Realty Bust Still Stalls the Economy

As we try to understand why the economy has not recovered faster from the present recession, we have to go back a decade and see just how badly the Investment Act of 1981 hurt sector after sector in a ripple effect.

The act itself was intended as a means of spurring plant and equipment construction. But its tax benefits for the wealthy steered its major impact to home, office, hotel, and shopping center construction.

Small investors -- often doctors, dentists, and money into the eager hands of developers in an effort to gain four-to-one or five-to-one writeoffs on their taxes.

With this flow of money and the funds that thrifts could obtain with the new $100,000 insurance ceiling and brokered deposits, builders were off to the races.

Who Needs Tenants?

Who cared if a project could find a buyer or tenants when the lenders were willing to provide 100% financing and more? And there were juicy up-front fees as well as management fees on top.

We built and built and built. We even reached the absurdity of promoters' selling co-ops in New York that were already occupied and for which there was no hope of removing the tenants. The gimmick: tax deductions.

So when Congress passed the Revenue Act of 1986, it was not a traitorist action against builders and developers, as so many claim, but rather an attempt to stop the building before we were so overloaded that it would take decades to put these buildings to work.

The Collapse Follows

But the damage was done. We ended up with far more supply of commercial and residential facilities than demand. And the result has been the well-understood collapse of real estate values, followed by the collapse of thrifts and then the damage that has been done to banks and insurance companies as well.

While all the above has been known for quite a while, what is happening now is that we are seeing the "ripple effect" of the decline in value. It pulled down the value of bank-financed properties, too, even though most bank loans were better structured and probably could have survived as performers had property values not plummeted in the entire environment.

The next ripple effect was on suburban rims or overbuilt cities. For as property values declined on downtown office buildings, they weakened the attractiveness of suburban alternatives until the suburban developers had to reduce their rates and prices, too.

Equally serious was the impact of the decline in real estate values on consumer attitudes.

The Census Bureau has reported that Americans are getting poorer rather than richer. Why did they keep spending until recently? Because they felt that they were richer as they saw the value of their homes rise. But once these home prices started to fall, they realized that they couldn't afford much of what they were spending, leading to problems for retailers.

And as if this were not enough, retailers saw the expansion of the bank credit card rob them of a basic source of income. For until the bank card took away the financing income, many retailers made more money from their credit operations than from their sales of goods.

Spending Patterns Changed

Add to this the fact that the popularization of the credit card has made possible shopping by phone, and throw in the growth of giant shopping warehouses that also help kill the income of local retailers, and you can see why shopping centers have joined office buildings and other commercial properties in the danger area for the banks and others who financed them.

And finally we have a vicious cycle: As banks and thrifts downsize to cut costs and fight back in the face of their heavy loan losses, they reduce further the need for the office buildings and shopping centers they have financed. And laid-off bank employees are not strong spenders at malls and shopping outlets in town.

Where are we headed? Some analysts believe it will be the end of the decade before we can use most of the facilities we financed in the 1980s - a discouraging thought indeed.

Maybe part of the answer will come from conversion of unneeded office properties into college facilities, replacements for outdated public buildings, and even converting unneeded office space into space for light manufacturing, just as we turned solid old factory buildings in some towns into attractive residential condos.

But unfortunately, much of our construction is in central cities, and more and more companies are deciding that even if the rent in the urban center is cut drastically, the fear factor, the disadvantage of commuting, and the desire for a better life-style make urban core properties unattractive for rental or purchase at any price.

So as we look back at the Investment Act of 1981 and its ever widening implications, we can think again and again of the old saying: Be careful what you wish for, for you may be cursed to get it.

Mr. Paul S. Nadler is a contributing editor of the American Banker and professor of finance at the Rutgers University Graduate School of Management.

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