REAL ESTATE VS. THE ECONOMY

Real estate may well be the biggest industry in Dallas,” says Edward L. McClelland, vice president and economist for RepublicBank Corp. “When you add up construction, brokerage services, management and related retail activity, the real estate sector probably accounts for one out of six jobs in the Metroplex.” Considering that the Dallas/Fort Worth area currently employs 1.7 million workers, that’s a lot of jobs.

With only minor sputtering, the Dallas real estate boom has been under way for nearly a decade. But the industry is now entering what is likely to be a long period of retrenchment. The existing inventory of unoccupied commercial and retail space, coupled with that planned or under construction, suggests the city is faced with an oversupply of property that may not be absorbed for six or seven years. Such an oversupply promises hard times ahead for commercial developers saddled with heavy debt and unleased space. In fact, many small developers who lack substantial reserves of cash may be forced out of business during the coming lean years.

Moreover, the growing supply of unleased property also spells trouble for banks and savings and loans that have invested heavily in commercial real estate development. At the end of the second quarter, for example, the earnings statement filed with the Securities and Exchange Commission by Dallas Federal Financial Corp. (now part of Bright Banc Savings Association) reported non-performing assets of nearly $60 million against total assets of $2.2 billion, a reflection principally of soured commercial real estate investments. Nor is residential real estate development particularly healthy. Figures released recently by Lomas and Nettleton indicate housing permits for the first six months of 1985 in Dallas/Fort Worth were down 21 percent from the same period last year despite the fect that mortgage interest rates have fallen, on average, by a little more than 1.5 percentage points since March. And figures made available by the Greater Dallas Board of Realtors, Inc., reveal that 12 percent fewer existing houses were sold in the Dallas area during July than in the same month last year. In addition, approximately 850 properties, mostly residential, were posted for foreclosure sale in September. Of course, Dallas’ real estate problems certainly are not unique. Texas is leading the nation in mortgage foreclosures this year, and in Houston, mortgage foreclosures currently exceed 1,000 per month.

Real estate economics vs. the economics of real estate: The widespread media coverage of Dallas’ overbuilding indicates clearly that real estate here is an important industry, as it is in most large cities. For the most part, real estate development owes its prominence to the vast sums of money that are usually involved in development projects; and the fact that real estate investments are often highly speculative only serves to intensify public curiosity. But real estate development also commands attention because it has become a metaphor for economic growth. Buildings, shopping centers and houses are widely perceived as tangible evidence of prosperity. This is a misleading perception, however, because it encourages a view of the real estate industry as a generator, rather than beneficiary, of economic growth, which is akin to suggesting that the real estate tail is wagging the economic dog.

Think of the Dallas economy, or any economy for that matter, as a pyramid; that is, as a successive layering of different industries, each one more dependent upon the stability of those beneath it. At the foundation of this economic pyramid lie basic industries, while closer to the top are the economy’s secondary and tertiary industries. A number of characteristics distinguish basic from secondary or tertiary industries. Ultimately, an economy’s basic industries are those that generate the bulk of the jobs and income to support secondary and tertiary industries. The strength or weakness of an economy’s basic industries will determine, to a large degree, the relative strength or weakness of its secondary or tertiary industries, although other factors that are nominally unrelated to the economy’s industrial structure may also exert an influence.

Dallas’ economic pyramid rests on a foundation of manufacturing industries that account, collectively, for 18 percent of the area’s total nonagricultural employment. Although the manufacturing sector ranks third behind trade and services in terms of its relative share of overall employment, its strong linkages to the other sectors of the economy-through a demand for materials and services as well as its workers’ comparatively higher wages-make it the primary stimulus to economic growth in Dallas. Real estate development, in contrast, is a secondary industry that depends principally on growth in manufacturing or in services and trade that are directly or indirectly manufacturing-dependent. Indeed, as alluded to above, much real estate development is undertaken on a speculative basis in anticipation of its absorption through growth of the other sectors of the economy. Frequently, of course, the development industry’s expectations for growth outpace actual growth, in which case real estate development appears to assume a life of its own and proceeds more rapidly than growth in the economy overall. Real estate development, in other words, is initially “demand-driven.” But as time passes and more players jump into the game in hopes of acquiring a piece of the action, supply eventually exceeds demand. “Supply-side” development has also been encouraged by the phenomenal amount of cash available as S&Ls, pension funds, insurance companies and foreign investors have plunged into commercial real estate over the past few years.

“We’ve seen this pattern before,” says David Little, president of David Little Real Estate, Inc., a Dallas-based commercial brokerage firm. “Every developer does a feasibility study that shows a need for additional office space. Then a dozen new projects are announced at about the same time. Money starts chasing deals, brokers and lenders become developers, and we wind up with overcapacity and lots of marginal projects.” A recent survey by Coldwell Banker that found Dallas behind only Houston nationally in vacant office space would seem to lend credence to Little’s observations.

Over the past year, employment growth in Dallas has slowed substantially and the number of unemployed has jumped 57 percent, bringing area unemployment to 4.9 percent. Many of Dallas’ basic industries, such as electronics and oil-field equipment, have been hard hit by overcapacity, the strong dollar and federal controls on the sales of U.S. products overseas, especially to the Soviet Union. Corporate relocations to the area have virtually ceased, and no new manufacturing plants have been announced. These developments don’t augur well for commercial and industrial leasing, not to mention retail and residential activity.

The Dallas real estate industry can only remain healthy if the undergirding economic base of the region remains strong and expansionary. Developers can’t survive by constructing and leasing buildings to each other. In the absence of real economic growth, office leasing simply becomes a game of musical chairs, with law firms and advertising agencies bouncing from one building to the next to take advantage of “free rent” and other inducements.

Trouble ahead: Will softness in the Dallas economy bring down the empty buildings and the developers too? In some cases, yes. According to John F. Eulich, chairman of the Vantage Companies, only those developers with the greatest staying power and deepest pockets will remain in the game after the dust has settled. “Many of the new breed of developers will experience severe indigestion,” says Eulich, “and the old pros will find their newer projects less remunerative than forecast originally because of this oversupply.” Echoes David Little: “In the 18 years I’ve been involved with commercial real estate in Dallas, I’ve never seen the market so glutted. But we’re fortunate in having some quality people in the development business, and they’ll still be around after the amateurs have been burned.”

The most serious problems are likely to be faced by the banks, S&Ls and other financial institutions who have been underwriting much of the new commercial construction. Indeed, some industry observers expect non-performing real estate loans to become just as troublesome as non-performing energy loans.

Residential woes: For years, Dallas/Fort Worth has been the hottest single-family housing market in the nation. Even though permits are down over 20 percent this year, Dallas is still ahead of all other major metropolitan areas in the number of units under construction. But an ominous overhang of inventory is building because Dallas’ population and employment growth have slowed markedly over the past year, a reflection of recent changes in the basic demographics of the area.

During the Seventies and early Eighties, migrants flocked into Dallas/Fort Worth. The explosion in energy and electronics, coupled with the general allure of the Sunbelt, attracted workers from the Frostbelt, where economic conditions were far less rosy. As the economy of the Northeast and Midwest has improved in recent years, in-migration to the Sunbelt has slowed, and most forecasts point to a further diminution of in-migration for the next decade. And as the population has aged, there’s less mobility because older folks don’t move around as much as younger folks, Miami Beach migrations notwithstanding. Thus, the overall demand for housing in Dallas can be expected to drop at a steady rate for some time.

Unfortunately, many of Dallas’ residential developers have been slow to recognize these basic facts of demographic life. According to M/PF Research, Inc., there are nearly 11,000 unoccupied new homes on the Dallas market right now. A year ago, 9,554 new homes were unsold or under construction. More telling figures come from the Greater Dallas Board of Realtors. At present, about 25,000 homes are listed through the Multiple Listing Service, 8,000 more than a year ago and the largest number ever. Even with closings averaging more than 2,000 per month during the peak summer sales period, the Dallas metropolitan area appears to have a huge inventory of unsold homes.

Where will it all end? As we have seen, the demand for real estate is driven principally by the pace of development in the economy’s basic industries. The health of secondary industries, such as real estate, depends mostly on the health of basic industries, not vice-versa. But, as was acknowledged earlier, other factors that are unrelated to the economy’s industrial structure may also come into play. This relatively minor caveat is resurrected simply because it may help to explain the psychology of supply-driven real estate development. In other words, while the data demonstrate conclusively that the economy’s ability to sustain rapid real estate development has faltered, they do not explain why such development continued long after it should have become evident to investors that something was amiss.

If the current oversupply of commercial real estate properties were to be absorbed considerably sooner than six or seven years from now, or if such development were being undertaken mainly by large developers with sufficient cash reserves and a proven ability to weather recessions in their industry, the psychology of Dallas’ supply-side development could be explained in terms of a willingness to bear risks in the short term in return for considerable gains in the longer term. The real answer, however, is probably found in the willingness of savings and loans to invest money in an industry where they have had little experience or knowledge. Since receiving broadened authority from state and federal agencies to become involved in commercial real estate, S&Ls have invested billions of dollars in development projects. Much of this money has found its way into the riskiest projects such as speculative office buildings. S&Ls have often shouldered most of the risk, frequently not requiring any cash from the developer. Enormous quantities of money were made available to builders of all stripes who, bearing little of the risk, weren’t terribly concerned with the laws of supply and demand.

The slowing economy, both in Dallas and the rest of Texas, coupled with the unprecedented availability of money for real estate development, left the industry and some financial institutions in shaky condition. Indeed, given the prospect of continued slow growth in the economy, the real estate industry’s problems are likely to worsen before they improve. And times will become even tighter for the over-exposed S&Ls, who, in the words of a well-known member of Dallas’ financial community, are “already as bare-assed as a nudist in a twister.”

The shakeout is coming, but the qualitydevelopers and financial institutions willsurvive and thrive. Dallas’ long-term economic outlook, in view of the area’s diversity, remains positive despite the currenteconomic slowdown. Though real propertyprices have dropped somewhat in recentmonths, land values and prices have remained high, suggesting that “the market”still considers the Dallas area a desirablelocation for the long term. After the bubblebursts, the brokers and bankers will go backto brokering and banking, the S&Ls willclean up their balance sheets, Dallas’ officeleases and home prices will once again become competitive, and some semblance ofrationality will return to the real estateindustry.