There has been a recent spate of books and articles declaring "The End" of various things that had, up to now, seemed likely to continue indefinitely. The first was The End of History by a political scientist, and another was The End of Work by an economist. (I believe both these books were fundamentally wrong in declaring those respective elements over.) More recently, Christopher Leinberger has declared "The End of Real Estate." Has real estate really ended? Or is he exaggerating trends that have recently appeared and are likely to get bigger, but will not really end anything whatsoever?
The End of Real Estate
This is the title of an article recently published by Christopher Leinberger in the Robert Charles Lessor & Co. newsletter. Leinberger argues that most project-oriented activities, especially development, now undertaken under the under the term "real estate" will be transformed into process-oriented activities that can be securitized and financed through the stock market. This will occur to each type of such activity as soon as it produces the predictable cashflows that the stock market demands for success. Therefore, real estate as an industry will shift away from its past project-by-project orientation, which was managed by individual developers using money borrowed from financial institutions. This will change most commercial real estate properties into commodities, rather than unique parcels distinguished from each other by their specific locations and other traits.
Leinberger correctly points out that most commercial and industrial real property in the United States is not owned by developers or stock companies but by corporations which use that property in their day-to-day operations. He predicts that most of these corporate owners will get rid of their real estate equity. They will outsource their properties to professional management firms like Trammell Crow and others, who will take over those properties and go public. Thus, the market power within the real estate industry will be transferred from developers, who wielded it in the past, to property and asset managers. Developers will become second-class citizens who only create new projects on the orders of users or asset managers. When all this corporate property is transferred to professional management firms, they will constitute a major industry in themselves. It will have an annual cashflow of $105 billion to $150 billion - more than that of the entire aerospace and defense industry. This new management industry will have a capitalized value of $168 billion to $240 billion. It will consist almost entirely of firms that have gone public in the stock markets.
Because of these massive changes, real estate will no longer be an industry separate from other industries financed through the stock market today. It will operate with standardized information flows, and nearly all its practitioners will be nationwide firms with public stock. Leinberger implies that this will be a great benefit to one and all - except developers.
Will the real estate industry really "end"?
How realistic is this scenario of dramatic change? Much as I admire my friend Chris Leinberger, for several reasons I believe he has exaggerated an important trend into a complete revolution far beyond what will actually happen. First, many corporate owners of real property will decide to profit from better managing it themselves, rather than outsourcing it. Leinberger uses the example of information management by outsiders to argue that most large corporations are outsourcing all but their own core functions. But most large corporations are building internal capabilities for handling information and computers, rather than outsourcing those vital functions. They realize that the relationship between information flows and their core businesses is so basic to their future that they must internalize it, rather than entrusting it to others. In the same way, many firms will retain control over their real estate but manage it in a more rationalized and profitable manner than in the past. That will keep the professional property ownership and management business from becoming nearly as large as he predicts, though it will undoubtedly become larger than it is now.
The second reason I believe he is exaggerating is that securitized financing of real estate has several disadvantages in comparison with traditional project-by-project financing. If real property is securitized in the form of real estate investment trusts (REITs), the trusts' operators must pay out most of their cashflow and profits to stockholders, rather than retaining those funds for reinvestment in expansion. To grow, they often must use other sources of finance, such as borrowing on mortgages against individual properties or cross-collateralized properties. The other major securitized form for real estate consists of commercial mortgage-backed securities - bonds divided into different tranches and backed by pools of commercial mortgages. Annual volumes of such securities have been steadily rising and will probably rise more in the future. However, the trading market in these securities is still relatively weak. Therefore, the liquidity sought by pension funds stung by real property value declines in the early-1990s is by no means assured by such instruments.
Moreover, Leinberger implicitly assumes that the stock market will continue to rise without major interruptions in the future, presumably because it has done so for the past 14 years. But there have been long periods in the not-so-distant past when it did not rise at all - in fact, its real value fell drastically. In the 1960s and 1970s, real properties financed in the traditional manner outperformed REITs and stocks generally by immense margins. Those were periods of notable inflation too, and real estate was a far better hedge against inflation than were stocks. True, those conditions do not prevail today, but they could return, especially if inflation accelerates and we gradually work through our current surpluses of commercial space. It is tempting, but unrealistic, to think that the economic conditions that spawned the recent explosion of the REIT industry will somehow become universal and permanent.
Another important fact is that many types of commercial property do not have large economies of scale gradually forcing them into the hands of owners controlling huge amounts of property. This is true of most apartments, small shopping centers, localized office space, and relatively small industrial and warehouse properties. It is less true of regional malls, major hotels and motels and large office buildings. But the former categories contain immense amounts of space across the nation still held by relatively small-scale owners. Most of those properties are not likely to become securitized or converted into national chains anytime soon. They provide services to users that will compete quite handily against any similar services offered by large national corporations.
My final argument with Chris Leinberger is that real properties are not, and never will be, strictly commodities, because they have specific locations in space that differentiate them from each other. A commodity is something like wheat or coffee that is totally standardized - it is impossible to tell one grain or bushel from another. But even a McDonald's restaurant has a specific location that makes it perform differently from many other McDonald's outlets. Therefore, the owner or operator of each real property has to exercise specific judgments to market it successfully. Those judgments must be based in part upon particular knowledge of the local market concerned. This means that small-scale, local or regional operators of many types of real Properties, including operators who first create those properties and then own and manage them, can develop particular market knowledge and skills that make them highly competitive with national chains.
Moreover, they can obtain project-oriented financing from institutions like banks and insurance companies which need to place debt funds at relatively high interest rates. Therefore, small-scale developer-owners are not obsolete. In fact, they will remain quite healthy concerning those types of operations that have weak economies of scale. It will not pay such owners to convert to stock companies because of the many remaining advantages of direct real estate ownership, including tax shelter and the ability to leverage heavily and pay off that debt fully through amortization.
It is quite natural for observers who detect some important new social trend to leap to the conclusion that it is going to revolutionize all past relationships in the sphere of activity involved. Such a leap both increases the apparent importance of their finding and attracts more attention to their brilliance and foresight. In fact, in our media-saturated society, it is often necessary to grossly exaggerate any new idea in order to get anyone to pay any attention to it whatsoever. That is why politicians so often inflate the likely effectiveness of whatever policies they are espousing. In the long run, however, it is wiser to try to place any such new trend in a broader and more realistic perspective that recognizes its limitations. Therefore, although Chris Leinberger has provided us with useful and thought-provoking insights, the future of real estate will not be anywhere nearly as revolutionary as he has predicted.
Anthony Downs is senior fellow at the Brookings Institution, Washington, D.C. The views in this article are those of the author and not necessarily those of officers, trustees or other staff members of the Brookings Institution.