Are Easy Liquidity and Razor-Thin Returns Driving Real Estate to Dangerous Highs?Published: July 13, 2005 in Knowledge@Wharton
A round of nervous laughter followed the comments of Robert Cherry, chief investment officer of LNR Property Corp., a large real estate investment and development company based in Miami Beach, Fla. "We can't believe the latest request. We got a call last week from somebody who asked if we would lend to a guy who was in jail," he told the audience at a meeting of Wharton's Samuel Zell and Robert Lurie Real Estate Center recently. Cherry made his comments at a panel discussion on "What is Driving Debt Markets in Real Estate?"
Cherry didn't oblige, of course, but the bravado of that jail-house borrower reflects the huge capital flows into the real estate industry. They represent too much of a good thing, according to participants in the discussion moderated by Asuka Nakahara, associate director at the Zell/Lurie Center. "There is so much capital flowing into the system that on the lending side we're already seeing a deterioration of underwriting standards," said Alice Connell, managing director of TIAA-CREF in New York City, one of the world's largest retirement systems and the country's largest institutional real estate investor, with a portfolio worth $50 billion.
Connell says she could understand why it was happening "if it were just these intermediaries who were the people holding these bonds for an hour and a half...." She worries it could be more widespread than that. Another panelist, Michelle Felman, executive vice president of Vornado Realty Trust in New York City, is a buyer of debt. "In commodity deals, the three-minute holders of the paper are basically churning out paper -- they are not holding on to paper," she said. "The borrower who really holds the power right now basically sets all the terms, and somebody is going to underwrite that in 30 seconds."
Eric Schwartz, managing director of Deutsche Bank, agreed that underwriting standards are being loosened "to some extent," and that many lenders are focusing on their risk-adjusted spreads. He said loan-to-value ratios have gone up from 80% to 90% or more, although he himself doesn't go above 80%. "Maybe the market is getting a little bit frothy, but there is a fair amount of sophisticated buyers who are buying at the bottom," he said. "Whether they are getting the right risk-adjusted spread is a different question."
So it must be a "great time" to be a borrower, Nakahara told his panelists, urging them to foretell if greater times lay ahead. Connell, whose retirement system is a long-term fixed rate lender, felt the moment was now. "I just think it is irrational for people to not lock in long today. What are people waiting for?" she asked.
Schwartz said borrowers would have a great time in the immediate future. But he clarified that while a common perception is that debt is driving the equity markets, it's the other way around in some cases. "We are seeing a lot of equity money coming into deals. Some of these companies are putting $100 million in a deal which, no matter how you plan it out, maybe they are making a 2% return, maybe 0%, for the next five years," he said. "And they are making their bets that five years from now the asset values are going to be great."
Schwartz added that equity components of $100 million or $150 million make his debt paper much more liquid. "When I go to sell it, someone else is willing to look at that and say, 'I'll participate in that piece of that debt. These guys are not going to walk away from $150 million cash.'" However, he however didn't expect things to get any better. "We are underwriting deals now where we think equity is hardly getting any return," he said. "Unless you get negative, I don't know how much higher you can go."
Some people in the market must surely be making mistakes, Nakahara suggested. Cherry felt the mezzanine debt providers are not reading the market right. "We sit there and scratch our heads that those guys aren't going to get repaid at the end of the deal. We see huge balloon risk," he said. Connell pointed to declining returns on assets in some markets, where those who "catch the wrong side of interest rates" could face problems. "Those who want short-term financial cocaine could get hurt," she said. She also said problems await specific product segments in certain markets, such as condos in South Carolina. But her biggest concerns were reserved for the office space markets. "Lets face it, the vacancy rates in the rest of the office markets are ugly; the landlords do not have any pricing power. There could be some real problems there," she said.
Felman recalled the early 1990s when she was among "a handful of players" that took risks and made a lot of money. "What looked like risk then is nothing to what you look at now," she said. Even so, if things go wrong, there is enough money in the system to absorb shocks, she felt. "We may be able to take up some good deals but that would be a new competitive market. Hopefully you'll still be able to make above-average returns for the risk that you're going to take in picking up the pieces, but it won't be anything like we saw 20 years ago."
"It's probably going to be something we didn't see coming," said Schwartz of what could go wrong. One of his concerns was how individual real estate investors would respond if they get caught on the wrong side of the curve. "If liquidity dries up you may see people starting to get less enamored across the board about real estate as on an individual basis they can't get out the way they thought."
Going forward, Schwartz felt that lenders "have to build a better mousetrap." He said many institutions started out as lenders who focused on little else besides the balance sheets of borrowers, and worked their way out of bad loans by going after the borrower or foreclosing on loans. Borrowers today are more savvy, he said, and know they face an easier environment with more options unless the lending company has specific constraints. His other concern was the apparent lack of experience among lenders regarding what could go wrong. "A lot of people in the lending area today really have never been through any kind of downturn," he said.
Felman worried about how those with exposures would respond if the market turned for the worse. "If that were to happen, then all these people who were underwriting aggressively could suddenly get into one of those situations where the pendulum may go all the way to the other side," she said. "They will be scared. You'll probably get into a situation where underwriting standards get very strict."
Awash in Liquidity
How do veterans read the emerging scenario in the real estate industry? Conference attendees got generous peeks into those minds at the session entitled, "A Conversation with Sam Zell and Barry Sternlicht" moderated by Peter Linneman, a real estate professor at Wharton. Sternlicht is the founder of Starwood Hotels & Resorts Worldwide in White Plains, New York, which owns the Westin and Sheraton brands, among others. In early May he resigned as executive chairman and stepped down from the company's board, assuming the title of founder and chairman emeritus. Zell is founder and chairman of Equity Office Properties Trust of Chicago, the country's largest office space landlord.
"We just hope we are sitting on a chair when the music stops, because it is an unbelievable time for almost anybody in the property world," said Sternlicht. "The only people who look stupid are those who didn't buy real estate in the last couple of years because it's worth more today," he added. "But at some point it won't be worth more today, or shouldn't be."
"Liquidity," said Zell, when asked by Linneman what was on his mind these days. "Everybody that's in real estate today has to understand that we have had a bubble of liquidity. We as global capital markets have probably had more monetization in the last 10 years than we've had in the history of the world. Just think about the fact that today Saudi Arabia has $350 million more to invest per day than they had to invest exactly one year ago."
While that "tremendous liquidity" is one factor, Zell noted that the demand for income is higher than ever before. He offered an example: "In 1980 I made my first major deal with a major pension fund. At that time the pension fund was collecting a dollar and paying out 10 cents. Today the same pension fund, 25 years later, is collecting a dollar and paying out just under 60 cents. So whereas that pension fund in 1980 could make long-term bets, today it has to have income."
According to Zell, real estate "is no longer an isolated, separate, distinct industry." Instead, it is part of the overall capital markets. He said the low levels of capitalization rates are testimony to his reading that "the real estate industry has become much more efficient." (Capitalization rates measure the relationship between income streams from a property and its market value; a lower cap rate reflects a willingness on the part of buyers to pay higher prices.)
Sternlicht saw the build-up of "the perfect storm." He pointed to the current four-year lows in interest rates, historic lows in credit spreads for real estate, and the disintermediation of the debt markets. "Half of all the debt is being held by banks originating it to sell it off," he said. "You have record high lending levels; you have interest-only money. You now pay more for the property; you pray that everything will go up in value. It has -- the only people who look stupid are those who didn't step up and buy something." On the equity side, he talked about all manner of providers of capital, including hedge funds. "Europeans fueled by the dollar, the Israelis, and then you have all of us, and then you have the institutions...that are interested in value added opportunity funds."
For Zell, the one metric that he says has worked well in all his 40 years in the business is replacement cost. "Today, despite what we all think are unbelievably low cap rates, we have not seen very many assets that have traded -- even in competitive auctions -- above replacement costs," he said. "An office in a CBD (central business district) today costs 30% more to build than it did 18 months ago." That, he explained, was because of rising construction costs, especially those of copper, steel, glass and cement. "Real estate is subject to probably twice the inflation rate as the rest of the economy," said Zell. "The elements that make up construction have been significantly more impacted on the supply-demand side than manufactured goods."
Sternlicht felt steel prices are set to decline with large additions to Chinese manufacturing capacity coming online in the next couple of years. He also pointed to rising labor costs as a source of worry. "The biggest issue is inflation," he said. "If you really think inflation is coming back you want to own property. It's a smart move for an institution to hedge its portfolio by owning property."
Taking Environment into Consideration
Conference participants grappled with a different set of concerns at a panel discussion on "The New Demographics of Jobs: Implications for Real Estate." Lynne Sagalyn, professor of real estate development and planning at Wharton, moderated the discussions that focused on the real estate options for distribution and logistics companies as their environment changes.
Paul Congleton, managing director of ProLogis, a global provider of distribution facilities and services based in Aurora, Colo., said location decisions are driven by the nature of activity to be performed. For example, a company that wants to serve consumers in Los Angeles would want to have a distribution center there. But the role of the Los Angeles port as a transshipment hub (where cargo is re-routed to other destinations, sometimes with repacking) also calls for a distribution facility, although the work there would be of a different nature.
Congleton pointed to emerging technologies that are increasing efficiencies and driving the way distribution centers are used. "The current buzz is radio frequency identification tags (RFID)," he said. Describing RFID as "an evolution beyond bar coding," he explained how they work: With receivers and transmitters inside warehouses, forklift drivers going down aisles can electronically read product codes to help them navigate. Those codes are transmitted to systems that help in a larger scheme of data management. "The entire evolution of distribution and supply chain management is about seeing where your inventory is at all times," he said. "The more you can see your products, the less the inventory you need to have in your system."
Susan Hudson-Wilson, founder of Property & Portfolio Research, a Boston-based provider of real estate research, among other services, said decisions on where to locate warehouses and distribution centers will be guided by spending patterns. She said those with the highest earning and spending powers are between the ages of 35 and 54, and that this spending population's growth rate was declining and turning negative. "But in some places it's going to be growing and in some places it's going to be shrinking," she said. That translates into a search for market niches populated by spenders. "So all of a sudden you will have these major bifurcations, city by city, in terms of which cities can support more storage, retail sales and which places can support less," she said.
The conference also saw the unveiling of the initial set of findings of a mammoth research project being undertaken at the Zell-Lurie Center. For the past 14 years, researchers throughout the country, including government agencies, have used a Wharton survey conducted by Linneman and Anita Summers, now an emeritus professor of public policy, management, real estate and education. That survey covered the 60 largest central cities and 2,474 suburbs in the U.S. Following up on that effort, the Zell-Lurie Center has launched a bigger, more complex nationwide survey on residential land use regulation. The latest survey covers 6,900 jurisdictions with a response rate of 37%. Three specific metropolitan areas are also covered in depth -- Philadelphia, Boston and the Bay Area in California.
Joseph Gyourko, director of the Zell-Lurie Center, presented some of the initial findings. He said that between 1940 and 1970, the average house price in the country was "almost identical to our best estimate of the physical construction cost." In other words, land was cheap. But that story has been changing since 1980, with rising land prices -- Gyourko says these have gone up some 40% in the past 10 or 15 years. That trend was seen initially in the coastal areas of California. It has since spread to the Boston-Washington corridor and other interior markets like Denver and Austin, Texas.
Gyourko said one explanation offered for that by economists is scarcity of land in the face of rising demand. "The other possible explanation is, we have just artificially restricted supply," he says. "That is, the scarcity is not fundamental -- it is man made."
Summers talked about some of the questions her researchers have been asking those who have been surveyed: What are the lot development costs and what have been the increases over the past decade? Have they been required to pay the allocable cost of infrastructure costs and infrastructure support? Have they had open space requirements, and do they need to include affordable housing? Said Summers: "We are able to analyze these results looking all across the nation, sorting by rich and poor communities; more educated and less educated communities; high and fewer pockets of poverty; and combining our survey data with census data." Summers added that the questions also cover the effects of regulation on certainty, including length of time for issuance of a building permit, as uncertainty translates into higher costs. The surveyors also looked at who is responsible for whatever level of regulation exists in a community.