait out a dip, confident that inflation would revive and push the building's return above mortgage costs again. There was no need to sell the place to get out from under. During a prolonged deflation, though, a cyclical rescue won't be imminent. Hence, selling--and cutting losses--might make more sense.

In the future, lenders won't be a friendly bunch. They'll want wider spreads between their borrowing and lending rates to offset the risks of declines in building collateral values. Unfortunately, spreads will be under pressure from low nominal interest rates and borrowing costs that won't go below zero, regardless of how much deflation depresses lending interest rates. Financial institutions won't be able to improve spreads by borrowing short and lending long because the yield curve will be flat on average, as explained in my Sept. 7, 1998 column.

Property insurers will also be under fire. Falling real estate prices will reduce insured values and premiums. Plus, high vacancies and depressed rents in older buildings may result in inadequate maintenance, and even arson.

Also, watch out for real estate investment trusts, especially the ones with leverage. Real interest rates were artificially depressed by the Fed in most of the postwar years, first for fear of a return of the Great Depression and then, in the early Nineties, to help the banks recover from bad loan losses. But with 1% to 2% deflation ahead, real mortgage rates will run 5% to 6% compared with 4% earlier.

No, real estate won't be an utter disaster in times of good deflation. Economic growth will maintain enough demand to keep the industry viable. Nevertheless, investors will certainly need to sharpen their pencils and change their strategies to make owning property a worthwhile exercise.

ILLUSTRATION

~~~~~~~~

BY A. Gary Shilling

A. Gary Shilling is president of A. Gary Shilling & Co., economic consultants, investment advisers and publishers of Insight. Web site: www.agaryshilling.com. E-mail: shil@ix.netcom.com.