The Future of Development
With Investment Advisor Randhir Sahni
How will the subprime fallout affect the current generation of developers?
First we should ask, "What is the typical developer's goal when he gets into the business?" His goal is to make the most money in the least amount of time, and have minimal risk.
When the stars align and market demand and money supply are both high, interest rates dip. And when low interest rates emerge, the buyer sees "affordability." The demand for housing is always there?it's affordability that isn't. When the developer anticipates the onset of those conditions contributing to affordability, he begins the development/building process.
How does the cycle end?
It ends with the cost of long-term money rising, causing supply to shrink, or when the Fed raises the rate, tightening supply. When that happens, the developer backs off from the resulting exposure and risk. When he comes to that point, he has either achieved his financial goals for the effort, or he has not. If he has, then chances are that he will move on, rather than wait for the next seven- to 10-year cycle.
The people at the head of these firms have incentives including performance clauses in their contracts?a highly attractive perk in the present market situation and changing economic conditions. If the developer started with virtually nothing and now has a few million in cashable equity coming to him if he leaves, he certainly attempts to retire.
You can look at history and see that this is a cyclical trend, and the examples are plentiful. Crescent Realty, for instance, invested in numerous properties around the country. Two months ago, Crescent Realty's major shareholders, including Richard Rainwater, sold their positions to Morgan Stanley and got out.
As a general rule then, developers will be in the game as long as it's clear to them they can make money. When they see the market trending away from that, they'll retire or move on, take the money and go do something else.
In 1986, Congress' tax law accelerated many such retirements. When they changed the law in terms of what returns and tax breaks one could expect, the oil companies got out of that industry in a hurry?a lot of property was sold or repositioned with modified ownership.
Now we're seeing the subprime lending situation accelerate a new wave of retirements. The common element is cost and money availability. When the profits decline, for whatever reason, people move on.
How will this trend change developers' view of real estate and their expectations?
If their future goals are to create family wealth, then they won't sell. People like that are not in the same game as most developers, who are trying to extract every penny by leasing everything at the maximum price and increasing the residual value of the improved property. They are interested in cash flow, causing residual property values to appreciate and then sell rather than holding property through economic and real estate cycles.
I think the question really becomes, "Will we see a new breed of developers enter the arena as a result of this?" And I think the answer is yes.
At the height of subprime lending, the sort of developer we saw was someone who was looking to turn a quick profit, and was able to offer "affordability" to the would-be homeowner because money was so inexpensive. That's not the case anymore, and we're seeing a mass exodus of those developers as well as, unfortunately, people from their homes.
The new breed of developers will be those who can bring some innovation to the table?something new to make homeownership a viable option for people who couldn't afford it before.
If you look at houses in some older areas, you'll see small, one-story wood structures, because that's all people could afford in the 1960s and early '70s when those houses were being built. We started to see a change in this model with the arrival of FHA, Fanny Mae and other methods of affordable financing, creations of a Congress with the goal to provide liquidity to the housing market.
As all these mechanisms came into place, that helped the housing industry become a major thrust. We started to see more houses with two, three or four bedrooms, larger bedrooms, kitchens that came with all the latest technology and air conditioners that were bigger. And the houses started to bloat. Interest rates came down and cost per month sank, so people began to buy bigger houses on the same housing budget.
And when you bought bigger houses, everything was bloated. There were developers like U.S. Homes (non-existent today) who were around in the 1980s and had introduced and mastered the assembly line technique of homebuilding. They had also gotten very good at building a certain sized house for a certain low price because they would go to manufacturers and say, "I'm going to build 5,000 houses in the next year. What price will you give me on your materials?" And they'd get the price they were after.
They'd reduced the cost but weren't innovative in understanding how people lived. That tendency continued as the cost of money and affordability shrank. Developers saw it didn't cost much more to build more house; but the return on a 2,000- to 3,000-square-foot house was substantial. House size began to change over a period of time.
You don't see this so much in small communities, but in large metropolitan areas, house size increased considerably and consistently.
Do you see that changing?
Yes. The bloating may go away?except for the unaffected upper strata?but in coming years, a majority of the housing stock may consist of smaller, energy-efficient houses. And as the dollar declines in value, materials coming from overseas will go up in cost, and people won't be able to afford the same house for the same amount of money.
This new breed of developer will be characterized as one with a new set of parameters perceived as necessary for profit. I suspect that we'll see things like densities going up for homes per acre, and square footage of rooms coming down. I would anticipate a reduction in amenities as well. For example, I think that the $1,200 washer/dryer combo installed in a tract home may be a thing of the past.
How has the crisis affected the confidence of lenders in backing development projects?
Severely, because banks making money are under scrutiny, and they aren't going to lend the way they used to. They will be more careful at lending as the standards have changed, including more fees and points, etc., to make sure there's enough money to cover any losses ? or any mistakes they make.
How do planned developments and master plans go out the window when the market changes and cash flow disappears?
Let's say you're a developer and, at the height of subprime lending, you could get $100,000 for a completed house. Well, now you can only get $80,000 because the interest rates have gone up and the buying power has shrunk. You can't produce the same house because you can't sell it, and this changes how you think. You come back to the drawing board and say, "Do we build smaller houses? Do we build on narrower lots?" About 35 percent of every development goes into roads and open space.
If you can increase the density, you get more return. In that case, the same amount of street and open space serves a greater number of houses, so your return goes up.
That's why the master planned communities keep their covenants very flexible. They want the option to come back and change the requirements over time in response to the market conditions.
What land ownership changes have occurred as a result?
Examples are too many to catalogue. What I think is more interesting is that a lot of overseas money has come and gone, and this happened before the dollar was weak. In the '80s, it was Japanese developers when the yen was strong. In the '90s, it was the oil barons that came and bought property all over the country. And now it's going to be the Chinese, Canadians and Indians. So, whoever has the money will come.
It's like going to Vegas and playing the dice, and when they lose, out they go.
According to Hindu philosophy, wealth is called Lakshmi, and it has the ability to make its possessor move in circles. Controlling one's resources is vital, or your wealth may end up managing you.
Randhir Sahni is president of Llewelyn-Davies Sahni, the Houston-based architectural, planning and design firm he has directed for nearly 30 years. In 1997, he became a Registered Investment Advisor and currently offers investment advisory services through Resource Horizons, Corp. His work in these two fields has given him an in-depth knowledge of the role of capital in development as well as a rare insight into some of the more far-reaching effects of subprime lending.
