During the last bubble in real estate, I remember speaking
with a number of my fellow industry veterans about the dangers of an
overheating market. We all had experienced past recessions in the overall
economy and the industry in particular. Uniformly, the response was: “It’s a
whole different economy this time around. The basic rules have changed.” I’m
not sure what they may have been smoking at the time, but, as we all know now,
nothing really had changed. Once again, we found out the hard way that there’s
truth in the old saw, “The more things change, the more they stay the same”.
No, this isn’t a warning that the market once again has
overheated. Personally, I believe we still have a way to go before that
happens. For example, financing projects is still challenging. Deals actually
have to make sense economically. Lenders haven’t yet started soliciting
developers to borrow more money than the project will cost. And, barbers, beauticians,
and valets haven’t started flipping pre-constructed condos at a 10% to 20%
mark-up. So the current market still appears to have a lot of legs.
But there is something different this time around. In past
recoveries, investors and developers quickly picked all the low-hanging fruit.
Then, as the demand for developable sites escalated, they began making offers
on the not-so-easy-pickin’s. They seemed to realize that the growing demand
would justify stepping up their games if they wanted to be in a position to
supply that demand. Yes, eventually, they (all of us, really) got caught up in
the feeding frenzy and began to throw money into deals that made economic sense
only with the continuation of the hyper inflated market of the day. We all were
desperate to acquire land to meet the expected demands of the market. We now
know, of course, that we should have spent less time hyperventilating over our
anticipated profits and more time calmly studying the underpinnings of that
surging market.
Again, this is not an admonition that the end is at hand and
we need to pull back sharply. To the contrary, absent some economic shock
brought on by the political incompetence currently raging on both sides of the
aisle, or other unforeseen factors, the market for development in certain areas
appears to be quite healthy. Southwest Florida, for example, is booming. Where
we only recently had an 88-month inventory of housing, we now have less that one-month’s
supply. A recent article in the local newspaper noted that the median home
price in Naples was $538,000. In the depths of the recession, it was closer to
half that figure.
Commercial, as we all know, follows residential. So it’s no
surprise that the commercial market also is showing signs of recovery. It's in the commercial sector that I detect a distinct difference this time
around. In the past, the market followed a certain process. Sellers asked a specific
price for a property. Buyers, with a specific project in mind, calculated its
end value then subtracted the costs of developing it and their profit margin (based
on a desired rate of return) to arrive at the cost of the land. This is a
simplified statement of a residual land value calculation. Based on this, the
developer knew what the land’s value was for the project in mind. If it was
well below the asking price, the developer worked to structure the deal to
achieve the desired return and get it closer to the asking price. The next step
was to make an offer based on that price and structure. Today, this offer
probably is in the form of an LOI. If the seller countered, which was not
unusual, the developer met with the seller and they worked out a modified price
and structure that got both parties what they wanted from the deal. When it
comes to real estate investment, there have always been two irrefutable
variables for achieving the desired return—price and structure (terms).
That’s what’s not
happening today. The low-hanging fruit is gone in areas that have strong markets. Landowners
are not pressed to sell. While most of them will negotiate, they don’t need to sell at
distress prices. Prospective buyers from outside this area don’t seem to
realize that. Often, they appear to lack familiarity with the local market (and ALL real estate is local) and apply
factors based on their home markets. That unfamiliarity also causes them to
undervalue property based on their undervaluation of the potential income
stream. The bottom line: they let the asking prices scare them away.
The solution is simple. Do it the old fashioned way. Suck it up, do your homework and make an
offer based on how the deal pencils out for you. When the seller counters, sit
down and negotiate a price and structure that works for both sides.
