In an Uncertain Economy, Real Estate Holds its Ground

Real-estate entrepreneur Samuel Zell stunned a gathering of 300-plus developers, brokers and academics at Philadelphia s Rittenhouse Hotel recently when he told them how his company got a big check for  believe it or not  not constructing an office building. Zell, who is chairman of Chicago-based Equity Office Properties Trust (EOP), the country s largest real estate investment trust and the biggest publicly held owner of office properties, said,  Somebody just paid EOP $85 million not to build a building that they had leased from us. The tenant (whom Zell did not identify) had signed a lease for a property it no longer wanted, and paying off EOP was the cheapest way out.

 

The point of Zell s story was that in the present economic climate, no one is taking any chances. Developers and tenants are restraining their ambitions and cutting their losses.

 

More such insights were in store at the two-day spring members meeting of the Samuel Zell and Robert Lurie Real Estate Center at Wharton on April 18 and 19. The discussions covered the impact of September 11 on real estate, the current economic downturn, the coming design and construction changes, niche markets and the pros and cons of being publicly or privately owned. While the panels featured speakers from real estate development and services firms and investment banking houses, Glenn Hubbard, chairman of the President s Council of Economic Advisors, provided the broad economic backdrop in his keynote address.

 

Property markets have held their ground fairly well in the current uncertain economic times, but equilibrium is still some distance away, the speakers said. Office rents have been depressed for about a year now, with massive amounts of cheaper-than-usual subleased space coming on to the markets. Zell put it in perspective.  You have to be really careful when you talk about how far rents have come down, he said, adding that of late, rents have begun moving back to 1999 levels  and 1999 was a good year. But what makes the situation worrisome is that the cost of building new space is at 2002 prices. Zell added:  The spread between current rents and the cost of replacement that creates new competition will go back to what it was in 1993, when there was a big gap. It obviously means that I see very little construction for the next four years.

 

Zell knows that  the cost of rents and the cost of construction must come back together, in which he reads  very positive scenarios for the office building market beginning probably in the first quarter of 2003 and becoming really meaningful in the second half of 2003. He expects the real estate markets to show positive absorption (or a net increase in space leased) again by the end of this year. To be sure, until rent levels make new construction meaningful, existing buildings would have the demand all for themselves.

 

There are bends in that year-long tunnel, though, and the imponderables associated with terrorism risk insurance are chief among them. In fact, presidential advisor Hubbard said that when the Bush Administration weighed the downside risks in the economy after September 11, terrorism risk insurance ranked along with energy prices as the two big question marks hovering over the economy s future.  The absence of terrorism risk insurance will act as a damper on the construction of new projects. It will complicate the massing of projects on the block but not yet started, and projects that are ongoing, he said.  Perhaps most serious of all [will be] the decline in the value of commercial real estate portfolios as owners of large commercial properties suddenly realize that there is in effect a reduction in the value of the properties they held.

 

Hubbard noted that as the government worked with the insurance industry, real estate companies and pension funds on rationally pricing terrorism risk insurance, numerous property owners face problems obtaining proper coverage, and this has had  a chilling effect on projects.

 

Currently only three companies provide such insurance  AIG, Berkshire Hathaway and Lloyds of London  according to Stuart Rothenberg, a partner at Goldman, Sachs & Co., who added that while two of these companies have a $250 million cap on coverage, the other was willing to go up to $500 million  for an astronomical premium. Douglas W. Shorenstein, CEO of Shorenstein Company in San Francisco, a big owner of premium office properties, expected  some form of tax from Washington to bridge the gap. But he did find premiums for such insurance getting more reasonable, barring another terrorist attack. Zell saw no scope for a  really fluid or deep market developing in terrorism insurance in the absence of an actuarial model to predict such events.

 

September 11 and its aftermath clearly weighed heavily on all minds.  What are the lessons? was the stage-setting question from Joseph Gyourko, director of the Zell/Lurie Real Estate Center, who moderated two of the sessions. Drawing upon the history of urban disasters, Witold Rybczynski, a professor of urbanism and real estate, placed his faith in the adaptiveness and resilience of cities. He cited Warsaw as inspiration.  Warsaw was completely destroyed in 1944  80% of the buildings were destroyed, 100% of its people were taken out of the city, he said.  In 1945 there were already 4,000 people moving in there starting to rebuild the city, and they did in fact rebuild it.

 

Rothenberg said Goldman Sachs understands it  may be at some level of risk when it is in a major urban center.  In the major cities of the world we feel we should be in buildings that we absolutely control, he says, referring to one of the big September 11 lessons for his company. The company is the fifth largest tenant in Manhattan  all five are on the same power grid but the company has had problems enforcing security in buildings where it s a tenant and not an owner.

 

While security is being ramped up in buildings, designers and architects are also reassessing structural risks.  We are looking at ways of permanently and less obtrusively dealing with providing safe zones around buildings from major bomb attacks, said Richard F. Tomlinson, II, partner at the New York City-based architectural firm Skidmore, Owings & Merrill. He cited the examples of London, where blast protection is a design requirement, and earthquake-prone Tokyo, where building codes require special emergency facilities to be in place. But he said he worried about  overreaction to some of these things  we should deal with problems where they exist.

 

Former Philadelphia police commissioner John F. Timoney, who is now CEO of Beau Dietl & Associates in New York City, an investigative and security services firm, agreed.  I would suggest you resist this notion of allowing the government to bring in so many regulations, he said.  Clearly you can t develop high-rise buildings like you have in the past, but that doesn t mean you throw out the baby with the bath water.

 

High-rise trophy buildings were not in favor, and Rothenberg seemed relieved that Goldman Sachs did not own too many trophy assets. In fact, after deciding against expanding in the New York Stock Exchange building because it wasn t comfortable from a security perspective, the financial services giant picked Jersey City s former Colgate Center complex to grow.

 

Rothenberg recalled an internal PR campaign before September 11 promoting the Jersey City development to employees as a desirable trophy address.  Post September 11, that campaign backfired, he said.  We are doing a number of things to that building to scale back from the standpoint of its exterior design, to make it much less a trophy building.

 

From the investment market s standpoint, large parts of the real estate industry are still attractive, according to the conference participants. Rothenberg said there is  tremendous demand from lenders for refinancing assets. He said Goldman Sachs residential investments are also recapturing ground lost after September 11, and  it s all come back and prices are holding up. Lenders are, however, not enthused by mixed-use properties and hotel projects.

 

Christopher J. Mayer, a professor of real estate who moderated the session  What Have We Learned From This Cycle? noted that  real estate seems to have taken it [the recession] much less on the chin than other parts of the economy. Lehman Brothers managing director Robert C. Lieber agreed, saying  This isn t really a real estate recession.

 

Charles Baughn, executive vice president of real estate developer Hines, pointed to several aspects where the real estate industry had come a long way from the recession of the early 1990s. Among them were the lack of overbuilding this time; transparency in information flows; improved disclosures in the public real estate markets by real estate investment trusts; and a lot more equity in deal structures, enforced by lenders wary of high debt loads.  In the last cycle, there were a lot fewer financial institutions, said Lieber.  Now there is discipline with securitization and syndication…and a much bigger emphasis on finding something that is rationally priced.

 

Robert E. Sulentic, CEO of real estate services firm Trammell Crow, said another important factor was the increased difficulty of finding good construction sites. There are other obstacles too.  Zoning and other approvals are getting harder and harder, time consuming and risky, said Hamid Moghadam, chairman and CEO of AMB Property Corp., a leading owner-operator of industrial real estate.

 

Moghadam felt that given its relative strengths, the real estate industry should now feel less compelled to project itself as a lucrative investment destination. He said real estate investments have always been viewed as an inflation hedge and carved out of investment fund allocations.  The minute real estate gets out of this allocation business and rejoins the rest of the capital market, over time its returns will get more in line with other capital assets, and end up being more volatile, too, he said.  Warren Buffett says equity returns are 7%-8%. Why do we as an industry have to keep saying that we will deliver 20%?

 

The Enron scandal has scared investors in general, and the real estate industry is unlearning its own lessons, such as off-balance sheet deal variants like synthetic leases. Although Lieber doesn t see  any big Enron out there in the real estate world, Jeremy Siegel, a professor of finance at Wharton, said he sees  a tilt towards value stocks. He said investors prefer tangible earnings like dividends and cash flows; here,  clearly real estate stocks are benefiting. But he was worried about a trend among investors  to chase some of these smaller asset classes - small, micro stocks  where you have the possibility for dangerous bubbles.

 

More bounties await publicly-owned real estate companies, according to Zell, who expected them to double in size in the next decade.  In the long run, public ownership of high quality, scalable real estate is the ultimate nirvana, he said, adding that the transparency and accountability in the industry since the last recession have created the underpinnings for this situation.  Today the public REITs represent probably 10% or 11% of all the commercial real estate in the country and probably 30% to 35% of investment grade real estate, he said.  In 10 years that number will be 60% of investment grade real estate.

 

Zell s views stirred a debate with Shorenstein, whose family-owned business goes back to 1924. He found greater merit in staying private. Apart from investment expertise, access to capital, operating and leasing expertise, he said it was important  to be able to buy at the appropriate time in a cycle and most importantly sell at the appropriate time. He felt privately-owned companies have greater flexibility in selling real estate.  In our format, if we do our job right, the total return should be higher because we can sell and realize our value at the appropriate time, Shorenstein said.

 

Wherever the investments come from in the long run, the bigger macroeconomic trends are encouraging, according to presidential advisor Hubbard.  In the last part of last year, we had investment in equipment and software grow at negative rates, he said.  All that is required for a turnaround in the economy is to have investment growth returning to near normal levels. He felt that was achievable because barring some sectors like telecommunications,  the capital overhang is largely over and while  businesses may have gotten a bit ahead of themselves in the 1990s, much of that is being unwound. On top of all that, he found an improving investment climate with a combination of strong consumer spending, buoyant home prices, monetary policy actions by the Federal Reserve and public policy initiatives, such as tax cuts, from the Bush Administration.

 

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