After the fall: Opportunities and strategies for real estate investing in the coming decade

June 17, 2009

Author Steve Bergsman is a real estate investment junkie much as others are political or sports junkies. His 2009 book, "After the Fall," subtitled "Opportunities and Strategies for Real Estate Investing in the Coming Decade," cogently explains where we've been, where we are and where we are going in the wake of the great economic, financial and real estate crash of 2008.

Bergsman's message: Proceed with caution, be patient and realize that there are many kinds of real estate markets -- each with particular potentials and pitfalls.

"When bubbles burst, the effects almost always last a long time," writes Bergsman. "When real estate bubbles deflate, it is never a short-term problem."

A manual for the current market

A resident the city of Mesa in the Phoenix, Arizona, metro area, Bergsman observed from a front row seat as one of the most troubled markets in the country plummeted. He's been writing about property and financial markets for three decades, enabling him to compare the late-1980s real estate recession with the current malaise. "After the Fall" will be discouraging to anyone out there who still might be fantasizing about the housing bubble re-inflating to abnormally high levels.

"Although that (late-'80s) recession was different in that it was led by commercial real estate overbuilding instead of residential real estate over-lending, essentially when it comes down to it, we are talking about the same thing: too much liquidity in the system, which over-stimulates investment and drives up values falsely," Bergsman writes. "A time-line summation of that property crash and recovery shows about three years in the trough and then another three years to clean up the markets and reset values. By year seven, financial systems and real estate markets get back to normal."

Bergsman's book is well-timed, but that good timing presented challenges to his focus on market fundamentals and trend lines, he admits, as he began to research and to write it in late-winter 2008.

"Eventually, events did get ahead of me because by late summer and early autumn, the financial world shifted: Fannie Mae and Freddie Mac were taken over by the federal government; Merrill Lynch,  Washington Mutual and Wachovia were sold; Lehman Brothers went under; and AIG needed federal intervention," he writes.

"There is the possibility that the vast new financial landscape could slow down the trend lines and postpone the recovery of individual markets. On the other hand, the changes could actually speed up recovery because the new institutions that control real estate would more likely move the bad stuff off their books, albeit at a very big discount."

And once values are known, new investment can proceed. With prices having fallen far, it is tempting to buy now in order to sell high. But how low will things go, and when?

Bergsman guides readers with chapters about commercial, industrial, retail, multi-family, single-family, condominium, second-home and vacation real estate.

The chapters are subdivided by these headings: "Where We Are Today," "Where We Were," and "Where We Are Headed." 

In this regard, "After the Fall" is almost manual-like in its utility, but it also is well-written; witness this delightful turn of phrase about the kind of extreme short-term investment that can best be described as real estate scalping and which bit many of its greedy practitioners (even institutional investors got burned) in the backside:

"When flipping starts, the investment market begins to take on all the characteristics of musical chairs, except in the children's game when the music stops, the last child sitting is the winner. In the flipping game, when markets collapse, the last investor sitting or standing is the loser."

The commercial market

Regarding commercial real estate, Bergsman's "The Office Market" chapter urges fundamentals over flipping and notes that location gives a safer-investment edge to big cities including Manhattan, Boston, San Francisco and Chicago.

"Institutional investors, including REITs, pension plans, insurance companies, and even opportunity funds, are known as long-term holders of real estate, sitting on their investments for at least seven  to 10 years. But their holding periods dropped to five to seven years and in many cases two to five years," Bergsman writes. "Over the next few years, the United States will become a have and have-not marketplace for office investors. Those cities with less perceived risk will attract capital and those with perceived risk (called second- and third-tier cities) will not." 

After frenzied trading in 2007, the big downturn also hit office property, but it was not a result of the kind of overbuilding that took place in the late '80s -- it was because too many investment dollars were feverishly chasing the false promise of ever-escalating prices, Bergsman writes. "The folks who own and manage office properties expect to see considerable pain inflicted on those investors who thought office properties are good as gold."

He advises investment in office condominiums only if you plan to use the space to run a business. "Office condos are a useful product for a small service company needing 5,000 square feet or less, but it's a relatively new phenomenon; and therefore the secondary market has not established any track record. Buy an office condo if it fits your company needs, but as a pure investment it will take another decade to sort out this niche."

As bad commercial real estate loans come due in 2009 and 2010, more commercial property will be up for sale.

Industrial

Regarding industrial property, it is a sign of the times that Bergsman writes that "it's all about massive distribution facilities" and supply chains of goods manufactured outside the United States. "For any given product, raw materials can be sourced in Africa, refined in India, partly manufactured in China and finally distributed in the United States."

The trend is toward fewer but massively bigger distribution centers along major transportation routes, including the Cana-Mex Corridor, Bergsman says. And although tough economic times slow down the absorption of space, industrial real estate is a resilient, stable value and could show the kind of strength in an economic recovery that has not been seen since the midst of the high-tech boom in 1997.

Chronic pain for retail

Bergsman sees the retail real estate market changing along with patterns of more population location in cities and the rising cost of gasoline. As more urban in-fill housing is built and people walk more and drive less, remote shopping centers and malls suffer.

Bergsman also keeps his eye on the quality and health of an anchor in a given retail center. If a new center is anchored by a more prestigious and more popular anchor than its competitors, "Performance can drop dramatically. Think of how many empty retails centers you drive past."

Bergsman sees much bad news ahead. "Retail construction consistently followed the consumption boom as consumers, from the start of the millennium through 2006, were growing their spending faster than their income and were doing so by extracting home equity." By 2008 the consumer household was deep in debt, and Bergsman predicts "the capacity to grow spending will be severely limited in the years ahead."

The Rodney Dangerfield of real estate

Which brings up the market for household living quarters, in which Bergsman expects excess product to be absorbed -- given time. 

Bergsman sees multi-family as a "the Rodney Dangerfield of real estate," with little volatility, low risk and moderate returns. He is enthusiastic about apartments in the next decade with growth in demand for rentals.

"Even if the current capital malaise hangs about longer than expected, by the early years of the next decade the economy should be on the mend. It will happen at a fortuitous time for multi-family," Bergsman predicts. "Demographically, the eco-boomers, children of the baby boomers, a large cohort, will be entering the market in a major way. In addition, strong immigration is expected to continue."

Single-family housing, goosed into unrealistic price levels by the Federal Reserve's attempts to boost the economy by keeping interest rates low, crashed badly and prices may not rise until the next decade.

Bergsman injects perspective, however, noting that single-family sales rose from a respectable 5 million annually in the late '90s to a record 7.5 million in 2004, then sunk to 6.5 million in 2006 and about 5.39 million in 2008, which is still historically respectable.

"New families entering the housing market and investors circling the carcasses of the housing industry looking for deals in 2008 through 2009 will be able to take advantage of the current market weakness, but only time will tell if those investments will pay off in a meaningful way," Bergsman writes. "By consensus opinion, anything bought today probably won't look like a good investment until around 2013."

He says in-fill is urban and suburban, and its success does not bode well for free-standing single-family homes that are a long drive from places of employment. He also reports that families are having fewer children or no children, which boosts the in-fill trend.

Condominiums

Bergsman says condominiums always have been volatile, and he expects urban residential units to have a much briefer and smaller downturn than vacation condos.

Residential condo sales have decreased uniformly across the nation, he says, while the median price sunk from $283,800 in 2005 to $241,000 by early 2008. The strongest price stability "surprisingly" for condos has been in the Midwest -- perhaps it's because Midwesterners live up to their earnest stereotype by buying condos to live in them and are less likely to engage in condo scalping to flip a quick profit.

Bergsman makes an obvious point that still is worth repeating: "All this speculation escalates pricing," artificially bidding up the price of housing. "With tight credit markets," Bergsman observes, "some of those good folks who placed a down payment on a condo and really intended to live in it can't get financing." 

Condos continue to be built despite slow sales. "Even in 2008, developers (and lenders) were still developing condo projects hoping to take a smaller loss selling the completed building rather than taking a big loss by just walking away."

A factor that could boost condos in the long term is the trend toward in-fill development, a trend also discussed in "After the Fall's" chapter titled "Sustainability."

The focus is on LEED (Leadership in Energy and Environmental Design) certification, a must in urban areas that brings about energy efficiency, alternative energy, renewable energy and ozone protection protocols -- along with higher per-square-foot selling prices. Bergsman says apartment tenants and condo buyers want sustainability, which adds value to real estate.

He says solar transforms rooftops into a value-generating asset. He quotes Jones-Lang LaSalle's global CEO-CFO, Lauralee Martin: "The question each of us should ask is whether we are taking an aggressive enough position, given the rapidly approaching tipping point of the (Green) issue." 

Other issues

His chapter on distressed real estate and troubled loans laments the way sellers bog down the market by vainly clinging to outdated prices. 

His chapter on insurance and taxes laments the fact that even in Florida, "there is barely any kind of hurricane strength rating on a house, but the buyer certainly knows if the house has granite countertops or hardwood floors"; it also advocates that homestead tax provisions would work better if they were portable for at least one new move.

He reports that the timing is right in some locations (Arizona, North Carolina and Nevada) to get into the second-home market but that second homes will be "part of the walking wounded" for some time in, for example, South Florida. He says vacation properties should bought to be enjoyed, not as an investment.

Bottom Line

  • Money still can be made on real estate, but it will take time and a specific approach to types of property and their locations.
  • It is not likely, nor  a desirable thing, that the real estate bubble will reinflate to its former false glory.
  • Distressed property is moving slowly because it’s priced too high; Bergsman quotes one distressed-property investor as saying the FDIC should order new appraisals to break the logjam.
  • In 2009 and 2010 more commercial properties will come on to the market.
  • Sold and rented housing that is part of in-fill development, urban and suburban, will outperform stand-alone single homes that require long commutes to work.
  • Industrial real estate will remain resilient and could take off if the economy sustains a recovery.