Why Real Estate Escaped the Recent Wave of ScandalsPublished: June 30, 2004 in Knowledge@Wharton
Peterson, who is now chairman and co-founder of The Blackstone Group, an investment and advisory services firm in New York City, finds that little has changed. Speaking last month at a meeting of the Samuel Zell and Robert Lurie Real Estate Center of the Wharton School, he delivered the keynote address, titled "Corporate Scandals: The Whys, The Whats, and What Can Be Done About It." Peterson's desire to clean up Corporate America continues; he is also co-chair of The Conference Board Commission on Public Trust and Private Enterprises, along with Treasury Secretary John Snow.
The public's trust in Corporate America may be scraping bottom these days, but many companies have stayed clear of the rogues' galleries. Unlike the boom of the 1980s, whose aftermath revealed a host of shady deals between real estate developers and unscrupulous S&L executives, publicly traded REITs have largely been untouched by the most recent scandals.
Sam Zell, chairman of Equity Group Investments of Chicago, believes REITs are likely to remain scandal-free. Answering a question from Wharton real estate professor Peter Linneman, who asked if "corporate governance in a 'real world' sense - not in an absolute sense - is in pretty good shape in the real estate industry," Zell replied that it was. He gave three reasons why publicly-held REITs have escaped the recent wave of scandals. One is the necessity to create cleaner companies after the 1989-92 recession that played havoc with the real estate industry. "There is no question that real estate had a horrendous reputation in the public markets," he said of the pre-1990s era. "But come 1992, the shoe was on the other foot. We were desperate. We had to raise money or our industry was gone."
Zell noted the second reason is that "the nature of our business doesn't lend itself to quite the same amount of Mickey Mouse" as in many other companies. It is hard for REITs to cook their books when they pay out 90% or more of their cash flow as dividends. (REITs are exempt from federal tax so long as they distribute at least 90% of taxable income to investors each year.) The third reason is the level of ownership by management. "No segment of the S&P 500 has a higher concentration of ownership by management than the REITs do," said Zell. "I'm the largest shareholder of our four REITs, and it's very hard for me to imagine that I'm going to cheat myself." The REITs in Zell's Equity Group include Equity Office Properties, Manufactured Home Communities, Equity Residential Properties Trust and Capital Trust.
REITs, however, have been roughed up in recent weeks on Wall Street. The Bloomberg REIT index dropped 12% between April 1 and April 27 in what many observers describe as a market correction. REIT stocks perhaps had it coming, after a blistering pace of price appreciation in the last few years. The Vanguard REIT Index Fund, to name one, saw returns of 36% last year, after average gains of 15% annually in the prior three years.
Zell offered some explanations when Linneman asked him some questions about the subject. "The flow of funds into REITs in the first quarter [of 2004] was greater than that in all of 2003," he said. "You had a staggering inflow of capital into the industry. And it stopped all of a sudden." He said the fund spigot was turned off because institutional investors had exhausted their allocations, and there were no more buyers. "When there are no more buyers, there are sellers," Zell reasoned.
Some found that change in market sentiment advance in a hurry. "The public markets can be vicious," said Michael Fascitelli, president of Vornado Realty Trust, a REIT based in New York City. "REIT stocks were going up 25 cents, 50 cents and 10 cents a day (during their climb), but when they came down, they were coming down $2 and $3 a day. That doesn't seem fair." He was speaking at a panel discussion titled "Has Real Estate Gotten Out Of Sync With The Economy?" moderated by Joseph Gyourko, a professor of real estate at Wharton.
Zell doubted that the price fall was a long-term correction. "I still believe that the REIT vehicle produces a level of income and a level of potential appreciation that makes it an extraordinarily attractive investment," he said. Richard Saltzman, president of Colony Capital, a private investment firm in Los Angeles, echoed that sentiment. "As with everything, in terms of the capital markets, the pendulum always swings too far in both directions," he said. Saltzman's assessment: "What we have witnessed recently [with REIT stocks] is that the pendulum has yet again swung too far in the overvalued direction."
Saltzman supported that observation by pointing to the relationship between the price-earning multiples of REIT stocks and those of the S&P 500. He said that REITs have historically traded at a P/E multiple that's 65% of the S&P 500 average; the range has been between a low of 32% and a peak of 87%. "At the beginning of this year, we blew right through [that peak] and for the first time the relative multiple of REITs was actually greater than that of the S&P 500 - it went up to 110%," he said. "When you get to such valuations, no matter how good the fundamentals may be for real estate, it is an accident waiting to happen," he said.
REIT stocks are back these days to the 87% range after the recent correction, Saltzman noted. He said the hemorrhage in the public markets may eventually spill over to the private markets too. But if and when private capital flows begin to ebb, "the longer term trend is going to be very positive," he said.
Raymond Mikulich, managing director of investment banking giant Lehman Brothers, did not attribute the relative attractiveness of REIT stocks to their being fundamentally better investments than others. He said the driver was a focus by investors on stable income producers as opposed to those promising growth. "The market has been chasing yield for the last couple of years," he said, "and real estate generates yield."
Joseph Robert, Jr., chairman and CEO of J. E. Robert Companies, a large real estate investment firm based in McLean, Va., endorsed the yield theory. "If you look at pension fund flows into the market in 2002 and 2003 and what is projected for 2004, there is no question that substantially greater amounts of capital will flow in at the lower end of the risk curve, chasing again, as Ray said, yield."
Well-performing markets can cause their own problems, Saltzman noted. "The market we have found difficult in terms of trying to find higher yielding opportunities has been the U.S.," he said, "just because it's so liquid and so efficient." He said the flow of deals is slowing because of more competition, even though real estate fundamentals are not in their best shape yet. He found a similar situation in the British markets too.
Across the Pond
European markets tend to follow trends in the U.S., but with a lag, according to Saltzman. He expects several opportunities to flow from Europe, with more restructurings and privatizations. Saltzman finds "the most prolific deal flow" in Asian countries such as China, and the least amount of competition. But that picture is scarred. "You've got the best economic growth in the world," he said, referring to China, "but right next door to that is the creation of tremendous distress." He said that "distress" was because Chinese banks are state-owned, "so there's no credit and no underwriting facility." Worse, he said, was the mess in the books of Chinese banks. "If you look at the balance sheets of the banks in China today, 40% of their loans have issues of one sort or another."
What then are the top concerns facing real estate in the future, was the question posed by Gyourko to his panelists. Mikulich felt the industry continued to suffer from overcapacity. "To be frank, the development side of the [real estate] business is not where it used to be, because the demand isn't there," he said. "It just isn't as booming a business as it used to be. We are still facing consolidation in that regard."
Fascitelli says a big task is to run businesses efficiently as they grow in size. "One of the challenges I wouldn't have talked about three or four years ago is just the challenge in the size of the deals," he said. Roberts cited leadership change as an issue the real estate industry will confront over time. "Compared with entrepreneurial firms, where leadership passes on to a family member, you are going to see a challenge in the transfer of institutional leadership to newer, younger talent."
Some real estate leaders have passed the baton to the next generation to good effect. Three of them were invited to a special Zell/Lurie session titled "Legends of The Real Estate Industry": Gerald Hines, chairman of the Hines group of Houston ; Walter Shorenstein, founder of The Shorenstein Company of San Francisco ; and Alfred Taubman, founder and former chairman of The Taubman Company of Bloomfield Hills, Mich.
Taubman started out in 1950 with a $5,000 loan to erect his first shopping center in Flint, Mich. Today, Taubman's empire covers 21 regional shopping centers in nine states. Hines had his beginnings in the 1950s as a mechanical engineer who also dabbled in real estate; he made $5,000 from his first deal, which gave him the courage to set up an independent company in 1957. Today, it commands a portfolio of more than 700 properties around the world. Shorenstein was a broker before he turned investor and developer and had more chutzpah than hard cash to fuel him. Today Shorenstein Co. has become one of the country's largest real estate investors, owning more than 20 million sq. ft. of office space.
All that was not enough to divert attention from the one issue that kept coming back to the discussion table: confidence levels in corporate America. At one point, Linneman asked Zell: "We are the richest economy in the history of mankind, whether it is in terms of per capita income, or life expectancy, and all those wonderful things. Why are people so unhappy if things are so good?"