Yale’s Goetzmann on Real Estate in the 2000s and the 1920s

Yale Professor William Goetzmann draws a parallel between the commercial mortgage-backed securities of recent years,  and a real estate bond boom in the 1920s. A boom he argues led to the stock market crash of 1929.

“By nearly every measure,” he and his co-author notes, “real estate securities were as toxic in the 1930s as they are now.”

In an interesting paper from the National Bureau of Economic Research, he and  Frank Newman,  a former research assistant at the Yale School of Management, dig into the bonds that financed the greatest boom in the building of skyscrapers ever. In 1925, 23% of all corporate debt were these bonds. Nine years later, the entire class of investments had nearly vanished.

It’s a compelling example of how the markets move in cycles, and how economic history — both negative and positive — repeats itself.

The bonds, marketed heavily to individual investors, marked a departure from earlier years when companies built giants like the Woolworth Building in downtown Manhattan out of their own coffers and for their own use.  Economic optimism following World War I drove demand for office space, a rise in rents, and eventually a lot of speculative construction. To finance it, the switch was made to free market financing,  spawning a boom that financed most of the skyscrapers built in the 1920s, and eventually lead, the authors note, to overbuilding and eventually widespread vacancies.

“The present crisis is not the first time that the real estate securities market has expanded to the brink of collapse…Ultimately, the size, scope and complexity of the 1920s real estate market undermined its merits, causing a crash not unlike the one underpinning the nation’s current financial crisis, due in part to a commercial construction boom matched only in the mid-2000s,” they conclude. “These analyses allow us to conclude that publicly-issued real estate securities affected real construction activity in the 1920s and that the breakdown in their valuation, through the mechanism of the collateral cycle, may have led to the subsequent stock market crash of 1929-30.”

The boom was quite terrific, with more office buildings taller than 70 meters erected between 1922 and 1931 than in any other ten-year period before or since, according to the NBER’s writeup of the research.

The speculative construction meant building for the express purpose of maximizing rents in buildings with multiple tenants in order to turn a profit. Before that time, office buildings were financed and built by companies primarily for their own use.

In order to feed the demand for capital to finance construction, bond sellers courted retail investors, selling them shares in these commercial ventures as well as bonds backed by the properties — a precursor to the modern markets’ complex forms of securitization. Previously, only institutional investors, such as banks and insurance companies, were the sources of such funds.

Demand was such that a real estate securities exchange was created in 1929 and commercial mortgage-backed securities quickly grew into one of the largest classes of investment assets of the 1920s, raising more than $4.1 billion from 1,090 bond offerings between 1919 and 1931. Among the reasons for this rapid growth was the presence of small investors who, it turned out, relied on poorly supported assertions of asset value provided by a few large intermediaries in a market with little centralization or regulatory oversight.

The authors conclude that building companies viewed the public as a lender of last resort, yet courted retail investors, selling them bonds backed by their properties — “a precursor to the modern markets’ complex forms of securitization.”

Significantly widening yield spreads on real estate bonds versus Treasuries began in December 1928, nearly a year before the stock market collapsed in October 1929. By April 1933, bond prices fell to a low of 24.75 cents on the dollar. And by 1936, at least 80 percent of the outstanding securities issued between 1920 and 1929 were failing to meet their contracts, resulting in widespread defaults. Recoverable value on those same issues ranged from approximately 80 percent for 1920-vintage bonds to less than 40 percent for 1928-vintage bonds.

… The real estate bond market soon vanished, as did many of the bond houses that created them, among them many of the most trusted names on Wall Street. That was followed by public outrage over institutional corruption.

There is a familiar ring to it.

City of Chicago’s photo of 35 E. Wacker Drive, Chicago, built from 1925-27

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