1988 vs. 1998: it's not deja vu all over again

By MIKE MAKAR, JACK STANDEFORD and DAVID STINEBAUGH
North Coast Mortgage

As they did a decade ago, real estate developers, building owners and many of the vendors to these real estate principals are all asking themselves the same question: Are we profitable and successful because we are smart or because we are incredibly good-looking?

Now, as then, it is probably external forces and cycles that are leading to today's success rather than anyone's innate talent or physical attributes. In the Puget Sound real estate market, surely the stars of the cosmos seem to be in alignment creating the most favorite situation imaginable for real estate ownership and development.

First, at the basic levels, all the major forces are working exactly the way the holder of real estate would desire. The national economy is very strong, with low unemployment but with negligible inflation. The local economy is stronger than the national economy. This not only helps create a very strong demand for virtually all types of rental real estate, but is also attracting outside capital that is either eager to buy or lend.

For the past five years there has been virtually no speculative development. Office vacancies which had been in the mid-teens are now down to less than 5 percent. Hotel occupancies for better properties are averaging 80 percent and apartments are being built at a rate that is approximately half the annual demand.

Virtually all new construction for office, high tech and retail has been build-to-suit, allowing new demand to absorb the vacant space. Only bulk industrial in the Kent Valley has seen much new speculative development and that only in the past year or so.

As a consequence of these construction patterns, we have (from a landlord's perspective) the best balance between supply and demand that has been seen in at least a generation. Rents are rising, especially for office space where the once theoretically predicted rent spike has proven to be very real, with rent increases of 10 percent to 20 percent taking place within less than a year.

If all the planned hotels and office buildings were built, the Puget Sound area would again have a glut of space, values would fall and real estate owners would again feel dumb and homely.

Values of the standing inventory of income properties have increased dramatically, not only because rents are increasing sharply, but because capitalization rates are falling which compounds the increase in value. Thus, the basic currents of general economy and real estate supply and demand are all moving in the same direction at once.

To this one can overlay trends in the financial markets which simply add to the momentum. Interest rates are low by historical standards, relatively stable with a flat yield curve. On a national basis, real estate is back in favor as an asset class for equity investment and viewed as safe collateral for long-term fixed-rate investments. Unlike six or seven years ago when real estate was bringing down the S&L industry, many banks and a number of insurance companies, it is now accepted in almost all quarters. Indeed capital is chasing real estate and there are more lenders than good deals.

In the late 1980's this situation led to overbuilding that was driven by capital that wanted to be in real estate. The most important distinction that can be drawn between the late 1980's and late 1990's is that today's capital is not structurally capable of overbuilding the real estate markets.

Ten years ago, the capital that drove overbuilding was primarily bank construction loan departments (the authors are quick to acknowledge that we were eager participants in this aspect of the 1980's and are not going to give back our bonus checks). At that time, with corporate borrowings going to Wall Street, the banks (of which there were too many) jumped into real estate lending as a way to build balances and grow. The result was that new buildings sprang out of the ground at an unprecedented rate with not enough tenants to fill them.

This time, most of the new capital that is chasing real estate is not from the banks but from Wall Street. The Resolution Trust Co. helped get bad real estate loans off the books of banks and helped develop the Wall Street financing system now know generically as "conduit lending." It is simply a way Wall Street brokerage firms have developed to re-package individual mortgages into instruments that are readily sold as both rated and unrated debt commodities, instruments with which Wall Street is familiar.

Conduit lending has made virtually any type of occupied property with an income stream financable. They are driven generally by historical operating results or by income from leasing in-place. While some can complain that conduits have financed poor quality real estate, at least they do not finance empty properties, which is the major difference between the late 80's and the late 90's.

Conduit lenders and their competitors, the life insurance companies (who generally finance the highest quality commercial properties), all seek refuge in leased properties and, at least to this point, have not shown an interest or a capacity to participate in the building of speculative projects. Conduits, particularly, could not get rated debt on empty buildings and thus our contention that "structurally" they simply will not be capable of over building a market.

We don't think this is because they are morally superior to the bankers of the 80's nor any wiser; they simply haven't figured out how to do it at a profit. If there was a profit in it, they'd do it. The only Wall Street vehicle capable of generating speculative buildings are REITs, but they are sensitive to endangering their dividend stream, hence, they build limited vacant space.

Due to the strengths of the Puget Sound economy, both today and for most of the last 10 years, financiers that invest money in real estate are in love with our fair city. They readily admit to offering better rates for transactions in the Puget Sound area than they will elsewhere.

For every good, well-leased building in Seattle, it is easy to attract half a dozen lenders who will compete with each other to lay claim to having done a deal in our area. This only helps to make the life of the real estate owner or financier more enjoyable and more profitable.

We have often noted that we have more friends and people laugh longer and louder at our jokes when 10-year treasuries are under 6 percent and we can finance real estate at rates in the 7 percent range.

Alas, this too shall pass.

As one speaker quipped at the Urban Land Institute meeting in November: "Real estate is not now over-built, but it is over-announced." If all the planned hotels and office buildings that were announced were built, the Puget Sound area would again have a glut of space, values would fall and real estate owners would again feel dumb and homely.

What will help to avoid this? The banks.

Banks alone seem to remember the excesses of the 1980s and, at least for now, they require preleasing, equity and/or guaranties. As long as they maintain this discipline, we should be relatively safe.

Said another way, the Seattle real estate market will remain healthy as long as Wall Street stays out of the construction lending business, and as long as bankers show vision, discipline and courage. How comfortable does that make you feel?

Copyright © 1998 Seattle Daily Journal of Commerce.