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Chapter 22 discusses how the structure of the U.S. real estate business has changed critically over the 25 years from 1992 to 2017, identifies the economic “forces” that triggered this change, and illustrates in what ways the forces have impacted the business.
Commercial real estate is a highly capital-intensive business, with developments and acquisitions typically involving tens of millions of dollars. Every capital-intensive industry, from steel to aerospace, has experienced a critical transition period, typically lasting 20-30 years. The transition of these capital-intensive industries was driven by the search for cheaper capital and resulted in a stronger and more rational industry, with greater transparency, higher consolidation of players and much lower use of leverage. The same has been the case for real estate since the early 1990s.
Prior to 1986, the U.S. commercial real estate business was fueled by financial gimmicks such as unsustainable tax write-offs, mispriced debt, over-leveraged properties, and inside deals with friendly local bankers. These features created highly fragmented ownership within the industry. As recently as 1990, 95-110% LTVs were the norm. This excessive debt financing was even available for speculative development projects, allowing real estate entrepreneurs to achieve wealth through acquisition and development, regardless of whether they created economic value.
The economic catalysts for the structural change in the U.S. real estate business started around 1990, primary of which were the withdrawal, en masse, of lenders and the industry’s subsequent collapse; regulatory changes in the banking and insurance industries; and the emergence of mutual funds as a preferred investment vehicle.
There were three main economic “forces” that triggered the change in U.S. real estate that started in the early 1990s:
- Shifting of control of capital from debt provided by local commercial banks and life insurance companies to equity provided by pension funds and mutual funds
- Consolidation of capital among fewer U.S. financial institutions, and
- Prevailing of basic economics in the real estate business.
Starting in the early 1990s, the “forces” converged to impact real estate ownership and, in part, determined which long-term owners were able to create considerable wealth for their financial stakeholders. The keys to successful long-term real estate ownership are:
- Visionary leadership and the ability to sell its vision
- Low long-term capital costs relative to competitors
- Low overhead relative to competitors
- Enhanced revenue opportunities relative to competitors
- Successful risk management
- Operating efficiency.
The impact of the forces is seen in the growth in real estate company size, liquidity, and prominence. It is also seen in continued low LTVs and growth in transparency among real estate companies.
These are the types of questions you’ll be able to answer after studying the full chapter.
1. Name three financing gimmicks that fueled the U.S. real estate business prior to 1990.
2. Since 1990, have capital structures shifted towards less debt and more equity, or the reverse? Why?
3. What evidence is there of the impact of the forces that changed the real estate industry since 1990?
A force that will change real estate over the next 40 years
- Real Estate is a Capital-Intensive Business
- The “Forces” Which Changed Real Estate
- Force #1: Shifting of Control of Capital
- Force #2: Consolidation of Capital
- Force #3: Prevailing of Basic Economics
- The Keys to Successful Long-Term Real Estate Ownership
- Managerial Vision and Ability to Sell It
- Low Capital Costs Relative to Competitors
- Lower Operating Costs Relative to Competitors
- Lower Overhead Costs Than Competitors
- Enhanced Revenues Relative to Competitors
- Successful Risk Management
- Operating Efficiency
- Proof of the “Forces” at Work
- Growth in Company Size, Liquidity, and Prominence
- No Reversion to Excessive Leverage
- Growth in Transparency
- Is Bigger Better?