Tentatively and Sporadically, Real Estate Investing Makes a ComebackPublished: November 24, 2009 in Knowledge@Wharton
Real estate is showing some early signs of a revival as an attractive investment destination compared to other opportunities like corporate debt, but the equity and debt markets have to open their wallets with more confidence to resume a normal flow of deals. That was one notable assessment by panelists at the fall conference of the Samuel Zell and Robert Lurie Real Estate Center held at Wharton recently. They also offered insights on lessons learned from the supervisory gaps that fueled the recent collapse of the financial markets and ways to fix them.
"Real estate looks like a better value [proposition] relative to other alternatives than it did six months ago," said David Twardock, president of Prudential Mortgage Capital, which manages the insurance group's real estate finances. He was speaking at a panel session titled, "Where Will the Capital Come from and How Will It Be Used?" He said benchmark securities like single A-plus corporate debt today offer returns that are a third of what they were at the end of last year. "So, as an alternative, making loans to real estate looks like a better place to be than it has in a long time, relative to those benchmarks."
Twardock, however, lamented that while debt capital is available, equity investors are still holding back. That phenomenon is not helping the process of deleveraging, or reducing the share of debt in portfolios, that banks and other lenders must undergo before a more normal deal flow can resume, Twardock and other panelists said. "The difference is very few people are writing equity checks to buy property," Twardock added. "What we need is equity to take this deleveraging process along."
Wharton real estate professor Peter D. Linneman told panelists in a later session that between September 2008 and February 2009, banks deposited as much money with the Federal Reserve as they had done in the previous 50 years. Lending those funds will cause inflationary pressures, but he and other panelists said the economy needs some of that liquidity to finance growth.
Peter E. Baccile, vice chairman of JPMorgan Securities and a fellow panelist, said the investment sentiment has improved significantly recently, and that "the capital markets have been wide open this year." Between January and August this year, public real estate investment trusts (REITs) issued $18 billion worth of securities, "which is more than what was issued in any single year in the 1990s when we had the big IPO (initial public offering) wave." The bond markets for investment-grade debt from REITs have also opened up, with issuances totaling $8 billion so far this year. All that "has given more confidence to the market participants and propels new opportunities," he added.
Those confidence levels will move to a higher plane only with deleveraging of investment portfolios, according to Twardock. He said banks hold about half the $3.4 trillion in private debt. Another 20% is in the commercial mortgage-backed securities (CMBS) market and the remainder is split between insurance companies and agencies of Fannie Mae, Freddie Mac and the Federal Housing Administration. "There is money for new loans; we have more money to invest than we can find the loans for, but the problem is deleveraging as a process is going to take time," Twardock said.
Still, while some glimmers of confidence are returning to some sectors, the positive signs are distributed unevenly. Activity is at "historic lows" among the roughly 600 private market funds that invest in real estate, said Terrance R. Ahern, principal, founder and CEO of The Townsend Group, a real estate consulting company that services pension funds, endowments and foundations. "Few, if any, funds are closing [deals], and managers who have capital are not executing deals," he noted. Aggravating that situation: Institutional investors were seeing "dramatic losses" at the end of the second quarter, with the prospect of that continuing.
Insurance companies wrote $40 billion in loans in their peak years but they "are not going to solve the problem on their own," he said. The market needs capital flows from banks and agencies such as Fannie Mae and Freddie Mac, as well as a revival of the CMBS market. "Everybody else, excluding insurance companies, took money off the table in the second quarter; you need some new form of capital."
'Catching a Falling Knife'
Private equity could help to fill the gap in the debt markets to a limited extent, according to Ahern. He divided private equity investors into three groups: "those who can, those who can't, and within those who can, those who are willing and those who aren't." Among those with the wherewithal to invest, the newer entrants are more aggressive than others, but among traditional small funds, "the mentality is the fear of catching a falling knife," he said. However, the market is seeing "some big players come in and set up [investment] programs...."
The challenges ahead are formidable, stated Baccile. "You can't ignore the size of the hole we've blown into the global banking system." The 75 largest financial institutions have seen their loan capacity eroded by $7 trillion. If regulators call for higher capital adequacy requirements, that number will approach $10 trillion. "That's an issue that will be with us for quite a while. We have to get used to operating in a much smaller environment for capital and it is going to be painful."
Banks face another problem -- they cannot suddenly get rid of distressed assets but have to "earn their way out of this," Baccile added. "We can't afford this massive overnight disgorging of bad assets." He sees them improving over the course of "a few years" to create and retain earnings, sell assets and build their deposit base.
A revival of the CMBS market will also help lenders securitize their investments, but that market needs some structural improvements, according to Baccile and other participants. "We don't need 10 or 12 or 15 different tranches of debt, but a simplified CMBS structure where either the person doing the lending is holding the risk or there is somebody buying that pool that is going to have long-term risk in the game," he said. "That is a model that can work and ultimately is likely to come back." The CMBS market will be slow to develop as it unlearns the mistakes of the past, the panelists suggested.
Securitization problems weren't unique to real estate, according to Keith F. Barket, senior managing director of Angelo Gordon & Co., an investment advisory services firm. He participated in a panel discussion titled, "The New Alphabet Soup of Regulation: What Will This Mean for You?"
Barket said the default rate for corporate debt paper currently is much higher than that in the CMBS market. In the 2001 recession, the corporate debt default rate was 10%, while the CMBS rate climbed to 2%, although the latter got "much more aggressive in 2006 and 2007. I don't think the CMBS model is as broken as some people think it is; you are looking for something to blame. It needs to be simplified; it needs to be modified; this is its first true test."
Sounder structures and regulatory fixes are important to help revive the CMBS and other markets, according to Susan Stiehm, deputy policy advisor in the markets group at the Federal Reserve Bank of New York. Securitization markets had "misaligned incentives that were structural deficiencies." At the same time, "there wasn't as much [of] a conservative approach" within the regulatory regime, and they "probably could have been more conservative," she added.
Linneman, who moderated the panel, asked why regulators didn't revoke the licenses of unsound depository institutions. Stiehm agreed that this situation "could have been served by more consistent regulation." But she also blamed the lapses on a dispersed regulatory system and the fact that many lending institutions were outside the supervisory regime. "We probably could have found some way to bring them under supervision or regulation," she said.
"It's a little of both, a mix of lackadaisical enforcement and some activities that were not in the net," suggested Jeffrey D. DeBoer, president and CEO of the Real Estate Roundtable, an industry advocacy group. He said some 40% of the financial services industry was largely free from regulatory oversight. Other panelists worried that lawmakers could go too far in the rush to plug regulatory gaps. "The pendulum is right now swinging too far, as it naturally does after big events like this," noted DeBoer, referring to the economic downturn. "People in Washington want to err on the side of protecting their backsides." The "number one cause" of the severity of the downturn was that "the rating agencies got it wrong on subprime (debt securities)," according to Barket. He explained that they didn't have data prior to 1991 on subprime debt.
DeBoer called for a change in the way rating agencies get paid. If the buyers of paper were paying the rating agencies rather than the issuers it would help, he said. He also wanted more players in the rating business, a process already underway. "Let a thousand flowers bloom." Further, he wanted regulators like the Federal Deposit Insurance Corp. to "check their models once in a while."
Barket pointed out how China recently controlled its housing finance industry to avert a collapse: It increased the down payment required on mortgages and raised bank reserve requirements from 8% to 17.5%. The latter move also gave policymakers the ability to provide stimulus. "If we had done that in 2005, we wouldn't have had this problem," he said.
'Most Over-hyped Recovery in History'
Stiehm and the other panelists agreed that in the U.S., government programs like TALF (term asset-backed securities loan facility) have helped lenders narrow spreads, increase lending volumes and stabilize prices. DeBoer cautioned against too much government intervention. "There is a difference between taking over the marketplace and reigniting the market," he said. "The danger is if it [the government] somehow became the marketplace." All the same, he acknowledged that the government-sponsored institutions of Fannie Mae and Freddie Mac brought stability to the multifamily real estate market, preventing it from facing the more serious problems that beset the office, industrial and hospitality space markets. Regarding the new regulatory regimes under consideration, Steihm said that "most of the focus now is on system risk and monitoring it.... Lots of lessons [are] being learned in banking supervision and being discussed pretty passionately on both sides."
The recovery is already underway, and "some green shoots are starting to spring up," said Todd Sinai, a Wharton real estate professor. He moderated a panel titled, "The Economy and the Property Markets: A Look Forward from Wharton's Senior Economists." Some companies are reporting revenue above expectations, the rate of job losses is slowing, and the Dow has crossed 10,000 and stayed there. "Is this a real recovery?"
Linneman predicted that "this will be the most over-hyped recovery in history." For one thing, it's unlike earlier recoveries, which only became apparent in hindsight. Panic, meanwhile, has played a key role, he said, arguing that "the panic element brings about a much stronger recovery." He expects the economy to lose some jobs in the next few months, then hit bottom and then start moving forward at much greater speed, "unless the government does some very crazy things, which is very much possible."
Expect job growth to resume around April 2010, creating nine million jobs over the following three years, Linneman said. The key driver: basic confidence in the economic outlook, just as it has been in earlier recoveries. "You're going to get that again because panics are as much psychological as anything else." He also expected housing starts to regain strength to meet the needs of a population increasing by three million people annually.
Linneman's co-panelists were not so sanguine. "This is going to be a slow recovery," said Susan Wachter, a Wharton real estate professor. "Interest rates are down and we have normalization of spreads -- which are good things," she said. The housing crisis has in some sense bottomed out, and construction volumes and inventory levels are down, although shadow, or hidden, inventory exists. "But it's totally dependent on the federal government," she stated. "We need to have private capital at risk."
Joseph Gyourko, chairman of Wharton's real estate department said he had a hard time finding growth drivers to support Linneman's view. Much of the recovery so far could be accounted for by "a restocking phenomenon" after businesses wound down their inventories and postponed or slowed new production while waiting for demand to pick up. "What you are having now is a one-time readjustment to the overreaction," he noted. "It could go on no more than six months."
According to Gyourko, economic growth in the U.S. has been led over the last 30 years by consumer spending -- which accounts for 70% of GDP -- and much less by investment, government spending and net exports. Do not expect consumer spending to be more than 1% or 1.5% next year, he said. "That's not enough to get substantial employment growth and buying at the malls. You need an ongoing growth driver after that."
No one has ever seen a growth driver while a recession was still underway, Linneman stated. "With hindsight, it happened -- it was consumer confidence," he added, noting that the key driver is the psychological effect of increasing consumer confidence, as measured by purchasing indicators. Rising confidence could embolden employers to replace employees who had left their payroll -- a process they had put off for later. "When that psychology does flip -- it could happen faster than we realize," Linneman said, pointing out that the country lost about eight million jobs in the past 14 months. The U.S. adds about 1.8 million jobs in a normal year, so "we need about five normal years of growth to return to June 2008 fundamentals in the buildings."
Wachter and Gyourko have big hopes for the technology sector and exports. "We didn't kill the entrepreneurs. The people who drive growth and think up neat ideas like the iPod are still out there," said Gyourko. "What we did was, we shot the finance system in the head. But that's being fixed." Wachter predicts that the weaker dollar will help lift exports and provide the other driver.
When might the country face the next financial meltdown? "I definitely think we will have one," Barket said. Why? The next four years will provide banks with good opportunities to make loans, but the fact that they have a lower cost of funds than REITs holds the seeds of the next problem. He forecast that to compete, REITs "will start using more leverage and do riskier things, which is why in every cycle the mortgage REITs don't make it." Barket added that while he does not favor "big government," the federal government could exercise its right to regulate banks, an authority it has because it guarantees their deposits.
"Hopefully there will be closer regulation," said Barket. "But there is no doubt there's going to be another blow-up."