As Big Money Chases Real Estate, Markets Await Better Fundamentals

When Samuel Zell speaks at meetings of the Zell-Lurie Real Estate Center at Wharton, people listen carefully. After all, besides being chairman of Equity Group Investments, a real estate holding company in Chicago that is the country’s biggest office landlord, he is a canny observer of the economic trends and how they affect real estate. At an April 25 meeting in Philadelphia, Zell and other panelists expounded on the state of property markets, investment drivers, and the business outlook. Zell, for one, was bullish about the way that real estate seems to be headed.

“The basic underlying elements of our economy are starting to improve,” Zell said. “Despite the war we grew at 1.6% in the first quarter. That’s a pretty astounding number, considering what the distractions were.” He noted that the demand recession plaguing the country’s office space markets today began on the West Coast two-and-a-half years ago, and that it has since moved to the East Coast. “Guess what?” he asked the 400-strong audience. “The recovery is starting on the West Coast and over the next year will move to the East Coast.” He said that office markets now were “probably bouncing along the bottom and actually starting to improve in some areas.”

Zell spoke at a session titled “Is There Really a New (Low) Cap Rate Paradigm for Well-Leased Properties,” moderated by Michael Fascitelli, president of Vornado Realty Trust in New York City. The other panelists were Robert Lieber, managing director of Lehman Brothers in New York City, and Robert Pfeiffer, senior vice president at GE Capital Real Estate in Stamford, Ct.

Flat Fundamentals

Lieber said he was concerned that “while the fundamentals may be flattening out or starting to look up, this recession has been around for a while, [and] it’s having a bigger impact on overall values.” He anticipated a gap in the economic relay race going forward. “When the markets start to pick up and we begin to see some economic expansion, it’s going to be a while before we see the pick-up again in values and improvements in the leasing rates,” he said. Even so, he found strong investment appeal in real estate in the current circumstances. “In January 2000, we talked about the new paradigm and irrational exuberance and all that. This is the same thing. Real estate is incredibly in favor because there’s predictability, there’s a modicum of transparency, and at the end of the day, you’ve got hard assets.”

GE Capital’s Pfeiffer said institutions — especially pension funds — were generating most of the demand. Lieber recounted how they gravitate towards a real estate investment decision: “When we talk to buyers today, they’re saying, `I have a lot of cash; I have seen the values of my portfolio evaporate over the past three years. I don’t care if the value of this [property] is less five years from now than it is today. What I care about is I can get out there five years from now and still have some kind of a positive return.’” He said the risk premium to real estate these days looks better than for corporate equity. “In the face of declining fundamentals, it is still relatively favorably viewed because there’s some tenure in the cash flow.”

Debt in a Slow Market

All this means a lot of investors are lining up. “We have the least worst asset class, and given the woeful performance of fixed income [investments] and other equity alternatives, we are awash with capital in the real estate sector,” said Alice Connell, managing director of TIAA-CREF, the real estate arm of the Teachers Insurance and Annuity Association of America, a big institutional investor based in New York City. She spoke at a session on “Understanding Real Estate Debt in a Slow Growth Market.” Moderated by Christopher Mayer, a professor of real estate at Wharton, the panel had John Klopp, vice chairman and CEO of Capital Trust, a New York City-based investment firm; and John Weaver, executive vice president of GMAC Commercial Mortgage Corporation, in Horsham, Pa.

Connell said that while fundamentals have been deteriorating over the past two years, this trend “has been masked by a 43-year low interest rate level.” But she added that interest rates cannot sustain that disconnect for long. “If recovery doesn’t outrace the expiration schedules in the commercial buildings, we are going to be in trouble,” she said.

Connell saw the risk segmentation among investors from a different perspective. “It’s a tale of two markets,” she said. “If you get a well-located, well-leased building with a relatively benign tenant roster and a nice, even distribution of expiration, you’ve got ample liquidity and excellent pricing.” If the investment platter is something less than that – near term lease exposure, poor creditworthiness of tenants and such – there is obviously much lesser liquidity, Connell noted, which in turn makes it more expensive to park your money in.

Concerns over what the future holds are prompting real estate investors to be more focused than they were in the past on securing the recovery of their investments at some stage. “Every lender today is very focused on his exit strategy,” said Connell. Allowing for a sharper focus on exit strategies, among other things, is well-defined segmentation of risk categories. “The liquidity today is really the result of segmentation,” said Weaver. “Twenty years ago, you were investing up to 80% loan-to-value (in other words, borrowing up to four-fifths of the invested amount) and you had everything from Triple A [instruments] to non-rated ones.” He compared that to today’s scenario, where he would have pre-sold all the investment grade investments and have several bidders for other pieces, including significant demand for the non-investment grade bonds. Clearly, appetite for real estate among investors is deeper and more broad-based than it was two decades ago.

Klopp had similar observations. “In the last five or six years since we started in the mezzanine business, the number of players has increased significantly,” he said. From a handful of players six years ago, he now counts 15 to 20 prominent mezzanine debt investors. (Mezzanine debt investors typically offer shorter term money at relatively higher rates of interest, and often step in as a form of bridge finance.] “All of that reflects the continuing evolution of the debt capital markets in real estate,” he said. Weaver concurred, adding, “In the mezzanine market, there are twice as many people with money as there are opportunities to put it out.”

Investment Strategies
The surfeit of mezzanine money spilled over to other sessions of the day-long conference. “It’s an unprecedented climate for opportunity funds on the debt side,” said Barry Sternlicht, chairman and CEO of Starwood Hotels and Resorts Worldwide. He was part of a panel on “Investment Strategies: Liquidity, Structures and Return Analysis” moderated by Peter Linneman, a professor of real estate at Wharton. Other panelists were Keith Barket, managing director of Angelo, Gordon & Co., an investment firm in New York City. and Richard Kincaid, president and trustee of Equity Office Properties, a real estate investment trust in Chicago.

Sternlicht observed that the range and amount of money chasing real estate these days is amazing. “You can get a lot of leverage – up to 85%,” he said. “And a lot of funds are being raised to provide mezzanine [finance].” It is here that he saw lessons for reading the market differently. “One thing you learn in the opportunity fund business is that you don’t get lost in the fundamentals,” he said. “The flow of funds overwhelms the fundamentals in the ups and the downs. Right now, you have a huge movement which is probably going to get larger, from European cash into the United States.”

All those investments will obviously make sense if the returns are good, especially for home-grown U.S. investors and developers. General Growth Properties, a large real estate investment trust in Chicago, is one such company with a happy record. John Bucksbaum, CEO of General Growth, recounted how his company generated 23% plus compounded annual returns between 1970 and 1985 as a public company. Bucksbaum’s secret is that his company is into retail real estate. “While we don’t have the peaks that other sectors of real estate have, we don’t have the valleys either,” he said during a panel discussion on “The Changing Retail Environment: Will the Favored Sector Stay That Way?”

Retail Ruminations

The retail real estate panel saw participation from some of the biggest names in the business — Paul Carter, retired vice president of Wal-Mart and president of Wal-Mart Realty Co., and Scott Wolstein, chairman, president and CEO of Developers Diversified Realty Corporation. Linneman also participated in the discussion.

Joseph Gyourko, director of the Zell-Lurie Real Estate Center, who moderated the discussion, wanted to know how Bucksbaum’s company managed its top performance. “The key is, we have always preached in the regional mall business the stability of cash flows,” he said. “You are dealing with a group of occupants in our properties that by and large have very strong credits, very good balance sheets, and the structure of our leases have produced strong cash flows.”

Wolstein said that in an economy where it is difficult to derive cash flows, retail has always outperformed other asset classes. “There is a demographic reason why retail does well,” he noted. “There are times when the rate of growth in retail sales slows down, but retail sales never actually decline, because the population keeps growing.” He pointed to the baby boom generation, which has reached its peak spending years and has helped retail investments perform above par.

Linneman noted that unlike in other real estate segments, retail space landlords rarely build on a speculative basis before signing tenants. “You spec-build apartments, you spec-build offices even though you lie about it, you spec-build warehouses, but you really don’t spec-built retail, by and large, with some bizarre exceptions.”

But Linneman also pointed out that all was not hunky dory with retail properties all the time. “In the last decade or 15 years, it has been a real challenge,” he said of making a lasting success of owning and operating retail establishments. “If you were building a retail center 10 years ago and you had K-Mart as an anchor, you were a happy guy. But if the center opened five years later after you get your permits and construction, and K-Mart is about to go into bankruptcy, that’s a big challenge. Today’s success is stumbling 15 years from now; that’s been the history of retailing.”

Wolstein responded, “There’s always somebody coming out with a better mousetrap.” He acknowledged that the retail business has seen “an enormous number of failures” and that this cycle will continue. “But today, the [retail] business is in the best shape it’s ever been in,” he said, attributing that to the lack of new capital coming in. “It’s basically the old guys taking away market share from the weak retailers, consolidating the industry in such a way that there is no more than a couple of players left in each category; the credits of those players and their ability to do business is much better than it was five or 10 years ago.” He also said that the retail business has no entry barriers apart from size and scale of operations.

Is bigger better, Gyourko wanted to know. Carter said size definitely mattered, impacting everything from lower per-unit overheads and increased bargaining power with suppliers of all kinds. “When I joined Wal-Mart in 1977 as a controller, our largest store was 42,000 sq. ft.,” he recalled. “Now, we will not open a store on average much less than 170,000 sq. ft., which are our Super Centers.” (These Super Centers carry both groceries and general merchandise.) He also recalled what Sam Walton said when he received the Medal of Freedom on March 12, 1992, from the then U.S. president George Bush: “Our mission is to lower the cost of living for the people of America,” and parenthetically, “to the world.”

Bucksbaum challenged a long-held view that America was over-retailed, while responding to a question on the future of retail real estate fortunes. “Everybody talks about being over-retailed, but really, the problem is we are under-demolished,” he said, pointing out that his company has not faced that problem. “A lot of the poor properties shouldn’t continue; they should become something else. But it has been slow in happening.” Wolstein said the economics actually make it cheaper to tear down a retail center and build it a different way than it would cost to re-tenant an office building.

After listening to all the panels, the question uppermost in everybody’s minds was: Where do we go from here? Sam Zell had some answers: “I believe that this is the country that will have to lead the recovery of the world,” he said, adding that September 11 has changed “the geopolitical definition” in a fundamental way where the U.S. may no longer see itself as a giant institution ensuring the good of the world. “I think we are going to have a much more jingoistic policy, as it relates to the U.S. for the particular emphasis on fixing and improving our world,” he said. “And I think we’ve never been quite so focused as we are today and will be in the future. All that bodes well for U.S. real estate.” And all heads in the audience nodded.

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