The Coming Collapse in Real Estate

Edmund Contoski | From the May 1974 issue

Major economic contractions all have the same cause: government manipulation of the country's money and credit. An economic contraction, that is, a recession or depression, is a correction of economic distortions that have built up during the preceding government expansion of credit. Various factors, mostly resulting from government policies, cause this credit to expand more easily in some segments of the economy than in others. Of course, any major inflation quickly affects all aspects of the economy, and all feel the subsequent effects of the ensuing deflation. But those segments of the economy into which inflated credit flowed most easily are the ones where the subsequent correction will be most dramatic.

The 1929 crash, while it affected all segments of the economy, was most dramatic in the stock market because it had become the primary outlet for the excess credit generated by the Federal Reserve in the preceding years. In other economic crises in our history the most striking collapse has occurred variously in commodities, land, the banking system, or some other area, depending on the credit structure of the time. While these crises have been repeated at almost regular intervals throughout our history, as a rule the collapse has not hit hardest in the same field twice in a row. This may be partly because the most recent cycle is within the memory of more people, leading them to be more cautious in that field. Most people expect the next economic crunch to be like the last one. In reality it is least likely to be like the last one. This is not only because of people's caution but because government policies in a mixed economy cause credit to flow unevenly through the system, and these policies are changed after every boom-and-bust cycle. So the next time the government resorts to inflation, the collapse comes in a different area.

WHERE THE COLLAPSE WILL COME

For the above reasons I do not believe the stock market will be the primary recipient of deflationary forces as it was in 1929. Make no mistake about it: I expect stock prices to tumble, as they already have begun doing. I simply expect the collapse in real estate prices to be much worse.

After 1929 the government restricted the margin buying of stocks, never again allowing stocks to be purchased on such thin margins. Despite the government's concern for restraining credit for stock purchases, over the last 40 years the government has progressively made it easier to obtain credit to buy a home. In the 1970's it has been common to purchase homes with down payments as low as 10 percent and possible to do it at 5 percent—which was not the case in 1929.

The whole credit structure of the real estate market as we know it today did not exist in 1929. That in itself is one of the reasons it has escaped the scrutiny and concern that has been focused on the stock market. The present structure of the real estate market has never been subjected to the strains the stock market has seen; it hasn't been around long enough. It's one of those areas where the government policies were changed after the last cyclical bust.

The present inflated values of real estate are the result of: (1) the government's monetary policy, tax policies, and financial regulations, (2) various federal grants, programs and social legislation, and (3) the suburbanization movement. The first two categories are obviously within the scope of government action, but the ways in which the government contributed to the suburbanization movement are not generally recognized. It is important to understand the suburbanization trend of recent decades because that is where the action has been; it's where most of the real estate money has gone, where most of the building has taken place—and where land prices have skyrocketed. Suburbanization, while not totally the product of government action, was strongly stimulated by it in many ways.

Like the inflation of the dollar, the government's influence on the rush to the suburbs began during the Roosevelt administration, thanks to the New Deal thinkers who were responsible for so much radical legislation in that era.

In 1931 Herbert Hoover called a national conference on housing. The conference made various recommendations for increased federal action, but nothing was done. The Roosevelt administration used some of these recommendations, coupled them with still more radical ideas of its own, and enacted them into law along with a flurry of other social legislation. The Home Owners Loan Act, the National Industrial Recovery Act (resulting in the National Planning Board and the Public Works Emergency Housing Corp.), the National Housing Act of 1934 (which established the FHA), and the Housing Act of 1937 were some of the laws enacted.

THE NEW DEAL PLANNERS

In that era the leading urban thinkers were "Decentrists," as Catherine Bauer aptly labelled them. This group included Ms. Bauer, Lewis Mumford, Clarence Stein, Henry Wright, Tracy Augur, Russell Van Nest Black, and others. They viewed the cities as failures, as evil, and believed salvation lay in getting people out of the cities and into the suburbs and small towns. This view, as with city planning ever since, was based on the earlier simplistic and unrealistic "Garden City" concept of Ebeneezer Howard. But as Jane Jacobs pointed out, "Howard was envisioning not simply a new physical environment, but a paternalistic political and economic society." [1] Thus the physical planning theories of that time fit well with the political views of the New Dealers.

Henry Wright and Clarence Stein were the designers of Radburn, N.J., a garden city-type plan modified for the auto age. Significantly, it was a suburb and was designed for only 25,000 people. Wright and Stein became members of the planning advisory group to Roosevelt's Resettlement Administration. Wright also toured the country for the National Association of Housing Officials campaigning for more public housing. Tracy Augur became a planner for TVA (another Roosevelt program), co-designed the federal town of Norris, and also was a member of the Resettlement Administration planning advisory group. The administrator of that agency, Rexford Tugwell, also had a Decentrist point of view:

My idea is to go just outside centers of population, pick up cheap land, build a whole new community and entice people into it. Then go back into the cities and tear down whole slums and make parks of them.

Catherine Bauer authored MODERN HOUSING, was executive director of the Labor Housing Conference, and testified before Congress on behalf of housing legislation. Mumford was, and is, an influential critic and author of many books denouncing the city. Black helped to promote the Planning Foundation of America, was selected by the National Planning Board to serve as a consultant to several states, and was also a member of the Resettlement Administration group.

Given the orientation of the opinion makers and people in power, it is not surprising that government created a national mortgage market with tax-backed guarantees so that the common man could leave the city and own a home in the outskirts. The Housing Act of 1937 even provided federal loans for buying peripheral sites for low rent housing.

The New Deal set the direction. It firmly established housing as an issue to be dealt with by the federal government. The government stimulated and subsidized private housing and influenced the flow of private credit in real estate. The government got directly into the real estate market in public housing projects, as a land developer, and a builder of whole new communities. The government established—indeed helped to create—the American ideal of a single-family home in the suburbs. In this it found something that the modern populace wanted even more than "bread and circuses," which the Roman government provided to keep its citizens content.

Politicians ever since Roosevelt have been practically stumbling over each other to try to deliver more of this American ideal to the public. Politicians could perpetuate themselves in office by buying votes with the taxpayers' money as long as the money was spent to please the voters. Thus, for example, when Harry Truman was reelected in 1948 after a campaign of blasting "that notorious do-nothing Republican Eightieth Congress," even conservative senators such as Robert Taft and William Knowland introduced a housing bill to counter a similar bill presented by the Democrats. The resulting bill with bipartisan support became the Housing Act of 1949, the most comprehensive bill of its kind up to that time. It provided a billion dollars for loans, $500 million for capital grants for redevelopment, and authorized 810,000 new public housing units.

STIMULATING THE SUBURBS

For 40 years the government has steadily expanded its role in housing and urban development by passing new bills, broadening its own powers, appropriating more funds, expanding the coverage of its programs—and adding more employees. Always adding more employees. And constantly adding impetus to the suburbanization movement. For example, it has always been easier to obtain FHA approval in the suburbs than in the cities. Government policies have consistently encouraged home ownership. In addition to furnishing mortgage guarantees, the government provides a further incentive by allowing interest on home mortgage payments as a deduction on federal income tax. Local governments also discriminate in favor of home owners by allowing homestead exemptions on property taxes. All these have contributed to the boom in home building in the suburbs. Anything encouraging the single-family home was bound to result in significant suburban development since single-family homes take up larger land areas than higher density housing types.

There were other ways, too, in which the government abetted suburban development. Billions of dollars were appropriated for federal highways, which made the suburbs more accessible, and for sewer and water grants, which gave the suburbs utility systems comparable to the big cities. Since the suburban residents paid for only a portion of these costs, they were receiving benefits subsidized by other taxpayers.

The financial effect of all the stimulants to suburban growth was to escalate prices, aside from the inflationary pressures that were raising prices everywhere. The latter merely added to the former, making the price rise seem even more spectacular. The supply of suburban land was limited, and the many financial incentives to suburban development exaggerated demand.

REGULATING INVESTMENT

Over the years increasing government funds have been spent on urban renewal, low-income housing, housing for the elderly, and various other programs involving or affecting real estate. The greatest effect, however, has not come from public funds or public construction but from the way in which the government has influenced private capital and private construction. The effect of the Interstate Highway System on private construction is an example of a public project having tremendous effect on the pattern of private development. It is possible, however, for the government to effect consequences of great magnitude without any public project at all simply by the government's regulatory powers over financial institutions.

The most important source of credit for real estate development is the private institutions. Of these the largest, in terms of mortgage holding, are the savings and loan associations, followed by the life insurance companies. For decades the S&L's have been allowed by the government to pay higher interest on savings than the banks. This gave the S&L's a competitive edge in bidding for savers' dollars and channeled billions of these dollars into real estate. The government prevents the S&L's from investing in anything but real estate!

Earlier it was pointed out that the government has diverted money into real estate by tax incentives for home owners, but these are not the only tax provisions which favor real estate. The depreciation and capital gains features of the federal income tax have attracted huge investments in real estate. Many a real estate development would not make economic sense, and would not have been undertaken, except for the depreciation schedule. Many a parcel of land has been bought as a tax shelter.

DESTROYING THE CITIES

To this point we have discussed ways in which the government has supplied positive incentives to the real estate boom. This boom has also received impetus from negative or contrary stimuli, as a reaction against certain policies and problems. For example, the failure of governments at all levels to deal effectively with riots and crime in the cities, the massive failures of urban renewal, the corruption of many big city governments, the problems of integrating schools, and similar social issues have all resulted in more people moving to the suburbs.

Another contrary stimulus has been government monetary policy. In proportion as the government has resorted to inflation, real estate has attracted more money—and not just because there are more dollars available. The greater the inflation, the more incentive there is for people to own their own home or other property. (The boom in condominiums is largely a result of this.) Real estate has increasingly become a substitute for a monetary function. One of the essential functions of money is to serve as a store of value. Unhappily the dollar no longer does this. As people lose confidence in deteriorating paper, anything of tangible value becomes more desirable. Real estate has a particular attraction in this regard because:

The amount of land is fixed.
Income-producing real estate generally offers a better return than common stocks and a hope for appreciation that higher-yielding fixed-return instruments do not have.
The real estate market does not fluctuate daily the way commodities and stocks do. This relative stability is the result of a thin market for any given property. Sometimes a piece of property will be on the market for many months or even years before finding a buyer, whereas shares of stock in any medium-sized company are traded every day. This slowness of the real estate market allows it to avoid the minor dips evident in stocks and commodities and gives real estate an image of solidarity.
The history of suburban development leads to extravagant hopes for property appreciation in the future.

Fears of inflation have affected the investment policies of the big institutions as well as those of individuals. The institutions found themselves in the difficult position of supplying long-term mortgages at fixed rates of return while inflation continued to mount. This led to demands for "a piece of the action"—some form of participation in development projects. It also led to the purchase of huge tracts of raw land beyond immediate development needs as a way of "banking" assets for the future. The demand created by these institutions bid up land prices correspondingly.

The financial institutions were not alone in jumping into real estate. In the late 1960's nearly 300 major corporations, from Alcoa to Westinghouse, joined the bandwagon.

Now the trend is reversing. Institutions that were flush with money and enthusiastic about investing in real estate are in a different position today. Many of the corporate giants that eagerly entered the real estate field only a few years ago have suffered severe financial losses and are now just as eager to leave the field. Some already have. Here are some of the larger real estate losses: Boise Cascade $257 million, International Paper $30.5 million, International Telephone and Telegraph $57 million, Westinghouse $30 million. [2]

THE S&L SQUEEZE

In addition to the fact that many large real estate developments have not lived up to expectations, the financial institutions trimmed their plans because changes in interest rates reduced the amount of money available to them. During the past year the government changed its regulations to allow banks to offer higher rates for certificates of deposit. This plus the rates available on commercial paper and government securities caused a tremendous flow of funds away from the S&L's. Although more recently there has been a modest reflow of funds to the S&L's, it is highly unlikely such funds will result in a credit expansion massive enough to revive the boom in real estate development. The first priority for any new funds for the S&L's will be to pay back high interest loans from the Federal Home Loan Bank, which are up sharply as a result of the last credit crunch. Furthermore, the wide fluctuations in interest rates over the last few years make it unlikely that the S&L's and other institutions will commit themselves to large-scale, long-term development projects as they were doing just a few years ago. Projects of that scope require a stable economic climate for an extended period of time, which few money managers now anticipate. Thus the demand for large land areas suitable for development is now diminished among the same institutions that helped bid up the prices. Moreover, many of the institutions that formed joint ventures of one sort or another with land development companies or home builders are finding these marriages less than happy and are not anxious to extend themselves in that direction.

Meanwhile, high interest rates are killing the homebuilding industry by raising its costs while destroying its market. The building industry operates on borrowed money, the costs of which are now greater than most companies have prepared for, leaving many in serious financial difficulties. At the same time, the high interest rates have turned off the buyers. For most people buying a home is not an immediate necessity; it is a purchase they can postpone.

Right now consumer sentiment is very negative. The highly regarded University of Michigan Consumer Sentiment Survey, as well as other public opinion polls, shows the public with an extremely pessimistic economic outlook. A home is the largest purchase most people ever make. They are reluctant to make it in an adverse economic climate.

As to the numerous statements from government and industry sources about the need for a specific number of new housing units every year, I can only say that people will find they can get along without them. In hard times people will double-up. Couples will move in with their in-laws, or perhaps take in a lone surviving parent. Youngsters now enjoying the luxury of an apartment by themselves will move back with their parents or in with each other.

THE BAD NEWS FOR REAL ESTATE

As the euphoria of inflationary prosperity gives way to hard economic realities, the effect of trends adverse to the past suburban development pattern will become more apparent to the real estate industry. Here are a few of these:

In view of the oil crisis the consumer is apt to think twice before going further and further out of the city to buy a home and increase his commuting distance.
The Interstate Highway System is virtually complete. It seems unlikely any new major highway programs will be initiated soon, not only because of the oil situation but because of environmental, traffic, and other considerations. In fact, pressure is developing to use highway funds for mass transit systems. This would work against the continuation of the past pattern of suburban sprawl. Efficient mass transit systems can be developed only where there are higher densities.
The trend in the birth rate indicates that pressures for real estate development will not continue as they have in the past. In this I do not mean merely the recent spectacular drop in the birth rate. I am referring to the fact that the famous World War II baby boom has now matured to the family formation age. New family formations, indicative of a potential housing market, will not continue the past growth rate. The abundance of empty classrooms in the schools should tell the real estate industry what to expect.
Due to the publicity of numerous scandals and waste connected with government housing, urban renewal, and similar programs, these programs at long last appear to be coming to an end. Even FHA is winding down. In 1971 FHA processed 369,000 applications for assistance on single-family homes. In 1972 the number was 140,000, and last year it was only 44,000.

I believe the first effect on real estate of the deflationary forces shaping up will be a drop in raw land prices. Builders will sacrifice their future land inventory in order to maintain their current operations, and institutions and investors will scrap their long-term plans for the sake of their immediate cash requirements. Also, much land is held on very thin margins. With high interest rates and a gloomy market outlook land inventories will come to be viewed as liabilities to be disposed of rather than as assets to be retained for the future. Land held for future development does not pay its current carrying costs.

The decline in land values will spread to the values of developed real estate. In addition the low margins which have been encouraged for home owners will turn out to be troublesome. Too late it will be recognized that many who bought homes because of the easy credit available simply should never have been home owners in the first place.

As unemployment rises, the home owners' difficulties in meeting mortgage payments will be paralleled by businesses facing an increasingly bleak economic outlook. Prices of commercial and industrial real estate will adjust accordingly.

In time of crisis the very factor which exempted real estate from frequent fluctuations in price and made it appear so stable will work against it. The slow market, the lack of trading activity, will make it difficult to sell property quickly when it is necessary to raise cash. When cash is needed quickly, prices will be slashed to promote sales.

In a major economic contraction most of the tax incentives in the real estate industry will diminish in importance. The tax-shelter characteristics, for example, will not be important if profitability disappears.

In retrospect it might seem to some (not libertarians) that the problems the real estate market is headed for could have been avoided, or at least reduced, by stricter regulation of the industry, notably in the area of margin requirements. But that is not the problem; it is only a symptom of the problem. The problem is the government's power to generate credit. Blocking or restricting the flow of credit in a given area is no substitute for sound money, which is the only way the boom-and-bust cycle can be avoided. Whenever inflationary pressure builds up in even a semifree economy, it will find an outlet. Plugging one hole through which excess funds can flow merely increases the pressure within the system, and capital will find an outlet in other directions.

WHAT TO DO?

With the prospect of a bleak future for the real estate industry, what should the individual do? Here are my rules for real estate for the next few years:

Do not even think about real estate as an investment for the foreseeable future. This means avoiding real estate investment trusts (REIT's), real estate syndications, or individual properties for speculative or investment purposes. (Some of the REIT's have already taken a beating.) If you are convinced you must buy real estate for your own immediate needs, personal or business, then do so with the understanding that that alone justifies the purchase; do not rationalize that it also will be a good investment or will preserve your capital. It would be better not to buy at all at this time and to dispose of whatever real estate you own with the possible exception of your own home. Actually, you could probably profit by selling your home, if you own it, and buying another in a couple of years. But would the inconvenience or the change in your life style be worth the financial return? Everyone must answer that for himself. My own view is that if you have managed your other financial affairs prudently, if you own your home, or at least do not have a large debt against it and can foresee your ability to pay it, then why not treat yourself to living in the home you like? You will always need a place to live. On the other hand, if you are heavily in debt, if you have no hard money assets and your future income is questionable, sell now and rent.
If you are determined to own real estate in the period ahead, maintain as much financial and legal independence as possible. By this I mean avoid situations which bind you to the fortunes and decisions of other. Joint ventures, partnerships (including limited partnerships) or any other variety of multiple ownership (except joint tenancy for couples) should be avoided.
Make all leases for the shortest term possible. Current monetary instability renders it unwise to make long term commitments at this time. This applies to commercial and industrial properties as well as residential. I suspect future economic dislocations will also make many choice properties available.

This article has been concerned with urban and suburban real estate. Agricultural real estate has been deliberately excluded because it will be affected more by the market for agricultural products than by factors affecting urban and suburban real estate.

While recreational real estate has not been mentioned thus far, it is obviously a luxury. Such properties are in much demand in good times but not in hard times. If you are intent on buying a recreational property, look at it on the basis described under Rule One above: as a deliberate expenditure for your own needs or desires, not as an investment. If you can justify it in your own mind on that basis, go ahead; otherwise, forget it.

The only alternative I can foresee to the economic contraction predicted in this article would be a mere postponement of this inevitability by means of an intervening period of runaway inflation. The above rules should serve well in this eventuality also, for the end result would be the same only worse. Runaway inflation would surely destroy the mortgage market. New construction would grind to a virtual halt. Valuations of developed real estate would no doubt increase for a while along with everything else, but few people would profit. A small minority of exceptional properties would probably stay ahead of inflation, but the vast majority would not. In view of the illiquid nature of real estate it would be extremely difficult to ride the wave of inflationary valuations and then exit before the runaway inflation turned to collapse.

Real estate has been an excellent investment vehicle at many times in the past. It will be again at some time in the future—but not in the years immediately ahead.

Edmund Contoski has held various positions with several land development/home building companies and urban consulting firms, including: Director of Planning and Development, The Kennedy Company; Director of Planning, E.A. Hickok & Associates; Planning and Research Manager, Unimod Division, Pemtom, Inc.; and Senior Planner, Nason, Law, Wehrman & Knight, Inc. Mr. Contoski is also the author of the book THE MANIFESTO OF INDIVIDUALISM.

NOTES AND REFERENCES

[1] Jane Jacobs, THE DEATH AND LIFE OF GREAT AMERICAN CITIES (Random House 1961) Vintage book edition, p. 18.
[2] "Corporate Giants that Soured on Real Estate," BUSINESS WEEK, Feb. 16, 1974, p. 18.