Global Property Deals, CMBS and All ThatPublished: August 04, 1999 in Knowledge@Wharton
Baku, on the banks of the Caspian Sea, has been much in the news in recent months as a center of Azerbaijan’s emerging oil and gas industry. Lured by the potential of this lucrative market, Hyatt Hotels and Resorts decided to build a hotel and casino on Bukhanov Street, minutes away from the city’s downtown area. Within a year of Hyatt Regency Baku’s opening, however, Haider Aliyev, Azerbaijan’s president, indicated that he wanted the casino closed. Hyatt executives faced a dilemma: Should they accept or challenge Aliyev? As it turned out, it was an easy decision. Aliyev, a former top KGB officer, had once been a Soviet general who had led forays into Afghanistan. Hyatt decided to close its casino.
"That is the rule of law in Baku," said Thomas Pritzker, president of the Pritzer Organization and chairman of Hyatt Hotels and Resorts. Delivering a keynote speech about international real estate investment at the spring members’ meeting of Wharton’s Zell/Lurie Real Estate Center in Philadelphia, he noted that companies should recognize that the rule of law means different things in different parts of the world. At a hotel in Manila, a hotel management contract was terminated at gunpoint. In Greece, after Hyatt had spent $30 million to get a casino license, a minister threatened to yank it unless Hyatt asked every casino customer to submit tax returns. Companies that are willing to brave such risks, however, can also make piles of money. A case in point: the Hyatt Regency in Baku. "Our returns there have been 50%, cash on cash," said Pritzker. "That’s the real sucker bait."
According to Pritzker, currency risk is the single biggest challenge that confronts developers who want to invest globally. "Unless you can invest in the local currency, you will be subject to currency risks," he said. Hyatt considers four key issues in deciding whether to invest in a market: the social and political situation there; the volatility or otherwise of its currency; the tax impact of the investment; and the market’s potential staying power.
More on International Real Estate Investments
Panelists in a session about international real estate investment strategies offered similar advice. Peter Linneman, senior managing director, Equity International Properties (and former director of the Zell/Lurie Real Estate Center) noted that years ago, real estate companies invested overseas for diversification. "No one is making that pitch now," he said. "Today opportunistic buying is the catch phrase." Some developers invest in international real estate because their tenants–such as global consulting firms–want to continue using their services in new markets.
A few companies pursue international investments because, like Hyatt, they recognize that when a deal succeeds, it can be highly profitable. "We are buying non-performing mortgages in Thailand," said Stuart Rothenberg, worldwide head of acquisitions for the Whitehall Real Estate Funds at Goldman, Sachs. "Our returns have been north of 40% after hedging for currency movements." Other participants in this session included James Quille, CEO of Lend Lease Global Properties, and Ronald Spinney, CEO of Britain’s Hammerson plc.
The Future of Commercial Mortgage-Backed Securities
William Mack, managing partner of Apollo Real Estate Advisors, led a session about the future of commercial mortgage-backed securities and liquidity in the marketplace. Participants in this session included Larry Duggins, president of ARCap REIT, John Klopp, CEO of Capital Trust, and Raymond Mikulich, managing director of Lehman Brothers Real Estate and Mortgage Industries Group.
"In March 1998 we saw a slowing down of capital as a result of the Asian contagion,"said Mack. "Then the Russian crisis cut off capital to real estate. We saw liquidity disappear, cap rates rise and the value of real estate decline by 10% to 15%. So with all these problems, what has that done to mortgage originations and issuers?"
"Not a thing," replied Mikulich. "Lehman Brothers survived this crisis easily, as the industry went through an overdue consolidation." Mikulich noted that people lost money because of their hedge positions rather than because mortgages were devalued. "The good news is that market is back, and it is as strong as ever." Klopp of Capital Trust observed that the present system is "a manufacturing system," in which "manufacturers will produce products if they can be sold."
Duggins of ARCap REIT pointed out that the commercial mortgage-backed securities market is evolving in several new directions. He agreed with Mikulich that the market has bounced back. "Liquidity is back, though pricing is not as good for buyers," he said. "Commercial mortgage-backed securities are the most competitive source of capital."
Workable Strategies for These Times
Richard Saltzman, managing director of investment banking and real estate at Merrill Lynch, moderated a session about what real estate companies can do in current market conditions. He began by noting that in early 1998, the public real estate market hit an inflection point: the real estate investment trust (REIT) index was down by 18% at a time when the S&P index was up 25%. That situation, however, did not continue this year for two reasons. First, according to Saltzman, investors are moving into what he calls "cyclical and value-oriented plays," and second, Warren Buffett, CEO of Berkeshire Hathaway, has entered the REIT sector with two significant purchases.
Martin Cohen, president of Cohen & Steers Capital Management, a manager of real estate securities portfolios, observed that the "bear market of the past 15 months is over. We had a near-record bear market and a situation where REIT stocks were cheaper than real estate-that is what drove Buffett’s entry into real estate." Cohen added that returns from REITs are now very positive.
Ronald Baron, CEO of Baron Capital Management, and Michael Fascitelli, president of Vornado Realty Trust, who also participated in this session, shared this optimism. Asked how Vornado, which owns and manages more than 20 million sq. ft. of retail, office and industrial properties, prepares for growth, Fascitelli offered an analogy from baseball. "Most real estate people would hit at wide pitches because they want action," he said. "You have to wait for the right pitch."
Technology and Property Owners
Myles Tanenbaum, chairman of Arbor Enterprises, led a session about the impact of technology on real estate. The panelists included John J. Gilbert III, executive vice president of Rudin Management, Craig Benson, CEO of Cabletron Systems, and Jonathan Litt, director of PaineWebber Real Estate and Lodging Research.
Gilbert, also the chief technology officer of Rudin’s most recent project, the New York Information Technology Center, discussed the role that technology is playing in transforming office buildings for tenants who need high-speed telecommunications to do business over the Internet. "The old axiom of real estate used to be location, location, location," he said. "The new one is location, bandwidth, location." At the New York Information Technology Center, for example, Gilbert explained that Rudin Management had installed high-speed telecom lines that could serve as an on-ramp to the Internet. The concept caught on with tenants such as IBM, Ericksson and CD Now, and the building was "fully occupied 18 months after the grand opening," he added. "Companies that are not communicating with clients electronically won’t be in business tomorrow."
Benson, whose company is now among one the world’s largest networking companies, agreed. He explained that real estate developers who build strong digital capabilities can act as Internet aggregators and get access to the Internet at discounted rates. Mall developer Simon Properties offers tenants high-speed web access that allows, say, a Gap outlet to communicate with other Gap outlets. The income streams generated from acting as Internet aggregators can supplement landlords’ rental incomes, Benson noted.
Value Creation in Real Estate
The final session addressed value-creation in real estate. Mack of Apollo Properties teamed up with J. Ronald Terwilliger, national managing partner of Trammell Crow Residential, and Samuel Zell, chairman of the board of Equity Group Investments, to discuss the challenges that real estate professionals face.
Summing up the historic situation that has led to the present, Mack noted that the mid 1980s represented the best of times for real estate. "Demand and supply were brisk, and interest rates were low," he said. "But then came the real estate depression of the 1990s, wiped out trillions of dollars in equity. What emerged is an industry that is more transparent and is filled with public companies." Mack added that while the players involved in real estate have changed, "we have room for every type of player. I see a situation where we will have faster corrections and shorter cycles."
Zell pointed out that public companies are rapidly expanding their influence, although seemingly they still make up a small part of the real estate market. "Public companies represent 12% of the market, but in Class A and Class B properties they represent 25% of the market," he said. The future growth of commercial real estate is likely to be slow, Zell predicted, because "we are in an era where companies in industries like biotechnology or Internet services are not big real estate users. In the next few years, commercial real estate will represent 6% to 7% of the industry. Real estate will not grow as much as it has in the past. Can the marginal developer survive? He can’t."
Terwilliger sounded a cautiously optimistic note. "We are building in a really strong economy," he said. Mack shared his optimism. "For the next several years, I see us as a country in a very enviable spot," he said. "Those who have capital and structure will prosper."