By:  Ronald D. Struck                                                                 November 1991

A PENDULUM SWINGS - 
IT DOESN'T GO IN  CIRCLES 

It is said that successful real estate developers and investors must be born optimists, and lenders born pessimists.  But eternal optimism or pessimism is dangerous because they assume economic trends can move in the same direction indefinitely.  People who believe this I call Unrealists.  Long term success requires people to be Realists.  Realists make decisions recognizing that the economy moves like a pendulum, swinging back and forth between highs and lows, albeit with no regularity and seldom on the same path.  However, it never goes in circles.

When the economy is booming, decisions that incorporate a pessimistic outlook are very difficult to make.  And when we're in the tank, it's even more difficult to aggressively make optimistic decisions.  Currently, developers, lenders, and investors are overwhelmed with pessimism about further declines in real estate values.  Many people seem to feel that values are continually going to fall.  It is difficult to locate the rare Realist who knows that obviously can't happen.

Yes, the economy has declined substantially.  There are plenty of data constantly reported by the media that support this fact. Real estate is well into a major downward cycle that began in 1989.  Projections for further significant declines would have to assume a near collapse of the economy.  If you believe that a collapse is unlikely, that the current pessimistic environment is more like 1982 than 1932, then this could be a rare opportunity to make profitable investments in real estate.  By 1995, and perhaps even as early as 1993, investments made now may prove to be exceptionally timely and astute.

The basic rule of successful investing is to buy low and sell high. But Realists are fully aware of the impossibility of consistently acquiring investments only at the lowest points in cycles, and selling only at the highest points.  Realists actively manage their investments based upon their anticipation of likely changes in the swings, buying when they believe there is a greater probability of a shift to an upswing, and selling when they believe the opposite.

What do Unrealists do?  Typically very little other than riding with the swings wherever they are taken.  When the economy is expanding and profits come easily, regardless of capabilities, Unrealists develop a false sense of brilliance and become overly optimistic.  Because most of their assets are increasing in value, Unrealists think they know their markets like no one else and they are managing their investments superbly.  They also believe this trend will continue unabated.  Unrealists become almost euphoric, thinking that the only things restricting their profitability are the limits on their ability to expand.  They make as many new investments as their borrowing capacity will permit.  After all, the economic cycle can only keep going UP, right?

Wrong!  Like a pendulum, cycles always come DOWN.  The economy contracts, causing profits and net worth to become extremely difficult to maintain.  Although the Unrealists did not take advantage of opportunities available during the upswing to protect themselves, they accept little if any responsibility for their plight.  They blame overall economic conditions, the government and other such things, that they quickly point out are beyond their control.  An Unrealist's new operating strategy seldom calls for facing the reality of new market conditions, because that would involve recognizing the losses that are now built into their portfolios.  Instead, as though they had some other choice, they decide to ride out the cycle, doing everything they can to hold onto their investments until the next upswing.  But, when they begin incurring operating losses and their creditors won't carry them any longer, they are forced to sell off assets at depressed prices (usually to Realists).  If they have enough assets they may still be around for the next upswing, but in a much weaker condition than when the downswing started.

What about the handful of investors who continue doing well during the downturn, taking advantage of the opportunities to acquire assets at attractive levels?  The Unrealists say they are just lucky.  I say they made their own luck because they are Realists. Realists know that the three most important criteria for making good real estate investments are NOT - location, location, location.  They are - location, financing, and timing.  Of these, timing can be the most profitable or the most deadly.  It is essential that swings in economic conditions be carefully monitored and evaluated so that intelligent projections and profitable decisions can be made.

As a Realist, it's good to have an optimistic outlook for the real estate market.  Let me explain.  I got myself into a lot of trouble in 1989 for being pessimistic.  In 1988 I was chief financial officer of a $4 billion S&L in California.  As 1988 drew to a close, economic conditions in California were strong and consumer confidence was very high.  Real estate developers and lenders were aggressively expanding and competing for business.  In December 1988, I produced a cautious and conservative 1989 strategic financial plan, reflecting my concern that the economic pendulum had swung too far.  I believed the prevailing consumer optimism would be unsustainable and that a major downward shift in the economy and real estate market was imminent.  The plan included the following statements:

"We believe a combination of a general economic downturn, volatile market conditions and new restrictive regulatory capital requirements will make 1989 a time of extreme stress for the (banking) industry..."

"A recession will reduce mortgage rates and home prices, but employment and home sales will also contract...  (The recession) will adversely affect our primary market area of Southern California via three microeconomic factors specific to Southern California; a) The real estate bubble may finally burst... b) The airline industry could experience a contraction... c) Federal spending in military and space could fall as attempts are made to reduce the federal deficit in the face of declining revenues if a recession sets in.  (California receives twenty five percent of the Pentagon's outlays and an even higher share of NASA's expenditures.)  Reduced spending in these areas could also raise unemployment, reduce some real estate values and raise loan defaults in our market area."

"In this type of external environment, improving the capital and liquidity position is paramount.  This may involve further securitization of assets, shrinkage of assets and foregoing of current earnings to reduce risks."

The vice-chairman of the bank, in my opinion an Unrealist, was optimistic that the upswing in the economy would continue for some time.  He was furious about the views and precautionary steps recommended in the plan, saying they were outlandishly conservative and reflected a lack of the entrepreneurial spirit the bank needed in order to achieve its growth objectives.  In February 1989, he fired me for writing the cautionary plan and the bank's president for supporting it.  Thereafter, he obtained the approval of the board of directors to pursue an expansion plan that reflected his optimistic outlook.

As the saying goes - hindsight can give a twenty-twenty view of past events.  During the first three quarters of 1989, the S&L pursued the vice-chairman's aggressive growth plan, adding enormous amounts of exotic loans and real estate to an already high risk portfolio.  But, in the fourth quarter, the economic cycle shifted dramatically and rapidly downward.  At year end, the S&L reported major portfolio losses.  In late 1990, the vice-chairman was forced to resign and, in 1991, the S&L was taken over by the regulators and put into receivership.

So, in 1988 I was right when I went against the prevailing optimism and strongly recommended curtailing investments.  Now, I believe it is time to go against the prevailing pessimism.  The next twelve to eighteen months will prove to be an unusually attractive opportunity to selectively acquire real estate investments that can generate superior long term returns. Remember, this view is coming from someone who got fired in 1989 for taking a cautionary position based upon a pessimistic outlook.  The S&L should have listened to me back then.  But, if you are currently making your decisions based upon a pessimistic outlook, perhaps you should consider my optimistic outlook now.

 

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