PEOPLE CONTROL REAL ESTATE

I recently attended an apartment conference and saw yet another young real estate Broker from a large firm give a PowerPoint presentation about how rising interest rates will drive down the price of Real Estate. These presentations were probably typed up by a 20-something-year old kid behind a computer.

The implication behind these presentations is that as interest rates rise, values will drop precipitously and therefore you would list with that broker and sell your entire portfolio in order to maximize your profits. Then you are supposed to sit back, invest your money in an alternative investment and, clip coupons thinking some sucker has overpaid for your property.

While the concept is very seductive at first blush, I do not believe it is a complete story. I remember 30 years ago when I first got into Real Estate I had this naive notion that if you offered someone enough money they would surely sell and that there was only a profit motive for owning Real Estate. So the trick was to offer just enough to motivate them to sell and yet not overpay.

I have learned an enormous amount in my 30 year career in Real Estate. The most valuable thing I have learned is that there is always more to learn. I have also learned that peoples’ motivation for owning Real Estate vary according to the type of investor. There are the large REITs that are beholding to Wall Street; the large individual investment companies which try to hold for returns, you have the younger investor who is trying to build wealth, the older investor who is trying to protect his wealth and of course everything in between.

The motivations for selling properties vary greatly, but it is rarely “sell now because the market is going down.” People usually sell because they are motivated to either purchase another property that they perceive to be a better deal or they have another need for the cash such as children’s education. People sometimes sell when there has been a death in the family and the basis has been increased that allow the seller to avoid capital gains tax. Of course, in Santa Monica some people sell because they cannot deal with their obnoxious tenants. Again, the reasons for selling are as varied as the owners who own Real Estate and thus it is not motivated by the concept that “Prices are falling, I need to sell now.”

These youngsters inevitably point to the 80’s when interest rates went into the double digits and beyond. Interest rates for single family homes went up to 18%. Yes, that had a tremendous negative impact on Real Estate values. However, it was not until interest rates went above 10% to 12% that there was a real drop in values. So let’s step back from the simplistic idea and take a through look at the complicated reality of the Real Estate universe.

Having just said how complicated the Real Estate Universe is, I can only paint with broad strokes in this article in order to cover the distance necessary. So at the risk of sounding simplistic the Real Estate market is still controlled by Supply and Demand. It is anticipated that 7 million more people will move to California over the next decade. That is like the entire state of Pennsylvania moving to California. That has to increase demand for Real Estate. Of course, the amount of available land to build is steadily decreasing. Construction is the one area of Real Estate that is most susceptible to an increase in interest rates. As construction slows, supply will not be increasing as fast as it has in the last few years. Thus, the demand should outstrip supply and maintain upward pressure on rents and values.

Sometimes it is important to compare the Real Estate market to the Stock Market because they both are a place to store wealth. The Stock Market is a fairly efficient market because it is heavily regulated. Public companies are required to give public disclosure as to their profits or lack thereof. Stock Market investors appear to be pretty dispassionate about their investments and thus can make the cold hard investment decisions necessary to move funds between one stock and another. Capital gains tax does have an impact on the decision to sell and move to another stock. However, with capital gains rates at historic lows it has reduced the impact on the decision to buy or sell.

If you go back to the 50’s, 60’s and 70’s investors bought Real Estate with the hope of having a cash-on-cash return as the primary means of reaping a financial reward. Appreciation was secondary. While the model has changed since the 70’s when I started in Real Estate, investors ideally preferred to have cash-on-cash return, they also understood that appreciation offered the greatest return.

The Real Estate market on the other hand is much more inefficient. By that I mean there are underutilized properties which can be fixed up, improved and repositioned in the market, which allows a savvy Real Estate investor the opportunity to improve the cash flow and thus improve the value of the Real Estate. Also, as demand for rentals increase there is upward pressure on rents. This increase in rents also contributes to the appreciation in the value of Real Estate.

Real Estate investors are generally long-term investors. To sell a property takes more time than picking up the phone and calling your stock broker and saying “Sell IBM.” Over the last 20 years, Real Estate has been shifting into stronger and stronger hands. These investors have become much more sophisticated in asset management so there are fewer underutilized properties in the market place. One need only drive around our city or any other and look at the sky line and look at the improvements in virtually every metropolitan area to see the evidence of a much more efficient Real Estate market than ever before. Look at the Third Street Promenade and the area up toward Lincoln to see the number of new apartment and office buildings. You see it in San Diego, Sacramento, San Francisco, Pasadena, San Fernando Valley, and even Riverside. The entire Real Estate market in California has become much more efficient. These efficiencies have created a tremendous amount of wealth that will then be utilized.

Another thing that we have heard is that as interest rates go up, people will be forced to sell their homes. I believe this is a fallacy because the cheapest and least risky form of Real Estate financing available is for owner-occupied homes. The large lenders have learned that an owner will do anything possible to save their home. It is the last thing an individual will cut loose when faced with financial hardship. Also, if someone has not locked in a fixed rate loan and as interest rates do go up on their variable rate mortgage, their payments are capped by an annual increase of 7 ½ %. If a homeowner has a $5,000 a month mortgage payment their payment will only increase by $350 a month. Most people can absorb that kind of monthly payment increase. Thus, they won’t be forced to sell. Additionally, most people have a vast store of wealth locked up in their home, so they will not be required to sell.

Yes, we have been spoiled with interest rates at generational lows. However, it will take a lot more than a 2 or 3 point increase in interest rates to drive down the value of Real Estate. The longer I have been in Real Estate, the more I realize that it is not the Real Estate or interest rates that control it, it is the people, owners and corporations who own the Real Estate that control. I am reminded of a 90-year old gentleman I met who upon finding out that I was in Real Estate told me in a very gruff voice “My only mistake in Real Estate were the properties I sold” and I reflected on it and it applied to my own portfolio and the properties have sold from a Real Estate perspective. The properties that I sold were all mistakes in that they have all gone up tremendously. However, from an individual basis they were not mistakes because I was able to take the equity from those properties and buy other inefficient buildings and improve them and leverage up my holdings. However, and I believe that most Real Estate investors have learned similar lessons and as such are less inclined to sell their Real Estate unless they have an alternative plan or need for the earnings.

The L.A. Times last fall tried to do a media blitz saying that the sky was falling. You could tell because one of the headlines was “Real Estate Sales Are Down”, yet when you read the article, you recognize the truth was that the increase in Real Estate sales had slowed down. That hardly indicated a declining market, but it does indicate the acceleration of the market is slowing down. These are very different concepts. The L.A. Times has since backed off from that editorial bent and has recognized that Real Estate values are not declining and that we have a very strong robust market even though it is not at the same frenzied pace. So beware of editorials and brokers trying to motivate you to list by saying “the sky is falling.” Remember it is the people and the fundamentals that control.

While it is possible that Real Estate values may dip a little, it is probable that the increase in values will slow down. This will make some of the short-term investors less likely to invest and more likely to sell. The savvy long-term Real Estate investor will know to hold and wait until something motivates them to sell because, remember, it is people that make the decisions as when to sell.

So in conclusion, I am going to go out on a limb and making a prediction. Even if interest rates increase by a few points, the Real Estate market will not tumble because the vast majority of Real Estate is owned by stronger, more sophisticated owners than ever before. They will only sell when motivated by other opportunities. In fact, if interest rates go up owners of buildings will be disinclined to sell because they will not be able to replace the returns that they have on their existing properties with low interest rate loans. Thus, if fewer people sell, the values will remain strong for those who opt to sell for whatever reason.