There is plenty of doom and gloom among real estate lawyers. Dennis Horn takes a contrarian position. He believes that as long as commercial real estate is trading at some price, there is an important role for real estate lawyers. As the economy improves, so will the commercial real estate sector.

This alert is comprised of excerpts from a chapter authored by Mr. Horn which was published in “Structuring Commercial Real Estate Transactions: Leading Lawyers on Facilitating Successful Deals and Contracts That Meet Client Needs (Inside the Minds)” (Aspatore Books 2011). The title of the chapter in the book is Are We Headed Into “Seven Fat Years”?: What Real Estate Lawyers Can Expect for the Future.

Introduction

What does the future hold for real estate lawyers? While the last three years have been pretty dismal, it appears that the real estate industry will emerge again along with the US economy. Real estate lawyers will be in the thick of it, although some of the work we now do will be commoditized and will pay less. Clients will continue to demand alternative fee arrangements and increasingly rapid communications with their lawyers. Lawyers who have a passion for sticks and bricks and the stomach to go through the booms and busts that define the real estate industry will have the opportunity to work with some of the brightest, most entrepreneurial clients in the country.

Understanding the Current Real Estate Market

Most of the United States is still under water in real estate, so the biggest trend we will see in coming years is the re-emergence of the market. Like the economy of biblical Egypt where seven fat years were followed by seven lean years, real estate has always been a cyclical industry. When interest rates are low and when the market anticipates inflation, commercial real estate is a good, stable investment. Since rents trend upward with inflation, real estate values also tend to rise. Similarly, since real estate is often heavily leveraged, the net operating income after debt service is typically stronger when a property is financed with low interest rate loans. Today, with oil prices through the roof, and food and commodity prices following, many believe that we are ripe for inflation. Interest rates are at historic lows and prices for commercial real estate have been reset at more sustainable levels after three years of recession. All of these factors combined will contribute to a strong real estate market in coming years.

As the recession wanes, demand for retail goods has increased. In fact, retail sales have increased by 7.9 percent from March 2010 to March 2011. In addition, the tightening home mortgage market has meant that people who might have purchased a house or condo with easy credit are now moving into apartments. Because of both of these trends, retail outlets are expanding and, at least in the Washington, D.C. market, developers are building apartment projects again. For example, Disney announced in May 2011 that it was adding forty new retail locations around the country. The Peterson Companies announced in the same month that it is building a 350,000-square-foot, $100 million outlet mall adjacent to its National Harbor development outside of Washington, D.C. These projects will generate construction and retail jobs.

The landscape is not completely positive. Lenders are still struggling to develop underwriting standards for new home mortgages that do not choke off the market. New federal laws will require stricter underwriting and more equity for new home purchases. Foreclosures are up in many parts of the country. The near demise of Fannie Mae and Freddie Mac means that the secondary mortgage market is in disarray. This will ultimately affect interest rates and loan terms, which will negatively affect the housing market. Banks are only slowly getting back into the business of real estate lending – especially for new development outside of the “hot” markets. Many willing workers are still unemployed or underemployed. Finally, gridlock in Congress undermines America’s financial stability. However, in many parts of the United States, the real estate market is slowly recovering.

Interest rates, inflation, and consumer trends will influence the real estate market in the short to medium term. Demographics and jobs are more important for the long term. Both factors favor growth in the commercial real estate market. Between 2000 and 2010, the US population grew by 9.7 percent. The strongest population growth was in the South and West. Metro areas grew twice as fast as the national rate of growth. Houston, Atlanta, Dallas - Fort Worth, Washington, D.C., and Miami (in that order) were the fastest growing metro areas.

The population of the United States is growing and more specifically, our young population is growing. This is largely due to immigration and the rising Hispanic population. Unlike places such as Japan, where the population is decreasing and getting older, the growing U.S. population will create and support growth in our economy. A growing population and a growing economy means that more housing, offices, and commercial real estate will be needed.

More jobs are also being created in the United States. The Washington Post reports that Indian outsourcing companies are moving back into the United States. One Indian-based outsourcing company, Aegis, expects to triple its US head count. According to the article, the “strategy is based on the old-fashioned idea of being close to your customers.” Also, “some U.S. companies don’t want sensitive customer data transmitted abroad. Others are tired of poor service, accents and crackling phone lines.” Just as important, the wage disparities between US workers and foreign workers is shrinking fast. Hal Sirkin of the Boston Consulting Group is quoted as saying: “Pay for factory workers in China, for example, soared by 69% between 2005 and 2010 ... Sometime around 2015, manufacturers will be indifferent between locating in America or China for production for consumption in America.” At the same time, US manufacturing wages are declining in some industries. One example of this trend is in automobile manufacture. Volkswagen announced that they are opening a new plant in Tennessee with average wages of $27 per hour compared to Ford’s average wages of $58 per hour.

The tragic effects of the horrific tsunami in Japan will likely help commercial real estate in the United States. Because of the tragedy, manufacturing plants in Japan will not be able to supply parts for manufacturing plants in the United States and American manufacturers will reconsider locating their parts supply far away from their customers. The Economist article notes that, “complex supply chains turn out to be riskier than many firms realized. When oil prices soar, transport grows dearer. When an epidemic such as SARS hits Asia or when an earthquake hits Japan, supply chains are disrupted.”

Conclusion

It seems that we are about to enter the “fat years” in the real estate cycle. We are not there yet, but the demographics are with us and the business cycles appear to be coming into line. America is experiencing a slow recovery, and as the economy becomes revitalized, so will the real estate market. For the past three years, buyers expected real estate prices to fall and sellers expected prices to rise. Lenders were not lending and no one was transacting business. Many commercial assets have been re-priced to the current market. Clients will make deals as long as property is priced to the market and loans are available. In the long term, real estate law is a great field for those with a passion for dealmaking and for seeing tangible results in brick and mortar from their legal work.