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Defining the New Normal Relative to Real Estate

As The Economist put it recently, the phrase “new normal” is usually used to explain the persistence of underwhelming economic data. Certainly we have had that in most every expression of recovery numbers such as with the still high unemployment level or the rate of new job growth. I believe that the suggestion of a “new normal” is much more than that. In fact, what is new about normal I believe will transgress the very fabric of our society, including our politics, our fiscal budgets, our people, our businesses and our psyches.

Now that the economy is turning some kind of a corner, I thought it would be interesting to reflect on how the “new normal” impacts the real estate and finance sector. Here are some ideas, roughly divided by category:

Shrinking Investment Returns

The notion of “Return on Investment” has been turned on its head and the new normal is lower return. It is generally now understood in investment circles, certainly in real estate deals but not exclusively, that “acceptable” investment returns have been cut roughly in half. This essentially means that many, many investors will expose themselves to the same level of risk for one-half the return, be it an investment in an existing income property or even in real estate development, where risk is notoriously high, as is the return. Ten percent return in an investment is the “old” 20 percent. It has to be this way because most deals require more equity (see mortgages). When an investor has more equity (and less debt) it is simply about math that the return must go down.

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More Money Down

The new normal in mortgages — both commercial and residential — is that they will be harder to get and less money will be loaned. It is much more difficult to qualify for a mortgage. While this may change as lenders ease their requirements in line with a more comfortable economic outlook, they certainly will never go back to the “if you can fog a mirror you can get a loan” days that gave rise to the subprime mortgage debacle. The other aspect of this is that the old loan-to-value ratios where you could borrow all or most of the money with little equity or money down are gone. On all mortgages, be they residential or commercial, you are going to be required to have more “skin in the game,” meaning, your own money at risk in the deal, not just the lenders’.

Homes Will Be Smaller

The new normal in residential is that we will be building and ultimately living in smaller homes, mostly condos and apartments, and we will pay more for the privilege. The notion of both house size and housing type is going to change dramatically, particularly in the western coastal markets like San Diego. Simply put, to make financial sense to build, developers have to squeeze out more revenue per unit. One way to accomplish this is to raise prices. But there will be new upper limits in their ability to accomplish that in an economy replete with lower paying jobs. The only other choice to make projects feasible to develop is to lower the size of housing units and charge higher revenue per square foot. This will be happening regardless of whether it is a rental or a for-sale unit.

A Kaleidoscope of People

The new normal here is that our nation is marching toward a race neutral society such that the demographics of who we are will matter less as a standard or measurement of how and what we buy. We have been receiving a steady stream of census data, the most interesting of which is that Hispanics whom we have long known were the largest growing segment of the nation’s population — have overtaken whites and blacks as pluralities in California and other places. This is both due to their large immigration numbers, high number of young adults having children, and larger family sizes.

These numbers mean nothing from a practical perspective. I suspect that Hispanics will continue to blend with other races as the U.S. marches toward an effectively “race-less” society as the century unfolds. What they buy, where they live and how they think will become indistinguishable from other demographic groups. America has always been a melting pot. Yet, as people settle here, they aspire to be and do the same, blending as a people. As a precursor to what I am talking about, look to Brazil: here is a nation of 49 different colors, where races blended much earlier than here in the U.S.

Different shades, same dreams.

Servers Replace File Cabinets

The new normal in the commercial office sector is a smaller personal office space, less leased company space, in new locations and performing different functions. The need for office space will change. It certainly will not go away, but there are both social and technological changes that are altering the workspace. One is that companies and people have more choices in where and how they work. They no longer have to be in concentrated working environments because of the incredible technologies recently available to communicate — e-mail, Skype, social networking, etc. Also, many businesses are not tied to geography and can locate in remote places, far from the central business district. Most of the office development of the past two decades has been in the suburbs. Many of those businesses can be in the mountains for all that it matters.

And technology plays a huge role in how much space is actually needed. I have addressed this many times, but it is quite evident that hard drives (and soon the “cloud”) have replaced file cabinets. Software replaces some jobs. This equates to fewer space requirements for companies. It is an evolving trend that will continue.

Brick and Mortar Retail to Diminish

The “new normal” in retailing is that consumers may spend less, and those purchases will be more often made on the Internet, which will cut an ever-increasing slice into the consumer pie. Coming out of the recession, the nation’s retailers are hard-pressed to find solutions for lower consumer spending, high costs of brick-and-mortar space rent and the continuing onslaught of market share from Internet retailers. Look for these retailers to continue to compress the size of their stores (warehousing excess merchandise in former industrial space), and continue to “drive” their customers to their Web sites. Even retailers with failed business strategies — e.g. Borders and Blockbuster — continue to trade in their virtual space while closing down their “real” space.

Old Industrial Is the New Retail

The new normal in the industrial sector involves a sharing of functions. What used to be the exclusive domain of manufacturing, has now morphed into an ever-increasing devotion of space to warehousing. Much of this supports the trends in the retailing sector. Manufacturing itself is evolving to be less people-intensive through technology and robotics. Hence, the industrial market is much more stable than the other real estate sectors because it has accommodated the changes associated with the “new normal” much more adeptly than their brethren.

Brokers Are Specialists

The new normal in the business of real estate is that fees and percentages will go down as the availability to services and self-serve become the rule. I do not know how commission rates are going to shake out over the coming years. But here is what I suspect: there are many, many fewer transaction “middlemen” in either the residential or commercial sector. The recession cleared out the overpopulation of brokers and agents. During the last five years it has been a matter of “survival of the fittest” and there has been a large weeding out process of those who actually can make a living, much less prosper as transaction middlemen.

There will always be a role for brokers, but that role is both diminishing and changing. The prolific availability of information and data in open forums has effectively taken out their competitive advantage. Mostly, they are being reduced to a “luxury” or specialty function. One clue is in the travel industry: while travel agents still exist, their prime function is no longer to service the everyday, easy trip. Rather, they mostly specialize in luxury vacations or complex business trips.

So, too, will go commission rates. It is implausible that most commissionable events will be tied to the traditional, high 6 percent level. They will go lower in most transactions and be negotiable in all.

Life changes — and the life changing economic event we now dub the “Great Recession” — have catalyzed these changes. The focus for all with a stake in the real property sector is to recognize those changes, adapt to them in both your mind-set as well as the services which you provide, discovering the new opportunities that arise from the change. That will be your “new normal.”

Gary H. London is president of The London Group Realty Advisors, which provides real estate consulting and economic analysis. Check him out on the Web at londongroup.com.

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