Tony Downs was the keynote speaker at the UST Minnesota Real Estate Hall of Fame awards event that was recently held at the Minneapolis campus of the University of St Thomas. Tony is a senior fellow at the Brookings Institution in Washington, D.C. and is a recognized authority on real estate markets and their inter-relationship with the national economy. Dr. Downs had some interesting thoughts to share with the audience that night. His comments follow below.
It is a privilege to speak to you tonight at the University of St. Thomas, as you honor members of the real estate profession in Minnesota. My father, Jim Downs, worked in the real estate profession all his life, and I have done so, too. My father started in property management in the late 1920’s. He helped found the Institute of Property Management, in which he held Certified Property Management certificate number one. Then, in the midst of the Great Depression, he founded Real Estate Research Corp. to do research in real estate. I worked there for 18 years. My father spoke on real estate markets all over the country, including an annual presentation in the Twin Cities for the Minneapolis Real Estate Board which he participated in for over 20 years. He even wrote a book on Property Management, which went through 13 editions. It earned more royalties than received from the 25 books I have written! I followed in his footsteps, after getting a Ph.D. in economics and serving three years in the Navy. I also worked on the research side of the profession. In fact, I too, spoke yearly in Minneapolis under sponsorship of Jack of Rice, after my father retired. Jack became one of my best friends. I came to know many real estate experts in this area, who are still my friends.
Tonight, I want to speak about an aspect of real estate that makes it challenging: its tendency to move in cyclical swings in relation to the nation’s business cycles. At no time since I have been in this business, has the industry faced challenges as difficult and likely to be long lasting as it is facing now. This is thanks to the boom of 2000-2007 and the collapse of 2008-2009. In former recessions, real estate often led the way to recovery. But now it is a serious drag on the ability of our economy to return to prosperity. That is what I will discuss.
There are at least six major reasons why real estate is acting as a drag on the nation’s overall economy. Several reasons have to do with its impact upon the nation’s banking system which has been reluctant to resume its past lending behavior.
The first reason is that many banks have very high fraction of their loans based upon real property. In the third quarter of 2000, real estate comprised 44% of all bank lending, but by 2009, that rose to 60.7% – more than one third of all bank assets. Already holding over $1.4 trillion of real estate loans, many banks do not want any more.
The second reason is that almost all real properties have fallen sharply in value since 2006, leaving many loans with greater face values than the properties they support. Today, about 25% of all single-family homes with mortgages are underwater; that is, their mortgages are larger than the current market values of those homes. But 31.7% of such homes have no mortgages, so 17.8% of ALL homes are underwater. From 2004 to 2006, commercial real estate (CRE) loan to value ratios were 72-73%. But falling CRE prices have increased the LTV of those properties to 94-104%, putting many underwater – worth less than the loans on them. In addition, loans made on many real properties from 2000-2007 are now backed by properties with much lower values. Some banks are unwilling to sell or liquidate those loans because that might reveal that the banks are close to insolvency. But if they just hold such loans, that reduces the number of new loans they can make without raising new capital to act as reserves. Hence new loans are hard to get.
A third reason is that the prospects for rapid recovery in housing markets are very poor. Yet housing recoveries have been major positive forces in past recoveries. Existing housing sales have plunged to record low levels, averaging a 5.0 million annual rate in the first three quarters of 2010, back to their 2000 level and down 19% from the 2005 peak. In 2009, there were 554,000 home building starts – a 71% drop from their peak of over two million in 2005. That was the biggest drop in the history of such records. So far in 2010, starts are running at 600,000 – only 8% above their rate in 2009. The number of housing foreclosure filings went from 1.0 million in 2006 to 3.6 million in 2009, and will probably be 3.9 million again this year. Recently, several major banks have stopped filing foreclosures because of fraudulent or inaccurate documents. So the screwed up foreclosure situation will drag on for some time! The huge amount of foreclosures already carried out, with 72% of all those in 2010 in just nine states, has created a large number of housing units available for sale at low prices. That further reduces the willingness of home builders to start new homes, which helps keep new starts low construction unemployment very high.
The fourth reason is that commercial real estate is about to be hit by the rolling over of huge numbers of highly-leveraged loans made from 2000 to 2007 at very high property values and high loan-to-value ratios. This will create an acute shortage of borrower equity with which to pay off or roll over those loans. In the eight years from 2000 through 2007, $1.3 trillion dollars were lent on commercial properties – 5.9 times many dollars as were lent in the preceding eight years. Most of those loans were highly leveraged with cheap debt. Though the interest rates are still very low, banks cannot borrow to increase their leverage because regulators will object. And Fannie Mae and Freddie Mac do not make commercial loans, except apartments. If all banks fully deleveraged by reducing their huge debts, they would be unable to refinance these loans made from 2000 to 2007 without acquiring a lot more capital as reserves. The lending capacity of the entire U.S banking system is now much smaller than it was from 2000 to 2007, and will remain smaller in the future. As those earlier loans come due, lenders can refinance, forclose, or extend the loan. Refinancing is contingent upon whether they can raise new capital, which will not be easy. They can forclose and try to sell the properties to REITs or others who have raised more capital. Or, they can extend the loans with the hope values will improve.
The fifth reason, one underlying all the others, is that high rates of unemployment are likely to continue for several more years. As a result, consumers will not have the cash to return to heavy spending, and small businesses will have little reason to hire more. Lower levels of consumer spending are hurting our economy right now by keeping unemployment high. But we must get used to lower levels of spending – and of lower living standards in general – because we were living well beyond our own means from the mid-1990 through 2007 or so. The American people were importing and consuming more than they produced or saved, causing a huge rise in our national debt. That was unsustainable, but we are still doing it. Yet, I hear many real estate borrowers and developers declare they will not go back into market until rates of return are as good as they were in 2007. That is not going to happen. We are caught in a dilemma: we need more consumer spending to stimulate more employment, but we cannot merely generate it with more federal spending without aggravating our deficits. I believe some additional government spending to get economy going faster is probably warranted in near future. If the republicans win the House, they will probably not pass any more federal spending, even if it would increase jobs.
The sixth reason for concern is that no sudden change in conditions is likely to radically increase the demand for workers and for new production. That is what World War II did to bring the Great Depression of the 1930s to a sudden end. As an economist, I am convinced we did not get out of the Great Depression because of Roosevelt’s New Deal, or because the federal reserve change its policies. Rather, the recession ended abruptly because World War II suddenly generated enormous demands for government spending for war materials, and demands for man power drafted into the Armed Services. As result, the federal government abandoned all limits on its spending and poured funds into wartime industries of all types. It simultaneously drafted 8 million men into the armed forces, many out of unemployment. Obviously, that truly effective stimulus spending cannot be repeated for anything like the same reasons today.
Underlying our un-balanced economic situation is what I regard as a basic flaw in the American Electorate. The American people, as a group, want to receive many benefits from their governments, national, state, and local, but they are not willing to pay the full costs of those benefits. In this election campaign, many conservative groups are rightly dismayed by our high deficits. But when their leaders are asked to identify what government services they are willing to cut back, we hear only vague generalizations. That is also true of most liberal groups – in short, no one wants to cut back on any programs that benefit them.
The elderly want to maintain all their benefits from Social Security, Medicare, and Medicaid. American car owners – who include 92 percent of all U.S households – want to keep their gas-guzzling cars and get better roads, but they oppose any increase in today’s inadequate gasoline takes and fight mileage-based taxes on driving. Farmers bitterly oppose any reduction in huge subsidies to farm goods, or in tariffs on cheaper farm products we could import from developing nations. Homeowners get more than twice as large a subsidy in tax benefits as the government spends on all housing programs for lower-income owners. Yet the real estate industry bitterly opposes any changes in homeowner tax benefits. We spend enormous amounts on our military – more than almost all the other nations in the world combined. Yet we cannot reduce that spending much because Congressional members from states that contain major bases, or major defense plants, fight against any reductions in order to protect jobs in their local communities. Countless other examples could be given to show that no group benefitting from any government spending ever want their benefits to be cut back – they always assume such cuts should come from some other – but unnamed – part of the budget. As a result, there is no subject, there is no support to cut back on any particular spending – so we don’t do it.
Moreover none of our political leaders are willing to face this situation directly when dealing with the electorate. Nor are most business leaders willing to do so. I was at the Urban Land Institute convention in Washington this month and heard a panel of private sector housing experts discuss what our future federal housing policies should be. In fact, none were willing to answer that question: they all said we should have housing policy, but not one would describe what it might be for fear of antagonizing one group or another.
So what should we do about this ever-worsening situation? First, we should start telling the truth about the facts ourselves, and demanding that our political leaders do so too. The truth is not always pleasing to hear. In order to escape from this situation of ever rising debt to pay for consuming more than we pay for, the American people – including all of us in this room – are going to have to adjust to lower living standards than we got used to from the mid – 1990s through 2007. We should not go back to those standards.
One truth we must face is that real estate is not going to recover from its present weak condition for several more years. Housing is going to remain a drag on markets as long as unemployment and foreclosures remain high. Another truth is that we ought to change the distribution of incomes in the nation so the very wealthy – including many in this room – get less than the huge share they receive now, and the middle class gets more. In 2006, the top 20 present of all households of all households received more than half of all taxable income – that is, more than the remaining 80 percent of the entire nation combined. In fact, the top 5 percent received more income than the bottom 53 percent! I know many conservatives believe any attempt to change the distribution of incomes in America is a form of communism. I think it is appropriate to raise this subject in this university that declares its spiritual allegiance to Jesus Christ, who clearly favored the poor. St. Thomas was founded in 1885 with a mission educate students to be morally responsible leaders who think critically, act wisely, and work skillfully to advance the common good. That also means telling the truth.
I think I have said enough to convey my belief that we Americans must change our ways of thinking about our own economy and our responsibilities towards it and towards one another. If we do not, we will sink deeper into a quagmire of debt and eventual decay that will betray the nature of our history up to now. To prevent that outcome, we must all change our ways.
All of the people we honor here tonight also faced social, economic and political challenges during their careers, such as wars, depression, recession, monetary crisis, escalating regulations on development, labor struggles, etc. Yet they persevered because of their imagination, originality, courage, persistence, hard work and most important, their integrity.
I am hopeful that despite the current serious problems in our economy, real estate will eventually again be a leader in recovery from recessions, and be led by individuals who possess the same basic skill as today’s inductees in Minnesota Real Estate Hall of Fame. Thank you.