Regulatory Drag – The Hidden Hand Restraining Growth
This is Part 11 of a multipart series, please see past posts for context – Part 1, 2, 3, 4, 5, 6, 7,8, 9 and 10. Visit JharrisPHD.com for all past articles, biographical information, and photography portfolio.
The Integral Role of Regulation in the Economy
The United States, as almost all advanced economies, relies on a complex web of regulatory apparatuses to guide and control much of the economy and the daily functions of businesses and personal lives. These regulatory systems are comprised of laws passed by federal and state legislatures, rules and regulations promulgated by government agencies, precedents and orders decided by judicial rulings, and even private self-regulatory groups such as trade associations (often endowed with quasi-governmental power). Thus, if regulatory systems are not functioning well, then it is logical that the economy will function inefficiently, not achieve maximum productivity, and suffer a range of unintended or undesirable consequences. Today, it is beyond obvious that the current regulatory apparatuses are ill-equipped and ill-suited for today’s fast paced, technology laden world; this misalignment will have interesting impacts on the real estate investment and development industries for decades to come.
Regulatory Drag – Outdated and Inflexible
The first source of regulatory drag stems from the fact that many of the key laws that govern commerce and other aspects of daily life and the economy are decades old. Further, many were passed before the invention of the internet for a world that was driven by conflict (think Cold War) and global interconnectivity (Globalization). Worse, the laws often lack the creative flexibility to change and adopt to new technologies, market opportunities, or the changing global landscapes; this inflexibility is only exacerbated by current and historical levels of political divisiveness. For example, here is quick list of laws that still govern major aspects of U.S. commerce:
Clayton Antirust Act of 1914 – Still governs business organization and monopoly power
Securities Act of 1933/Securities Exchange Act of 1934 – Still governs how investments are sold and regulates the ability to raise capital from the public
Investment Company Act of 1940 – Still governs the investment management business and many investment products like mutual funds
Communications Act of 1934 – Still governs the Federal Communications Commission and regulates broadcasters, phone lines, and even the internet
Comprehensive Environmental Response, Compensation, and Liability Act of 1980 – Last major piece of environmental legislation passed in the US (notwithstanding reauthorizations and minor amendments)
Yes, you read that correct, there is still a piece of legislation from 1934 that purports to regulate the internet (to the extent that it is regulated). There have of course been various modernization rules and laws passed, but many core parts of these laws are still in effect and those updates are equally outdated at rapid paces. The net result is businesses contort themselves to either comply with old laws, or commonly rely on “exemptions” that get carved out by the regulators and the courts.
The real estate industry frequently contorts itself around many of these laws; one example is the longstanding use of exceptions to the securities laws in raising money via private placements (this past blog post examines a recent modernization law). As globalization and technological innovation only accelerates, the impact of this form of regulatory drag will only get worse. Jurisdictions that fail to adapt will lose competitive advantage and with it jobs and capital. Real estate investors should factor this is capital allocation decisions.
Regulatory Drag – Excessively Complex and Management Intensive
Most laws and legislative acts require additional rule making and/or implementation and empowerment of government agencies. As such, the actual implementation of a given law can be far more painstaking, time-consuming, and complex than the law itself may lead one to believe. In the United States, the Federal Register maintains the Code of Federal Regulations (CFR) the comprehensive database of all regulations at the federal level. In 1950, the CFR contained 9,745 pages, this has ballooned to 185,434 at the end of 2018; that equates to a compound annual growth rate of 4.43%. Unfortunately, growing size and complexity of regulations can have multiplicative (potentially exponential) rather than additive effects as the new and additional regulations can have interactive effects with prior regulations (which can often have unresolved conflicts). Further, these federal regulations are in additional to state and local regulations and the regulations of any other country in which a firm must operate.
What is the impact on the business environment? Large corporations, often with multi-national presences, have a huge competitive advantage over small, medium, and upstart enterprises. The exception are firms that are so small (including sole proprietorships) they essentially avoid regulation due to de minimis tests. This has been a central force to the consolidation of many industries including media, banking, finance, and increasingly real estate enterprises. Size generates scale and power. This scale allows for better distribution of the costs of compliance as well as increased power in lobbying and political influence. Interestingly, the level of complexity and management intensity have created market inefficiencies that some very nimble and dynamic firms have managed to exploit; Uber and Lyft are perhaps the best example in recent years. These firms openly flaunted the violation of local laws, but their structure given their technology made enforcement practically impossible. Today, they have even been “legalized” in many jurisdictions. Once again, real estate investors will need to increasingly factor these forces in long term business planning and investment and development decision making.
Real Estate Investing and Developing in an Inefficient World
The sooner a firm’s managements and shareholders accept the realities of the world, the sooner it can exploit them for a long-term sustainable advantage. Real estate investors and developers are engaged in a business that is capital intensive, long-term by nature, and geographically limited; thus, it is overly sensitive to regulatory impacts on a relative basis. The first prescriptive recommendation is to score the regulatory risk of the cities and states in which a firm owns and/or develops; these risks are not universal and must be accounted for in underwriting. Secondly, the regulatory risk of the tenants and users of the assets owned should be assessed and measured as well. These analyses are highly dynamic and complex but are the reality of real estate investing and developing in today’s world. The final recommendation is to seek and find inefficiencies that can be exploited and used to one’s advantage. If there is once critique of many real estate firms that applies in this case, it is the lack of creativity and flexible thinking. The world will require greater levels of creativity and flexibility to deal with regulatory and other issues going forward.
Simplicity is the Solution
While it is beyond hope for massive regulatory reform anytime soon or ever in most people’s lifetime, it is worth discussing what we, as an industry, should advocate for when possible. That is simplicity and flexibility. It is impossible to pass a law today that will not be out of date tomorrow. Thus, simple laws that are driven on long standing principles are the most powerful. Finally, empowering the downline regulatory apparatuses with the flexibility to apply and interpret rules with a flexible eye for the future would be ideal. This would be a somewhat radical departure from current law making in the United States.
Further, its worth noting that government or general rule/law-based regulation is not needed when the consumer or market has little to no deficiencies in making intelligent decisions. A brief example, the taxi cab industry benefited from standardized systems and processes as the rider was at a huge disadvantage of power when they stepped into car. Uber and Lyft, by contrast, use the power of algorithms and the open flow of communication (the bilateral rating system) to offer a product that is far superior to traditional taxi cab service without the need of regulation. Thus, Uber/Lyft is far more in demand by market participants. Good regulation looks like a well refereed football game, the refs make the right calls and keep the game moving; they do not set the outcome or impede game play. These are the outcomes and reforms that should be the focus of advocacy.
Real estate investors and developers have been dealing with increasingly complex regulatory frameworks since the dawn of any living career today, that will not change. Unfortunately, the rate of change in technological innovation and globalization will make clashes with old and inefficient regulatory systems more prevalent and painful in the upcoming decade. Thus, investors and developers should plan for, analyze, and score these risks when assessing markets and properties. Failing to do so may lead to unexpected losses or diminutions of value in the future.