The Real Estate Bubble Part 1 — The Past
August 2008 Los Angeles – In the early 1990s as the real estate market began changing, many Clients asked my opinion of the market direction. Many of these Clients held multi-million dollar properties ranging from vacant land to high-rise office buildings. Every month that went by seemed to bring worse news and many of these individuals lost everything as they failed to plan for the worst while hoping for the best. A strong word to the wise: Do not hope for the best; plan for the worst.
The following article was written be Jim Guffey, a Partner in the property tax reduction firm California Property Tax Associates located in Southern California. It is offered as a tool to assist in potential future decisions from an experience based perspective. It should be noted that things are changing so rapidly that many of the prognostications therein have already come to pass.
THE PAST
In the mid 1980s wild appreciation in the real estate market occurred. Many people used this opportunity, both in the residential and commercial sector to step up by buying and selling properties. As the market continued to explode many people and companies leveraged their ability to purchase with an expectation of continued appreciation. In effect, they bought today’s property with tomorrow’s equity. And why not? A house bought for $100,000 in a 90 day escrow might be worth $110,000 by the time it closed. The same house a year later might be worth $130,000. And the numbers worked the same way with large commercial properties. An office building bought for $10 million with a six-month escrow might be worth $11 million at the close. And a year later it might be worth $13 million. This attracted many foreign investors including a great deal of money which came from Japan.
In 1989-90 the market peaked and caught most people by surprise. During this time it became increasingly difficult to sell properties. Many experts claimed this to be only a temporary situation. Many denied a problem even existed. Nevertheless, new homes became increasingly difficult to sell and developers and contractors felt the pain. Incentives were offered and prices were reduced. Inventory was high and people began walking away from their recent home purchases because of negative equity situations and an inability to pay their mortgage payments. At this time credit cards were not an accepted way of paying bills or for purchasing consumables such as food and gasoline. Banks foreclosed on these properties and quickly turned them to get them off their books by lowering the prices. It wasn’t long before the market was flooded with foreclosures which began to dictate the market price. In many neighborhoods there were far more sales of foreclosure properties owned by banks and financial institutions than there were properties that were owner-occupied. This further depressed the market.
This trickled into the commercial sector as well since commercial projects took years of planning. Projects that began several years before it was recognized there was a problem, often with hundreds of thousands or even millions of dollars invested prior to commencement of the actual project construction moved forward. Larger projects could take years to achieve full occupancy and even smaller projects were leveraged and needed tenants willing to pay 1989 rates to pay the debt. However, existing businesses had begun cutting back and new business startups were in a decline. This resulted in a glut of commercial properties on the market. Many projects sat vacant or had large vacancies and subsequently asking rents began to fall. Huge concessions were given for leases including free tenant improvements and even free rent. This continued the downward progression of rental income thus reducing the value of income producing properties.
In 1991 and even more so in 1992 there was a general recognition that the market was in serious trouble. Those unfortunate enough to be in the midst of projects or holding inventories of speculation properties and specifically, highly leveraged properties lost vast amounts of money. The losers included financial institutions as well as individuals and companies. Obtaining loans became difficult and for many, impossible. Many banks required two appraisals from two different appraisers before committing to a loan, and then required substantial down payments. The market continued to deteriorate through the mid-1990s until it finally bottomed out around 1995.
For the next five plus years the real estate market in general was tranquil with very modest appreciation in most areas. Some areas outperformed others but the value of property was tied to the income it produced on a real-time basis and residential properties had a direct connection to the income of the buyer. Through the year 2000 things were relatively normal.
The aftermath of this devaluation left many, many people and companies bankrupt. Astute investors and developers threw caution to the wind in favor of a certain greed which resulted in decisions that were not viable for the market.
The reason for this? In my opinion, the real estate cycle is basically this. Residential properties are built and, as the income and economic circumstances of the buying public increases, property owners step up to these newer properties. Their existing properties in a lower price range are bought by the entry-level buying public. As this process continues and more new homes are built, there is a need for new commercial properties to support the new neighborhoods, as well as schools and fire stations, etc. As these new commercial properties are developed the asking rents are higher, enticing businesses to leave the older neighborhoods in favor of the higher traffic developments. Rents are higher in the new developments, justifying the cost of the development but at the same time pulling up the rents in the older developments, subject of course to the supply and demand of the market. As long as new houses are built and bought, new commercial developments are built and leased, first time home buyers have the ability to buy the houses left by the new house buyers, and new business startups lease the older properties left by the businesses relocating to the new developments, the cycle continues. But, when the market is not driven by the income and economic circumstances of the buying public, but is driven instead by the artificial gain (equity) generated by emotional desire without the underlying basis of an ability to pay, pay day has to come at some point. Without the stability of an ability to pay, the house of cards has to fall; there has to be a reckoning.
