CRE Opinion

This is How to Survive a Market Correction

Almost 50 Years in commercial real estate, Younger Partners' Sam Kartalis says this about coronavirus: All bets are off. This too shall pass.

After a career in the U.S. Navy and years of working in management as a salaried employee, I had never experienced the impact the state of the economy could have on my career. Before joining the commercial real estate world, my last corporate appointment was as general manager of Westinghouse’s Elevator Division of South America, officing in Caracas, Venezuela. Little did I know that my next career move would lead me to change my life.

When I first arrived in Dallas in 1972 as general manager of Westinghouse’s Elevator Division, my first thought was that I had never been west of the Mississippi. But, my boss gave me a great piece of advice: “Sam, everyone we send to Dallas never wants to leave.” He was right.

My first assignment in Dallas was to build a new office/warehouse.

Sam Kartalis

The best bid for the building was the Henry S. Miller Company, who I hired to do the job. During the time it took to build the facilities, I met and became friends with many of the brokers working for HSM. Immediately, I noticed their sharp suits and ties, alligator shoes, and their fancy Lincoln Mark IV cars. I also noticed that they were making much more than my annual salary.

My First Correction: The Greater Fool Theory

They introduced me to Henry S. Miller, Jr., who convinced me that my background and training could be better applied at the Miller company. Herb Weitzman hired me in April 1974 with a base salary and a bonus that would double what I was getting paid at the elevator company. Unfortunately, that first year, I only made that base salary, which was half what I had been making before. That was my introduction to the fluctuating world of being an independent contractor and the first correction.

It was also my initiation into the world of corrections, which started in May of that same year. The company was coming off a few strong years of business created by the announcement of the upcoming DFW International Airport, which had created a mad dash by speculators to tie up as much land as possible in and around the airport.

Aerial photograph of the Dallas-Fort Worth Regional Airport shortly after completion. (provided by Tarrant County College NE, Heritage Room)

That’s when I learned all about land syndications and wraps.

The HSM company was always an active and successful partner in land deals, both as a broker and investor. Our clients would join us in a syndicated partnership for buying land parcels by paying landowners a percentage of the total cost, say 25 to 50 percent, and then having the farmer/owner finance the remainder. The new owner would now pay interest only on the outstanding loan and hope for a sale at a higher cost to the next hyped-up buyer who would assume responsibility for the note. The next buyer would make a down payment to the new buyer and assume the original note; they would wrap the original note.

Confused? Each new buyer made money on the downpayment to the old buyer based upon the increased cost of the land. The original note doesn’t change; the new buyer wraps it and assumes the responsibility to pay it off.

This could happen many times by speculators assuming the property would keep increasing in value. This is known as the greater fool theory. If the property didn’t sell when expected, the syndication ran out of money, and desperation set in. When the last fool could not make the interest payments, they defaulted to the prior owners who couldn’t make the interest payments and on down the line to the original buyer who didn’t want the property, the last cardholder. All of the buyers had already booked a profit and couldn’t afford to pay off the note; they never expected to. So the farmer/owner would foreclose and get his land back, having made a nice profit from the down payment. It was a house of cards. The buyers/partners who put up the equity to the note all lost their money.

The winners of this airport hysteria were the original landowners who benefited from the substantial down payment and the return of their land; imagine. The company survived the run on cash and continued to be successful and eventually was sold to Grubb and Ellis at a price very beneficial to all of us at the company. I survived my first correction.

My Second Correction: The Robber Barons

The second large correction occurred in the late 1980s right around 1986. This was the result of the U.S. government easing restrictions on banks and savings and loan associations (i.e., S&Ls). The S&Ls, which focused on making boring residential loans, was now attractive to new ownership, which included some questionable characters) who were very interested in speculative ventures.

The change in banking regulations created a storm of questionable lending practices where commercial banks were lending monies with little, if any, equity, and the S&Ls were lending more than 100 percent of the cost in some instances, with no liability. This was a period for the robber barons (look it up if you don’t know the term, you’ll be glad you did) in the S&Ls. They would generate false profits in collusion with other financial friendly institutions, which included lending to developers who neither had the financial capability nor the expertise to develop an excess of poorly planned properties.

Millions of tons of concrete were used to develop properties with built-in structural problems, poor designs, no pre-leasing requirements, and no tenants. Here again, the S&Ls became a house of cards–fraud was prevalent. Developers had no financial responsibility and were walking away from projects, while the banks started failing one after another.

The Feds had to come in to save the banking structure of the U.S. by creating the Resolution Trust Corporation (RTC) to take over the failing banks and S&Ls.

The RTC gained control of the banks and all of the failed properties that had been foreclosed. Many of the people involved with the banks and the properties who stretched and tested the rules and regulations were sued, and many were sent to prison. Most of the properties were auctioned off for pennies on the dollar and proved to be suitable investments for new, well-financed buyers who held and managed the properties and later sold them for significant profits. The banks were rescued and now in the hands of responsible ownership and under substantial regulations.

Coincidentally, my partner and I had left the Miller company to start a development/brokerage company at that time.

We were traditional, conservative developers of shopping centers who did not borrow money from the S&Ls, but, alas, like so many other conventional, honest developers, we were critically affected by the bank virus. The entire country was infected, and many suffered financially, including many of my friends and associates. However, most of us survived started over again, and did well.

It took a few years, but we recovered from 1986 and had only a few minor blips until 2007. In general, times were excellent, and we were growing and profiting. Late in 2007, I benefited from the sale of a large portfolio of properties I partnered in, which luckily helped me prepare for what was coming.

In 1994, Robert Grunnah and I were involved in the re-start of the Henry S. Miller Cos. by partnering with our good friend, Vance Miller, who had been CEO of HSM during the Grubb and Ellis purchase. The Grubb and Ellis restrictions regarding the name had expired, and many of the ex-Miller people wanted to come back; they did, and we were doing well.

My Third Correction: The Great Recession

I remember with great clarity how I realized that we were in for a huge change in our lives while enjoying a good business year and planning for a few more good years.

We expected January 2008 to be a great month for us in brokerage, mainly because we were planning to close two mega deals of development land to two well-known, successful developers. During the first week of 2008, these two developers advised us that they were terminating their separate contracts and walking away from their earnest money deposits.

Canceling contracts is somewhat familiar, but one forfeited deposit was $600,000, and the other was $700,000. Unfortunately, our fees were also substantial, and there went my year. I remember meeting with our board and delivering the shock of what had transpired. Imagine walking away from $1.3 million.

That was the beginning of the next correction: the Great Recession in 2008. This one hit us like a Category 5 hurricane. Everyone refers to it as a recession, but to me, it was much stronger and more like a depression. In reviewing our book of business, we realized that another recession was in our midst, resulting from another house of cards created again by our Washington leadership.

During the years leading up to this correction, the government made it easier for citizens to buy homes. There is nothing wrong with that except that the government made it too easy to buy homes by those who could not afford them. Once again, banks were lending, too many homes were being built, and too much land was being purchased for development. Prices were being driven up; everyone was getting into the game, fraud was rampant, and, to no one’s surprise, homeowners began walking away from their mortgages in droves; they couldn’t afford to pay for their homes.

Welcome to the housing bubble of 2008 and subprime mortgages.

Subprime means lending to folks whose financials typically don’t qualify for normal mortgages. Figure that out. Once again, the banks are involved in having made all of those bad loans, and now there was no money to lend to all of the other business owners, or the money became very expensive. So, guess what? The house of cards began to collapse. Homeowners were defaulting on their loans; banks were foreclosing on their homes, no more land was needed for development, developers were giving their properties back to the banks, and so on.

This one hurt. It affected everyone’s cash flow and profits. I’ve read about the Great Depression and decided that 2008 through 2011 was a depression.

All things pass, and we have arrived on the back-end of a truly long period of abundance and good fortune. Business is good, the banks are in good shape, the stock market reaches new highs every day, everyone is working, and wham; here comes the coronavirus. All bets are off. This too shall pass.

After more than 40 years in the business, I feel like a corrections veteran. Stay tuned to see how we handle this new threat.

Sam Kartalis is a broker at Dallas-based Younger Partners.

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