What Real Estate Can Teach Banking

There's a lot that banking can learn from the real estate industry. I still vividly recall the real estate driven recession in the early nineties. This was the environment I graduated into with a fresh, new architecture degree! There was no work around. Real estate had collapsed as a business and was dragging the rest of the economy down with it. Rampant speculation had led to massive over building. There was a glut of empty office space that could not be leased. Solid reputable builders and owners were destroyed and lenders lost billions.

Look at real estate in Canada now. It is probably one of the most open and transparent sectors that you can find. Long term investors such as pension funds and REITs have brought financial discipline to the industry. Buildings are bought and sold on verifiable financial metrics. Tenants lease space based on the expectation of accurate areas (which has contributed to Space Database growth!) and they expect landlords to justify and disclose all operating expenses. This stable sector is able to develop in close coordination with market demand. Our open and transparent market has become very attractive to foreign investors which has led to an inflow of capital and a stable rise in prices.

But it was not easy to get to this situation. Our biggest and boldest developers went bankrupt. The builders of all today's prestigious addresses in Toronto have been wiped out. The fallout included huge financial losses and a major recession, but in the end we have in Canada a mature, healthy and safe commercial real estate industry.

So what lessons can the banks learn from real estate?

The first lesson is that losses have to be taken to clean up the system. Failures have to happen for there to be a turn-around. In order for pension funds, foreign investors and REITs to reshape the real estate industry, the old developers had to be dismantled. In banking we must expect more firms like Bear Sterns to disappear. Protecting them will only extend the agony.

The second lesson is that reality will always catch up. In the late eighties, there seemed to be no limit for developers. New, big buildings were appearing at a furious pace. The problem was that the underlying economy was not growing at the same pace and there were not enough tenants for the space. Similarly today, finance has rushed ahead of the economy. According to The Economist, financial services companies in the U.S. accounted for around 40% of all corporate profits in 2006! This grew from a more reasonable 10% share in the early eighties. Just as there turned out to be no real tenants to pay for the new buildings in the eighties, so too now, it turns out that there are no real backers of the 'products' that banks have created.

The third lesson is that real value survives its creators. If you look at the skyline of Toronto, we still have the TD Centre, Scotia Plaza and BCE place. The builders are bankrupt, but what they created had real and lasting value. We are likely to benefit from what these developers created for another hundred years. What value does a company like Bear Sterns leave behind? Does securitization create value? Is it the concept or the implementation that was flawed? An industry that does not create, but only redistributes wealth is not sustainable and will hurt us all in the long run. If anything is to be salvaged, then banks have to figure out what elements of what they do create real value for society.