Markets are irrational, because people are irrational. Rationality is a simplifying hypothesis for analytic purposes. That does not mean that there is not a rationalization for every market phenomenon. Forty years ago dividend yields were higher than bond yields. The rationalization was that equity returns were riskier and commanded a yield premium. Does that sound familiar? You can read it in appraisal texts today in the discussion of band of investment theory or built up capitalization rates. Of course it ceased to be true in the stock market, and the new rationalization was that dividend was only part of the return. There is also capital gains which is driven by earnings growth. Again this has been mirrored in real estate, although each step has been accompanied by controversy. First there was Elwood, and with the advent of microcomputers various discounted cash flow software. And the real estate market followed. Today, if there is any first year cash flow to equity, it is primarily due to lenders' requirements for debt coverage ratios (DCR). As lenders become more desperate to place money in real estate lending, either because of decreasing short-long term spreads, or in flight from unsecured credit card debt problems, DCR's will decline again. In any case, whether we are talking about long term variation in PE or dividend ratios, day to day fluctuations in price, or the cyclical variation in real estate capitalization rates, we are talking as much about herd behavior as rational decision making. This is not to say that it may not be rational to follow the herd to new pastures. It is just to say that claiming the herd acts rationally is a simplifying hypothesis, not reality. And it may be rational to stop on the edge of the cliff rather than follow the other lemmings into the fjord, but how many do?
The herd reacts, even over-reacts, to stimuli, which over the famous long term validates the rationality hypothesis. Arguably the Great Depression was the herd's more or less rational response to the Smoot-Hawley Tariff and the deflationary policy of the Federal Reserve. Unfortunately, the irrational herd aspect of events allowed everyone from Franklin D. Roosevelt to Joseph Stalin to assert that it was an inherent flaw of capitalism, rather than a catastrophe of government policy. And that has been the accepted wisdom for a couple of generations. In 1986 an article appeared in this magazine predicting that the effect of the 1986 tax act would be to trim about 20% off real estate values. It took the market a couple of years to absorb the truth of that argument. Then ensued the 1989-94 real estate debacle, which was compounded by the overbuilding of several markets in the course of the Savings and Loan crash. The eventual more or less rational outcome of this situation has been the adjustment of real estate price levels to the new levels of taxation in much the manner suggested.
But today is the euphoria of recovery leading to another wild real estate party, and subsequent hangover? Probably. I had a friend who swore in 1979 that everybody in the business had learned their lesson in 1974. One of these sage individuals was involved in multiple multi-million dollar defaults in the 1990's. A classic example started with two of his executives discussing at a cocktail party which bank they could "rip off" for $100 million. They reached a conclusion as to the best candidate, which has recently boarded up their project. Who will say that isn't happening today?
But, you may argue, I am rational and participate in the market. Presumably the other participants, at least the large majority, are equally rational, so the market must be rational. I accept the challenge. How do you defend your purchase of a lottery ticket, an IPO stock, and a blue chip? Ah, you say, the lottery ticket is an insignificant whim. Tthe IPO is a calculated risk, and I'm not betting the family jewels on it. The blue chip is an investment. Different rational criteria are applied to each decision, depending in part on how much is at stake. Besides, if I continue to play the lottery for a million years or so, my probablility of winning is almost a certainty. Well, then, why did you buy the lottery ticket when you know that the payout is substantially less than the amount paid in? Why did you buy the IPO at a multiple of its issue price on the day it hit the market? And why do you buy the blue chip at the presently elevated PE ratio, and depressed dividend yield? If you say that those prices are today's expression of the consensus of a rational market, that's a circular argument. I hear the thunder of hooves. Herd behavior works. It works best for buffalo, caribou, and various African herbivores.*
To the extent that real estate prices are market phenomena, they are a subset of capital markets, and respond similarly. If markets in general are best characterized by herd behavior, then real estate markets can also be visualized in that manner. But, you say, in real estate there are actual visible problems. There are empty office buildings, unmarketable condominiums, developed industrial parks on which nobody will build. True. One hundred years ago inventory gluts were cyclical phenomena for most markets. It may be only within the last ten years that inventory control has advanced sufficiently to avoid them in other industries.
Mostly, though, the herd behavior I would like to focus on is the perception and evaluation of apparent risks. Humans have practiced pastoral agriculture since the stone age. One of the tools of the trade is the ability to direct the herd. Show the herd something obvious that it doesn't like, and it turns: wave blankets, send dogs in to bark and nip heels. These techniques work because for natural phenomena, such as predators, a defensive response or a change in direction improves the odds of survival. In real estate today the equivalent is the cluster of see-through office buildings, or other similar disaster. The present pain or the example of others' pain obscures the rational conclusion that this is just a symptom of an inventory cycle. While it may be premature to build more, it is certainly appropriate to be ready when demand inevitably eats through the present supply. Conversely, when all is well, it is a time to prepare for the lean years which will come. Another interesting aspect of herd behavior is the question of magnitude. The lottery ticket is nothing, just a longshot chance at wealth available for a pittance. Real estate projects are large. For an individual, even home purchase is a large commitment. As such, these decisions are given the best consideration possible. There is a story about the development of the Embarcadero Center in San Francisco. This office project is on the order of one million square feet and comprised, when built, a substantial fraction of the total office space in downtown San Francisco. As such, in advance of construction, its market impact was not calculable. No analysis of past trends could encompass an addition to supply of this magnitude. After the feasibility experts had elegantly stated the limitations of their endeavors, the developer concluded that he was in the development business, had the money, and would therefore build it despite the uncertainty. When people buy a home, the quality of analysis is about the same, at best. Most of the time this works fine. The Embarcadero Center was a great success, and one of that developer's projects which did not default. And the herder simulates size to the herd by waving a blanket.
A friend of mine recently wrote a piece** which includes an interesting analysis. It was called Months to Meltdown. He extracted average net income for office buildings in various metropolitan areas from published income and expense data. He then compared income to price indexes, deriving a capitalization rate. By definition a capitalization rate is the sum of return on and return of investment. Return on investment can, too, be estimated from published sources, the residual, thererfore, is return of investment. Taking that payback rate and converting it to a payback period gives, in Dr. Smith's analysis, the market consensus of the Months to Meltdown in various metropolitan areas. Pretty cool, eh? I like it very much. And I hope that Dr. Smith makes this analysis into a time series. I suspect that the market consensus of Months to Meltdown will vary over time, and that it will be cyclical. In other words, the Months to Meltdown as seen in 1992 will be fewer than 1997. Do you hear those hooves? I look at this in a slightly different way. Capitalization rate is the sum of return on and return of investment, with an allowance for liquidity or illiquidity. Conventionally a percent or so was added to real estate for illiquidity. My hypothesis is that when the market is good, liquidity is high, and illiquidity premium low. And that when the market is bad, the opposite applies. Perhaps this cycle may also be a function of variation in capital expenditures. At the depth of the last cycle, capital expenditures, such as tenant improvements, were high depressing or erasing current cash flow. Arguably, this will be true in the glut phase of any cycle.
It is possible to be a countercyclical real estate investor, but it requires courage and cash. These are often rewarded. In one case in my experience an investor bought an office building from a developer-bank joint venture with 20% down and concessionary financing. The building resold for a 25% increase in price two years later. Unfortunately, while the outcome was predictable, the timing was not. This is usually the case.
One of the problems of cycles is establishing their timing and magnitude. To some extent that can be determined from following the inventory cycle, but that is not a perfect proxy for price. There are basically two general ways to follow price: appraisals and transactions. Appraisals were criticized in the last cycle for lagging the market. To some extent that is inevitable because they rely on transactions which are slowly reported. To some extent the lag may be client driven as asset managers exert their influence to keep appraisals, appraised values, management fees based thereon, and professional reputations, elevated. The simple alternative is to go to a transaction based index. The only problem there is what will the index do when the market dries up, as it usually does when real estate tanks?
Two reasons. First, understand and profit from this stage of the cycle. Second, understand the situation of markets that still suffer from various problems. So if you have property, this is a good time to develop, write good leases, refinance or maybe sell. If selling didn't take courage, the Dow wouldn't be over 8,000.
*Extraordinary Popular Delusions and the Madness of Crouds, Charles MacKay, LLD, 1841; Farrar, Strauss and Giroux, New York
**Visible Investments, Wallace F. Smith, PhD, self published,wfsmith@earthlink.net