Here's a litmus test. Where do you stand on the continuum from "small is beautiful" to "bigger is better"? There are no absolutes in this debate, of course, and the rooting interest goes back at least as far as the story of David and Goliath in the Bible. In 1996, though, the matter of scale will prove an important organizing principle for understanding change in the economy and in the real estate industry.
Take the on-going battle in Washington to bring the Federal budget under control. In the minds of many, this shapes up as a contest between the forces of Big Government versus the advocates of"devolution," moving decision-making down to smaller, more local authorities. As long as we have published the Landauer Forecast we have stressed the corrosive effect of huge Federal deficits on the nation's long-run economic well-being. In our 1993 edition we predicted, "After years of rhetoric about shrinking government, it will fall to this administration to actually reduce the bureaucratic headcount." So we are encouraged that the number of U.S. government employees is down 135,000 since then, and the deficit's share of GDP has gone from 4.9% to 2.5% over the same period.
The implications of the change of heart in Washington (and around the country) are, however, mixed for the real estate industry. Devolution means that responsibilities are being pushed down to state and local governments. Constituencies at these levels are no less sensitive to broad-based taxes, such as income or sales levies, than at the Federal level. Consequently, they tap the property tax pool. With market values in real estate beginning to recover, expect jurisdictions across the U.S. to look to commercial real estate for revenue by boosting assessments in the coming years.
Advocates for tax simplification, too, have much populist appeal but their plans show crippling defects upon scrutiny. A National Association of Realtors, analysis of the proposed "flat tax" computed a $22,500 present value cost to the median homeowner if mortgage deductibility were eliminated. If that is the price of simplification, the flat tax is going nowhere. Capital gains reform for investment real estate, on the other hand, has brighter prospects of passage. Though our legislators are right to steer clear of excesses such as the 1981 investment incentives, a lower capital gains rate makes good sense. A modest reduction would encourage investment in commercial property at a time when the riskiness of this sector is clear in everyone's minds. If passed, this will boost prospective rates of return to the real estate sector, pushing prices upward and accelerating deal volume once again in 1996.
Within the real estate community we see advantages to greater size moving to the fore in the coming year. The proliferation of REITs is likely to give way to a period of consolidation, as the investment trusts rationalize their holdings and seek to boost appreciation potential. Mergers will also give investment banks a new "story" to sell.
Among hotel operators, the "re-flagging" phenomenon will concentrate more economic power in the hands of the major operators. Though limited-service hotels were the hot spot in 1995, additional improvements in business travel volume and higher room rates put full-service facilities in position for upward movement. Bigger will be getting better in this part of the industry.
Development in the retail sector, both for regional malls and for community centers, should slow down as investors stay on the sidelines. Improvements at the anchors will challenge mall shops to remerchandise. Value-oriented megamalls will spread to more metropolitan areas, challenging established factory outlets. The nation's biggest cities will garner the greatest benefit from the revival of urban retailing. Overall, size will count in this property sector in the later ,90s.
Office investors presently favor suburban markets and smaller cities more advanced in their turnaround. With few exceptions, the large CBDs still carry too much vacancy risk to justify strong prices. But this will change in the near future. Particularly as the Japanese systematically lighten their portfolios,a number of properties once considered trophies will be available at attractive prices. Serious bidders will emerge, revealing a cultivated taste for CBD offices on the part of institutional investors, savvy old-line real estate firms and other foreign investors. For offices in 1996, small will be beautiful; by 2000, bigger will be much better.
The return of real estate to general acceptance in the investment community will mean even greater volumes of debt capital available. Loan volumes are up substantially at the life companies. Commercial banks will be booking many more deals as well. The recirculation of real estate financing through conduits and commercial mortgage-backed securities has lubricated the engine of the whole industry. Small deals are common among the conduits, but large and increasingly mixed-asset structures are coming to the CMBS market as institutional appetites for rated real estate debt increase.
Securitization has been characterized by the concentration on deal structure and asset review at the point of origination or initial public offering. There has been far too little attention, or available information on the underlying assets as time passes. Secondary REIT offerings, for example, are not scrutinized nearly as closely as IPOs, and there is little research available to support a CMBS aftermarket. Although some deals have unexpectedly gone bust, there has been comparatively little concern evidenced about this information void. But, as the holdings of real estate equity and debt securities grow, we expect a higher level of attention. Deal wizardry is no substitute for understanding the underlying real estate assets. We haven't heard much about"back to basics" recently, and that should cause us to reflect.
Whether your preference is for the big or the small, the fundamental laws of market supply and demand will assert themselves no matter how fast moving and complex the industry changes, or how exotic the investment vehicles may become. Navigating successfully in the current environment will require equal parts attention to detail and a sense of the big picture.