“When you walked in, did you think you would hear about the Eisenhower years?” asked Wharton real estate professor Peter Linneman to a group of some 150 people assembled at Wharton last month. That was just after they heard a speaker’s reference to the former president’s administration at the day-long Fall Members meeting of the Zell/Lurie Real Estate Center.
“I think you have to look to the late 1950s to find the same kind of markets, the same kind of spreads – the Eisenhower years,” said William Mack, managing partner of Apollo Real Estate Advisors, the real estate vehicle of a prominent investment family. He was participating in a panel discussion titled “What Does the Future Hold for Real Estate Private Equity?” moderated by Linneman. “We have a combination of 1973-74 and the Eisenhower years. We had a couple of mini recessions when the economy was very flat. We had slow growth, very low interest rates, [and] some opportunities, but it was not a huge boom. If we combine that with the stock market of 1973-74 in the downturn – the Nixon era – we had the same distrust and we had the same questioning about exactly who and what we are. We now see some of that same distrust of all kinds of corporate earnings, including real estate.”
Mack spoke about the Eisenhower years as Linneman prodded his panel members on the outlook for the real estate industry and the opportunities ahead. Painting a picture of what’s in store for the industry was the theme of the Zell/Lurie Center’s latest Fall meeting’s four panel discussions. These included one titled “Are House Prices Sustainable? Implications for Investing in High Price Markets,” “Real Estate in the Post-Bubble Economy: The Institutional Investor’s View,” and “Does Good Design Pay and What Works.”
“Our goal is to provide thought leadership to the real estate community with cutting edge research and facilitate a partnership between the industry and Wharton faculty and students,” said Joseph Gyourko, a professor of real estate and finance at Wharton, who kicked off the Zell/Lurie seminar.
The panel for the discussion on the future for real estate private equity funds involved three people who represent differing shades of investor behavior. While Mack represented a large real estate family, Stuart Rothenberg was from a giant investment banking firm; he is a partner at Goldman, Sachs & Company. Neil Bluhm provided the perspective of a boutique investment house, JMB Realty Corp.
Linneman noted that real estate private equity funds have matured over the past decade or so since 12-14 years ago when they came into existence. “Prior to 1990, you had a giant LBO industry,” he said, adding that the equitization of real estate came in the 1990s, chiefly with the real estate investment trusts for low risk profiles and the private equity funds which equitized higher risk investments.
Real estate private equity funds have collectively raised some $110 billion since the early 1990s, according to Linneman. He estimates that another $14-15 billion is available “as dry powder – undrawn but committed equity;” that would translate into about $42 billion with a 2:1 debt:equity ratio.
Linneman wanted to know what opportunities exist today for such money. “Leverage the heck out of your assets with very cheap debt and try to buy good assets,” said Bluhm, “because I don’t think we may have another opportunity like this.” Bluhm was discussing how the market components are teeing up. “Today you have some distressed markets where you are starting to see a few opportunities, but nothing like the early 1990s,” he said. “That’s because sellers and owners are very well capitalized, interest rates are low, and you are not seeing a flood of those transactions.” He added that in the 30 years he has been in this business, “I have never seen a situation where you could borrow money so cheaply and get such a great cash flow even though the underlying rental markets are not strong.”
Dismal View
Mack has a dismal view of the road ahead. “If I look at the macroeconomic basis, I believe we will have sub par growth based not upon historical standards, but upon what the economy should absorb, and can absorb, with the productivity levels we have today,” he said. “With the kind of productivity we have, I don’t think we are going to get out of this situation very fast because job growth will be rather anemic over the years. There will be some stress and there will be some opportunities…”
Mack said that “with judicious purchasing or redeveloping, you could probably get the high teens or 20%, but you are not going to get the 25% returns [as in earlier years].” Considering present yields and the cost of funds, investors would be well advised to lower their return targets by between 300 and 500 basis points, he added. He felt these were “highly acceptable returns” compared to present inflation rates. “The spreads are about the same, and may be on a risk adjusted basis. If you look at the bottom when we made these investments, it might be even a little more favorable.”
Rothenberg noted it is difficult to spot opportunistic investments in today’s markets. “In hindsight, the opportunities in the early 1990s were clearly ones where we thought we were making the money in the purchase – it was all about buying right,” he recalled. Today, he is compelled to revise earnings expectations. “The Whitehall (a Goldman Sachs fund class) type returns of north of 20% are very few and far between.” Returns in the high teens are “still very acceptable, opportunistic type of returns.”
If the U.S. markets seem to have lost some appeal, windows of opportunity have sprung up in Europe. Mack described the U.K. as “somewhat of a mirror image” of the U.S., but said he has seen “very stable, good business” in France and “okay” opportunities in Spain, the Netherlands and Belgium. He was particularly attracted to openings in the emerging central European countries such as the Czech Republic, Poland and Hungary. “Overall, although demand is a little weak, there is still a lot of money to be made because there continue to be divestitures by government, corporations and institutions.” He also noted that many of these properties are typically undermanaged, “so there is room for improving management, improving the leasing, and making some money.”
Rothenberg is disappointed with the way opportunities have shaped up in Germany, but he sees “great opportunity in Italy and to a lesser extent in Spain; France has been very stable where we have been able to buy and sell.”
But Mack and Rothenberg didn’t have too much company. “It’s easier to lose money in Europe than in the U.S.,” said Bluhm, adding, “I don’t know if any of these guys have ever lost money there. I have.” He said that although pension funds want to go there and a lot of real estate is available for sale, the risk of the economy tanking is greater in Europe. About present times, he said he’s “never seen the U.S. get clobbered for an extremely long period of time, unless you think it’s 1929 again.” He believes that when the global economy does start to turn around, the U.S. “will come back better than Europe.”
Bluhm felt the biggest opportunity around today was to refinance existing real estate assets. “If I owned an asset myself, I would refinance it,” he said. “But we promised our investors that we would sell, so we are selling and getting good prices.” He also felt it was a good time to buy real estate “because rates are so cheap.” In addition, according to Mack, these are great times in the U.S. to sell stabilized properties, which typically mean buildings with good credit quality tenants and long lease tenures, among other features.
That view was endorsed by several other panel participants, including Martin Cohen, president of Cohen & Steers Capital Management, a leading manager of real estate securities portfolios which also operates a family of real estate mutual funds. “The office building market is really a tale of two cities,” said Cohen, who was on the panel that discussed real estate in the post-bubble economy. “If you have a property that has a reasonably diverse or strong tenancy with no expected or material rollover for the next five years, you’ve got a property that will sell for a cap rate that will make your head spin,” he said. “On the other hand, if you’ve got a prime quality building with a lot of rollover risk and some questionable tenancies, you’ve got a serious marketing problem on your hands.”
Housing Bubble?
The subject of the real estate market’s strength entered territory that was more speculative when participants spoke about the housing market. Chris Mayer, a Wharton professor of real estate who moderated the session on home prices, wanted to know how this cycle was different from others. “We had a 10-year expansion in the 1990s – the longest in American history, and the strength of the economy is hard to overestimate,” said Karl Case, founding partner of Case Shiller Weiss and a popular commentator on housing prices. “We pushed the unemployment rate to 3.9%; we created 24 million jobs; the stock market went up $8.5 trillion. All the factors that favor expansion of demand were there.”
But in response to Mayer’s question about what makes the current cycle different, Case said, “What’s unusual in the downside now is the enormous strength of the housing market in the face of the recession that started two years ago.” One of the obvious reasons, he added, was expansionist monetary policy with low interest rates. He noted that housing starts were strong in this year’s second quarter at 1.6 million, while existing home sales this year have hit an all-time record at 5.3 million.
Bruce Toll, co-founder and president of Toll Brothers, the country’s largest builder of luxury homes costing upwards of $500,000 each, said he has seen the downturns of 1979-81, 1989-93 and others in his 35 years in the business. “This cycle is different; it’s been better,” he concluded. “Everybody keeps hollering bubble; we don’t have a bubble,” he said, pointing to reducing land availability throughout the U.S. and the constraints of securing building permits from municipalities.
“To have a bubble, you need two things, particularly in housing. One is inelastic supply and the other is bad information,” said Robert Van Order, chief international economist at Freddie Mac. “If something is elastic in supply, it’s going to be hard to bid the price up and get a bubble out of it.” As for “bad information,” he cited the experience with tech stocks or even the Tulip Mania in 19th century Holland where “people didn’t know how to project future income.”
Case said that while it is true “we have had an extraordinary period from 1995 till now” and investors have received returns of 30% of more, it is still time for caution. “None of these things are sustainable over the next year or two; we are going to have a reduction in housing prices,” he predicted. Mayer, too, had worries on this front. “If the credit markets have made it so easy for people to own homes, what if there is a pullback in that?” he asked. “We could see the opposite problem.”
Toll said he did not give up on the housing markets easily. He believes that “housing markets go down regionally but they have always come back within a few years.” Van Order pointed to the $100 billion or more of equity that was taken out in cash last year by homeowners through refinancing. “Quite often, when people take equity out of their homes, it’s because they are in trouble,” he said.
Case recalled “the only complete housing crash” he has seen – in Vancouver, Canada, during the 1979-81 recession. And he had an explanation for that. He said that unlike in the U.S., Canada didn’t have fixed rate mortgages. In the 1979-81 recession, the San Francisco market didn’t see a huge lot of homes coming to market even as interest rates climbed because homeowners had locked themselves into 30-year fixed rate mortgages at low rates. But in Canada, “when the rates went up, they couldn’t afford the payments,” recalls Case.
Investment Opportunities
The seminar’s attendees and participants also got glimpses into the future in the final session of the day. Everybody wanted to know if real estate would draw more investments in the future. “Real estate has been the best performing asset class for two years, maybe three,” said Bernard Winograd, CEO of Prudential Real Estate Investors, one of the largest institutional investors in the marketplace with some $300 billion under management. “That has meant it has gained a new level of respect. But it has not translated into a lot of cash, frankly,” he added.
Even so, real estate has seen several new players in recent years such as pension funds, especially corporate pension funds, according to Winograd. But he said “they are looking for a one-stop solution; a single fund they can invest in which is broadly diversified [in real estate].” Also, he said they don’t show a lot of appetite for risk. He compared the interest real estate is evoking among investors to the hedge fund industry, which according to him is being “swamped by capital.” He said that was because of the general “cultural bias” against investing in real estate. “Until the industry finds ways to make itself more congenial … the number of people who are going to participate in it is going to remain somewhat restricted.”
Some movement is visible, and may point to a longer-term change of heart. Marjorie Tsang, assistant deputy comptroller for real estate investments for the New York State Common Fund, a big retirement fund, said that she is seeing “a greater respect for real estate” and that a number of pension funds are formally and informally increasing their real estate allocations.
According to Philip Ward, managing director of CIGNA Retirement and Investment Services and Times Square Real Estate Investors, foreign banks and foreign investment banks are the ones driving liquidity these days. But he’s worried when he sees the fundamentals getting worse and cap rates (a measure of income from a property to determine its market value) going down. “It makes me nervous that we will do what we did the last time with real estate (referring to the 1989-92 recession which saw massive overbuilding and distress sales by investors and landlords), which is to bring everybody in at the wrong point in time,” he said. “Two years later they will all be unhappy and they will go away for 10 more years.”
But some serious problems persist. Winograd said liquidity problems dog acquisitions of large-scale properties because they are tied to terrorism insurance issues. “It’s very, very difficult to put together a deal of any size where the building has what we call ’postcard risk’ – that is, they sell postcards with the property’s picture on it, which is not a good thing.” He said concentration is another issue they didn’t have to bother about until last year: Investors these days are also studying how many buildings they have “within four blocks of each other.”
That said, it is true that lots of high net worth individuals want a piece of the action in real estate, as Winograd noted. Foreign money, especially German, is crowding the industry; newer investors such as corporate pension funds have arrived; and many existing institutional investors have increased their allocations.
If there’s one message that rang out loud and clear that day, it was that real estate now has a rare opportunity to win a place in the hearts of investors. And its players must not squander this away, but treat it with care. Tsang, whose real estate allocations are now so low that the “four top stocks” in her fund eclipse its real estate holdings, said she “can see how these board members who don’t have a history in real estate would be easily swayed, once the rug is pulled out from under them, to say, ’real estate has done it again,’ and put it on ice for years.”
Tsang asked participants at the meeting to imagine what it would be like for a pension fund or corporate fund that has never been in real estate before. She said people like her make their case to their board members, projecting returns and the anticipated risks; her fear is when “two or three years later, you say it wasn’t there,” and faith is lost. “Credibility takes a long time to build up,” she told the audience. “It’s easy to damage. These are investors who would so much more easily run back to the domestic markets. Because it’s easy, you pick up the phone and place the order for Microsoft [shares].”
