Real Estate's Future: 'It Depends on What Degree of Risk You Are Looking For'Published: July 14, 2010 in Knowledge@Wharton
With the financial crisis wiping out trillions of dollars in property values worldwide, the challenges facing the global real estate industry are greater than they have been in decades. Within the turmoil, however, are opportunities for players in both the commercial and residential real estate markets, a point made by members of a panel at the recent Wharton Global Alumni Forum in Madrid called, "Real Estate: Exploring the Road to Recovery."
Panel moderator Olivia S. Mitchell, professor of insurance and risk management at Wharton, focused discussion on prospects for the longer term, including the impact of the recession on urban development and the fallout from "growing government deficits and unprecedented levels of debt."
Speaking about the condition of the real estate market in Spain, panelist Ismael Clemente, managing director of RREEF, the real estate investment management arm of Deutsche Bank, AG, noted that his initially negative outlook for the sector has now become "slightly more positive. We are witnessing the first steps of a recovery, with most of the correction for the sector already carried out. I believe we will survive this crisis," he stated, adding that while there remains some room for correction on the residential side, "the worst is probably over."
What is needed now, added Clemente, who is responsible for investments in Spain, Portugal and North Africa, is a determination of "the pace of recovery. It is important to get the timing right. If you invest too early, you will get burned, the same way as if you get the cycle wrong." He also cited several threats to the recovery, mostly on the macro level. "The funding of the immense deficit we are running in Western societies may drive governments to increase taxes and take other measures.... My biggest fear is overregulation [considering that] we are already in an extremely regulated sector."
Echoing Clemente's note of optimism was panelist Christian Schulte Eistrup, managing director, capital markets, for MGPA in London. "What is very helpful is that [the recession] has given the real estate industry pause. The day of the financial engineer who is focused on real estate is gone, and we are back to an environment where people understand the basics of real estate, the bricks and mortar." If these people continue to inform investment decisions, Schulte Eistrup predicts the industry can start to address issues like population growth and urbanization. Panelist Alfonso Vegara, founder and president of Fundación Metrópoli in Madrid and an expert on urban planning, agreed with the need to focus in these areas. Over the next 25 years, he said, countries will need to build shelter for two billion people, with growth occurring mainly in Asia, which is growing eight times faster than Europe, and in Latin America, which is growing six times faster.
Panelist Armin Lohr, a director in McKinsey's Middle East office who works mainly on infrastructure, real estate, and transportation and logistics, talked about challenges with regards to the supplier industry. He posed a question to the audience: "Suppose you are an OEM (original equipment manufacturer). What productivity gain would you expect from your suppliers? Two to three percent a year, at least? What has construction done over the last 15 to 20 years?" The answer is that productivity gains have been zero all across the world, he stated. "There has been literally no innovation. If you look at the U.S., productivity even came down. In Europe, it went up slightly." One of the big challenges for real estate developers, he said, "is to see yourselves as the OEM of the industry, and make sure construction productivity actually goes up."
Lohr recently studied 10,000 real estate projects to determine what most drives project results. "We looked at different drivers and didn't find any correlation except for one, and that was the project manager. Size and segment are both irrelevant. The one thing that drives performance is the project manager." He made a comparison to the auto industry. "You have [production] lines with good workers and bad workers. The good lines return top quality and the bottom lines return bottom quality. That is not acceptable. This is a huge opportunity for the whole industry going forward to drive productivity with suppliers."
Quality Work in Developing Countries
In assessing the prospects for commercial real estate, panelist Pelayo Primo de Rivera, managing director of Norfin in Madrid, an Iberian real estate fund management company, looked at three areas. One is the economy. "The economy will tell us if we do well." Although it typically takes several years for real estate to pick up after the economy recovers, "that doesn't mean one can't invest now, for example, in REITs [real estate investment trusts]." Real estate, he said, represents "50% of the tangible net worth of the world."
The second area to consider is potential growth in population and employment -- if banks aren't hiring, for example, office space needs decrease -- and the third area is the capacity (or vacancy rates) of the real estate sector. "The vacancy rate is the net result of new construction," but new construction depends on financing, which currently is in short supply, de Rivera noted.
In response to a question from Mitchell about regulation, Clemente pointed to the tough regulatory climate in Western economies for real estate developers. The biggest difference between operating in Morocco and operating in Spain, he said, is that in Morocco, "you can buy land, master plan it, develop it and sell it within a reasonable framework of three years to five years maximum. In Spain, that would take between 15 and 20 years, if you are lucky, because of the increasing number of stakeholders who now intervene in the master planning and development process."
People tend to believe that you can develop projects quickly in developing countries, but that the quality is bad, Clemente noted. "That's not true. In countries like Morocco, you can see examples of good architecture and good engineering. You can see ports, highways and railways which are very well executed, mainly by foreign companies first, but later on by local companies as well."
Lohr agreed with Clemente, describing a large university complex in Saudi Arabia that took only two years to develop from the time the idea came up until the first students appeared in the classrooms. "There was just plain desert there, nothing else," he stated, adding that the project was developed by a subsidiary of Saudi Aramco on behalf of the Saudi government. "Just imagine the speed of decision making that is required to get the permits and licenses, and at the same time attract talented professors and students."
Panelists discussed other global real estate markets and the different scenarios each is facing. For example, Schulte Eistrup noted "the massive secular demand for modern real estate" in Russia that so far is not being met. "You definitely see that people want to live in nicer places; they want more modern office spaces. And as purchasing power increases, people want to spend money in [attractive] retail outlets. So there are markets where we can be quite positive that real estate prices will continue to grow because there is demand for occupancy, which in turn will drive up rents."
In Portugal, added Clemente, "you can still make money if you are smart. Specific projects still need to be developed. And if inflation comes back, you will see a natural deleveraging of the whole economy because the value of assets will go up while debt remains more or less constant."
In response to an audience member's comment that most real estate cycles go through phases of euphoria, recession and denial -- and that Spain still seems in the denial phase -- Clemente noted the "huge separation between commercial and residential real estate in Spain." With regard to commercial real estate, "the denial phase is over because rents have gone down as they needed to, and capital values are where they need to be. The actors in the commercial sector are more professional -- pension funds, insurance companies -- and reflect more pricing levels. It is the residential sector "where we have the biggest lag in our system."
De Rivera had another view of the real estate industry in Spain. He cited a significant amount of undeveloped land that will remain undeveloped due to lack of financing and a substantial inventory of vacant buildings. "The fact of having had a bubble still has many consequences for the future development of the investment market. The prices [people] have been paying are stuck in their minds and stuck on the balance sheets of the institutions and banks, and that is stopping the development of the industry. There is no market. The bid-ask spread is so huge. There is a very big difference between what investors want to pay and what owners of real estate want to get."
Another audience member asked what is needed to improve cross-border investment. The answer is to look at the different regions, such as the Middle East, said Lohr, where investment firms have a good perspective on both local and international markets -- "a trend that is under way and is driven by developers, not by banks or sovereign wealth funds. Development conglomerates are being established that go international very, very fast, and don't just stay in Dubai or Abu Dhabi. The key spark behind this is driven by politics and political relationships."
Vegara offered the case of Singapore, which recently gave priority to the creation of an "urban solution" that provides housing, transportation, water and other elements that make urban living sustainable. "There is an agreement of collaboration" between the Singapore government and the Chinese government to create a new entity that can get the agreements necessary to build new cities intended for 500,000 people. The technology and management skills of Singapore are being used to build a new generation of eco cities," Vegara stated. "It's an impressive opportunity. Yet in Spain, our real estate sector is very fragmented. When it does go to China, it develops a small [project] with a lot of risk and no institutional connections, no umbrella."
The key difference between Asia and Europe is organization, Lohr added, noting that in Asia there are many developers looking at affordable housing "with creative techniques, with a clear idea of what segment they serve, and with clear target costing. We see margins in the area of 20%. There is tremendous opportunity." Schulte Eistrup, acknowledging the appeal of 20% returns, also noted that for Spanish banks, "Asia is far away, and 20% returns come with a degree of risk. So it depends on what degree of risk you are looking for."
Overall, panelists agreed on the many opportunities for investing in real estate that lie ahead. They also agreed on the need for both innovation in the industry and the need to invest not just in land, but in research, especially as populations expand, cities grow, and the demand for affordable housing becomes more pressing. The road to recovery, stated Vegara, "will become a dialogue between the real estate industry and the cities."