Global Real Estate: Ready for a Rebound?Published: January 20, 2010 in Knowledge@Wharton
The global real estate community is breathing easier than it was a year ago, judging by the sentiments of participants at a recent Knowledge@Wharton global real estate forum titled, "The Road to Recovery: Investing in the Global Real Estate Rebound." Held at the New York Stock Exchange on December 11 in conjunction with Interconnect Events, the forum focused on the developed world's challenges in freeing up private capital and finding opportunities in distressed real estate assets, among other topics. According to some speakers and panelists, opportunities that receded in the West in the wake of the financial crisis can still be found in emerging markets -- particularly China and Brazil -- although the barriers to entry remain high.
In developed markets, several big question marks remain, especially in the commercial real estate sector, the forum's participants noted. "People are talking about commercial real estate as the next shoe to drop," said Bruce Upbin, managing editor of Forbes, who moderated a panel on "Commercial Real Estate: Beyond the Downturn to New Opportunities."
"Jobs are being lost at a decreasing pace, so that is good news," said Barden Gale, CEO of J.E. Robert Companies, a U.S.-based investment fund with about $8 billion in assets under management. "But those of us who are the pessimists think there could be another way down due to the withdrawal of the methadone" -- the government's ongoing support of banks and other financial institutions following the subprime crisis. Jobs and household formation will continue to be a primary concern in the developed world, he added, where tenants have the upper hand and are able to dictate prices. "And I don't see that improving."
In a keynote session, Barry Sternlicht, chairman and CEO of U.S.-based Starwood Capital, noted that in 2009 his company had invested $800 million in real estate assets but did not find the environment in the U.S. encouraging enough. "No net new debt has been created by [U.S.] banks in real estate," he said. Instead, banks are merely rolling over existing debt and buying debt from other failed banks in transactions where they had some exposure as participants. "Banks are not lending; if they say they are lending, it's not true." The capital environment is "different, and worse," he added, noting that much of the current investment activity "is being powered by government spending and not private money."
During a panel discussion titled, "The Best Distressed List," James B. Lockhart III, vice chairman of U.S.-based WL Ross & Co., which invests in distressed assets, said that government-run programs to support the housing markets are not designed to deal with the enormity of that challenge and are short-term measures at best. The support for Fannie Mae, Freddie Mac and the Federal Housing Administration from the Federal Reserve and the Treasury will have to "come to an end at some point." That scenario could spell serious trouble for the one-quarter of U.S. homeowners who are under water on their mortgages, he noted, adding that limitations in government support for the housing markets will perhaps have to be offset by principal reductions on home mortgages.
Lockhart's fellow panelist Robert Toll, chairman and CEO of homebuilder Toll Brothers, didn't see principal reductions as a way out of the mess. "What do you lower it to? Do you lower it to exactly what the house is worth on a fair-appraisal basis, or do you give the borrower a spread, where you take him beneath the current value?" he asked. The problem in either case: Home values could continue to slip below the new level after principal reductions.
But principal reductions could be a way "to keep people in their houses," Lockhart said. "If we don't keep people in their houses, we are going to continue to have this downward cycle." Toll remained optimistic about the longer-term outlook for housing markets: "Sooner or later, the demographic has to kick in," he said, referring to the anticipated demand for homes associated with household formation and job growth once the recession ends.
More Suitors for Distressed Assets
According to Toll, competition to buy distressed real estate assets has intensified; his company ended fiscal 2009 in October with $1.9 billion in cash because "we can't get rid of it." For example, Toll recently bid $12.5 million for a finished land lot in California where the winning bid was $20 million.
By contrast, Sternlicht's Starwood Capital hit pay dirt soon after it started buying land about a year ago. His company paid $20,000 each for 70 land lots in February 2009, and 10 months later was receiving offers of $100,000, he said. "We're kind of in shock. There are pockets of significant shortage of finished lots in certain zip codes. The demographics are far better than people think." However, he added that "good land" -- with building permits and proximity to infrastructure -- is hard to come by, and the deals are typically too small for large companies to play in that market. "If you are a young entrepreneur, it's an interesting place to go -- 50 lots at $10,000 each is $500,000."
Ignatius Chithelen, managing partner of U.S.-based Banyan Tree Capital Management, said that the best time for buying distressed real estate may have occurred between October 2008 and March 2009, so long as equity markets remain steady going forward. Another possibility would be that the stock market "drops sharply, as it did last year, and rises again," opening up "a small window of opportunity" where investors "who have done their homework ... can go in and buy."But a more likely scenario is one where stock market values drop 20% and stay at those levels for the next two years, Chithelen said. "You have $2.7 trillion worth of commercial real estate that is going to be rolled around with the peak in 2011, and much of that has to be refinanced next year. That will be a major opportunity [to buy].... Everything will be driven by the stock market."
Capital Markets Rebound
During his panel discussion, Chithelen noted that Real Estate Investment Trusts (REITs) raised $35 billion in 2009 to recapitalize themselves -- a record for that sector after its previous peak in 1996. The combined market value of REIT stocks had risen from $10 billion in 1986 to $483 billion in 2006, he noted. "The 'REITification' process has pushed the risk of loss from developers and owners onto retail investors."
"Capital [is there] for the exceptional deal," said Grant Kelley, founder and CEO of Holdfast Capital in Hong Kong, during a panel discussion titled, "Real Estate Roundup: The Real Deal." Over the past year, a big change he has noticed is that institutional investors are no longer being driven by predetermined allocations of capital to real estate. "A couple of years ago, there was such an allocation pressure [that it was] resulting in deals that were not thought through.... That change has been a healthy process."
Frederick Cooper, senior vice president of finance at Toll Brothers -- who spoke on a panel titled, "Show Me the Money: Who Will Fund Future Real Estate Deals?" -- said that the capital market for debt has revived. He cited two issues totaling $650 million his company successfully floated in the previous year.
Jackson Hseih, vice chairman and global head of real estate-lodging and leisure at UBS, agreed with Cooper that "there is a tremendous amount of capital out there." In 2009, global property companies raised about $78 billion in equity capital, of which U.S. issuers accounted for $32 billion, he noted. However, the problem is in "applying today's new money to existing situations," because investors now shun the high risk associated with many of the assets created during the property boom.
Albert Rabil III, managing partner of Kayne Anderson Real Estate Partners, qualified Hsieh's comments: "There is no issue with the big guys getting capital," he said, but access to the capital markets hasn't opened up across the board.
Speaking during the same session, Donald Monti, president and CEO of Renaissance Downtowns, a Plainview, N.Y.-based developer focused on downtown revitalization projects, predicted that the recovery of the market in the U.S. will be rooted in third- and fourth-tier cities, driven by demand from "boomers and millennials." He cited William Levitt's planned developments in suburban America -- called "Levittowns" -- as an example of visionary thinking. In much the same way, urban downtowns will be the next preferred destination for 150 million retiring baby boomers and the younger generation, he said.
Christopher B. Leinberger, visiting fellow at the Brookings Institute, agreed with Monti. "The millennials, empty nesters and the retiring baby boomers want something different from what we have been building for the last 50 to 60 years." Houses in pedestrian-friendly urban places or those connected to rail transit with many amenities are seeing premiums of between 40% and 200% over those in drivable suburban locations, he noted.
Hopes and Fears in Emerging Markets
While investors wait for the U.S. and other Western markets to bounce back, opportunity is waiting in China, according to Jeffrey Schwartz, chairman and cofounder of Global Logistic Properties, a developer with significant exposure to that country. "In China, the downturn was significant, but not the way it was in Europe or the U.S. There never was an official recession [in China], but people were scared to make any decisions." Commercial leasing volumes were down 60% to 70% in the first quarter of 2009, but had rebounded to 150% by the fourth quarter, he noted. "That is a result of the economy doing well, a lack of competition and strong management."
Philip Wu, founder and CEO of Applied Strategy Ltd., a consulting firm in China, said the country's commercial real estate sector came into being only in the last decade. After a period of trial and error, investors have begun finding "cash-generating capabilities" in office parks, shopping malls and service apartments. Demand is robust for shopping centers as investors bulk up for an anticipated entry of REITs into the Chinese market sometime in the next 12 months, he added.
Wu was bullish about China's macroeconomic outlook for commercial real estate, noting that domestic consumption has been growing after the government established that as a priority to make up for lost exports. "My personal experience in investing in China for the past 13 years is you always go where the government says. You never know when they will achieve that target ... but they will achieve it."
Schwartz agreed with Wu on the long-term bullish outlook for China but said he had some concerns about the medium term, with rising asset prices, easy credit and excess inventory of office space. "Take Tianjen, outside of Beijing -- there is enough office space built to take care of 25 years of demand at the current absorption rate. It's overbuilt." Wu acknowledged the overhang of inventory but cautioned against extrapolating from current absorption rates. "It is a risky assumption to underestimate growth; it will always surprise you on the upside," he said.
Gary Garrabrant, CEO of Chicago-based Equity International, a private investment company focused on real estate-related businesses outside the U.S., said his company diversified into Brazil a decade ago because it saw "great value, great partners" in that country. "We think of Brazil and China as unique among the BRICs [Brazil, Russia, India and China] and consider the balance as frontier markets," Garrabrant noted during a panel on "Lessons Learned from Developing Markets." His hesitation to enter some of the other markets has to do with the quality of partners, he added.
Carlos Della Libera, executive advisor to Brazil's state housing secretary and to the chairman of its state housing agency CDHU, recalled how his country's economic growth -- with the eighth largest GDP worldwide -- has changed perceptions of his country in recent years. In earlier years, people he met across the world had questions about "samba [Brazilian dance], Caipirinha [a Brazilian cocktail] and carnival" -- but now, "the questions have changed," he said.
During a special address, Libera talked about his country's huge market for low income housing: It needs 29 million new homes by 2020. Government subsidies, regulatory reforms relating to property titles that enable freer commerce, and increased bank lending are driving demand, he said. The government is also pushing for environmentally sustainable development with solar panels, certified materials and designs to allow for handicapped access.
Gerardo de Nicolas, CEO of Mexico's biggest homebuilder, Homex, said his company's output has increased from 150,000 homes in 2000 to 700,000 homes in the past three-to-five years. He identified a huge untapped demand in Mexico fueled by encouraging trends in household formation and legal reforms enabling the creation of a market for home mortgages.
A high rate of household formation, a trend towards urbanization and strong demographics coupled with 7% economic growth are the key drivers of housing demand in Kenya and elsewhere in East Africa, according to Laila Macharia, CEO of Scion Real, an investment firm in Nairobi. "In Kenya alone, we need 200,000 homes [annually] but are able to deliver only 30,000 homes," she said. "In that, we see opportunity for developers."
In India, too, strong economic growth of about 8% has buffeted the impact of the global downturn, although its stock markets took the initial shocks and dented confidence levels, according to Aniruddha Joshi, executive director of U.K.-based Hirco Group, a developer of mixed-use townships in India. He said domestic demand accounts for 65% of overall demand, making India much more resilient than China to global shocks.
Emerging markets come with high entry barriers that in some cases increase the opportunity for investors, according to panelists. Bruce Gardner, managing director of Moscow-based Multinational Logistics Partnership, a developer of industrial space in Russia, said that country "suffers from a perception problem" in terms of how investors view it. "Russia is the opposite of all that [is said] about Brazil: It doesn't have the level of professional management, the level of transparency, [and] it's very difficult to get simple things done," he noted. "But therein lies the opportunity. I don't have a lot of competitors because they can't figure it out."
Garrabrant agreed with Gardner. "The barriers to entry [in emerging markets] actually are long-term and don't get solved easily. It effectively keeps the competition down." His company approaches those markets with a mindset of "continually balancing, adapting and influencing," he said.
Whither, Uncle Sam?
At the end of the day, many participants seemed focused on how and when the U.S. market would stage a recovery. Kelley noted that the U.S. government's support for real estate assets has limitations. "Private capital is probably best placed in real estate because it is a local business. It's very tough when you are a government body and don't have the valuation capability at the local level." The government has to eventually find a way "to retreat gracefully and hopefully seamlessly."
During an interview with Wharton real estate professor Peter Linneman, Samuel Zell, chairman of Equity Group Investments LLC, gave the government both a pat on the back and a slap on the wrist for its handling of the economic stimulus program. "To a large extent, the actions taken by the Treasury and the stimulus bill were well done. That's what had the most impact on allowing us to exit -- in effect, liquefying the banks," he said. But, he added, the stimulus bill should be renamed "The Democratic Party Payback" bill, since it "gives more money to states to hire more people. The last people [who] should be hiring are state and local governments."
Zell added: "Every day, we read another newspaper article saying that Congress bailed out Wall Street but didn't bail out Main Street. One of these days, there will be a journalist who understands that the future of Main Street is dependent on the success of Wall Street."
In the meantime, investors will wait for the government to restore the balance of power to the private markets, according to Kelley. "It is possible to do so -- America has always figured out a way to reinvent itself," he said. "It is remarkable that one year on from what was an extraordinary threat, we are actually having conversations about opportunities. Hopefully one year [from now] we will be having conversations about credit, and then after that hopefully we will stabilize."