Ask Clark Winter about the booming real estate market in the U.S., and the chief global investment strategist of Citigroup’s Global Wealth Management division puts it this way: “People invest out of greed and fear — and U.S. real estate works in both columns.” First, greed: Investors across the world are flocking to the U.S. real estate market, lured by rising prices and stories of sudden real estate fortunes. Historically low interest rates and a weak dollar relative to other currencies have created what Winter calls “a wall of money” that is pushing up property values. This in turn has led to a great deal of “blind money” from numerous sources into funds that buy office buildings, shopping malls, multifamily apartment complexes and the like. But many of those same investors are also acting out of fear, disillusioned by the recent poor performance of stocks and bonds, and wary of an uncertain economic outlook.


That may be as good a take as any on U.S. real estate’s recent star turn, but a key factor in the mix has been changing — that is, of course, interest rates. The benchmark federal-funds rate has risen steadily since June 2004; nevertheless, long-term real estate mortgage rates have remained at attractively low levels. But mortgage rates likely won’t stay resilient to rising short-term rates forever, and if mortgage rates do rise, commercial borrowers who haven’t locked themselves into low, long-term rates will face higher debt-service bills. Unless they are able to negotiate higher rents, the value of their properties will fall.


Perhaps more so now than in the recent past, the fate of the U.S. real estate market hinges on the behavior of interest rates. And while predicting the movement of interest rates is a notoriously difficult endeavor, investors in real estate would do well to understand the market forces at work in the sector, according to experts at The Citigroup Private Bank, a provider of wealth-management services for high net worth clients, and faculty at Wharton. Moreover, recent research from Wharton illustrates how an overheated real estate market, coupled with rising rates, can have a dire impact on a country’s banking system and economy at large.


The Disconnect from Fundamentals


Don Alexander, fixed-income strategist at Citigroup Global Wealth Management Macroeconomic Research, says that although interest rates likely could rise in the first half of 2006, the end of the Federal Reserve tightening cycle appears to be in sight. For one thing, the effect of the recent spike in crude-oil prices on core inflation should be limited, he says, since countries are more energy efficient now than they were in the 1970s. A tight labor market would justify further Fed tightening in the short term, but Alexander also notes that inflation tends to ease as the job market weakens and growth moderates. “Our base case is for economic growth of 3.3% for 2006, with growth moderating by mid-year. As the economy starts to weaken, the Fed could start to cut rates, and we could see the 10-year bond yield actually decline from the current level.”


Even so, commercial real estate investors would do well to be wary of higher interest rates. That’s because if interest rates do rise, they would carry a potential “double whammy,” according to Damian Kozlowski, CEO of The Citigroup Private Bank. First, higher interest rates would make the U.S. dollar stronger, choking off the flow of funds from foreign investors into U.S. real estate. Second, U.S.-based investors would obviously find it more difficult with costlier debt. “A strengthening dollar and more-expensive local real estate markets could lead to a significant correction in real estate prices,” Kozlowski says.


Indeed, for much of the real estate run-up in the U.S., values have not been accompanied by corresponding increases in the quality of returns from properties, creating a disconnect between asset prices and their underlying fundamentals. A property investor’s net operating income (NOI) — or income after local property taxes and operating expenses are deducted — is the spread between the rents they are able to charge and the cost of their capital, including debt service. “Property values are rising, but we are not seeing NOIs rise as rapidly,” says David Rosenberg, head of U.S. investment solutions for The Citigroup Private Bank. His group oversees client investments of about $15 billion across the U.S. Investors weigh NOI as a percentage of a property’s price to derive the capitalization rate, the indicator most commonly used to express value. (The higher the cap rate is, the less expensive the property is, assuming unchanged rents.) While he sees that vacancy rates are decreasing from their recent peaks, value growth has outstripped NOI increases — an indication that investors are settling for lower risk-premiums when buying real estate today compared with a similar point in other real estate cycles. Even as he spots exceptions in some markets where rents could rise, he finds others, like shopping malls, “extremely expensive and frothy.”


Rosenberg says many real estate investors think that they are hedged against a rising interest-rate environment — a notion that’s only partially true at best. Real estate acts as an inflation hedge, given fixed-rate mortgages and the ability to pass many operating expenses along to tenants. “But one must remember that as interest rates increase, economic activity often weakens. That makes it harder to push rents higher and find new tenants to replace old ones,” he says.


Ripples beyond the Real Estate Market


Such a turn in the market could have important effects far beyond the real estate market, according to a recent research paper by Susan Wachter, Wharton professor of real estate and finance, and Andrey Pavlov, professor of finance at Simon Fraser University in Burnaby, British Columbia. In their spring 2005 paper titled, “Real Estate Crashes and Bank Lending,” published in the Wharton Real Estate Review, they say bankers chasing market share and compensation bonuses tend to underprice risk in a systemic fashion with potentially disastrous consequences.


Wachter and Pavlov explain that all non-recourse, asset-backed loans imply a put option on the underlying asset, which essentially allows the lending institution to acquire the asset in case of defaults or delinquency. But in a fiercely competitive marketplace, short-term-oriented lenders might underprice the put option to gain business. They feel emboldened also by the cover of deposit insurance and limited liability in the event of a market crash. The authors say that as short-term-oriented lenders resort to such underpricing, it becomes “impossible for correctly pricing banks to compete, as other lenders are forced into underpricing, regardless of whether they are focused on short-term profits or on long-term performance.”


Wachter and Pavlov say that scenario could create crises beyond the banking system or the real estate industry. They contend that as such systemic underpricing narrows the spreads between lending and deposit rates, it also has the effect of pushing asset prices above fundamental levels, both of which erode lenders’ long-term profits. “The increase in asset prices is the most troubling,” they say, “because of the implications for macroeconomic stability.” They add that inflated real estate prices induce a construction boom and an inefficient allocation of resources within the economy.


Here is how the authors visualize the next stage: “With levered real estate, asset price declines below mortgage value will induce defaults. At the same time, the loss in asset value will decrease the value of bank collateral. Both effects have the potential to undermine the banking system’s financial soundness, as has been shown repeatedly in numerous banking crises that have accompanied real estate crashes.”


Three years ago, in fact, Wachter and Pavlov showed formally for the first time the conditions under which the chase for increased profits in good times led to underpricing risk. Their paper, “Robbing the Bank: Short-term Players, Debt Market Competition, and Asset Prices,” investigated the market prices of assets in fixed supply whose purchase was typically financed by non-recourse loans, as in the case of real estate. They also pointed to real estate crashes in the 1990s throughout Asia and found that asset-price declines were sharper and deeper in Thailand, Malaysia and Indonesia, where the governments did not exercise strong controls over lenders’ conduct. But Hong Kong and Singapore escaped with much lower property price declines — although they were substantial at 33% and 38%, respectively — because government regulators in those countries stepped in to prevent underpricing. The authors’ warning: “If banks are not correctly pricing risk, they are producing risk.”


Finding Opportunity in Risk


Wharton real estate professor Todd Sinai believes that the risks are overstated when it comes to real estate, especially the idea that a bubble will burst with higher interest rates. “Real estate interest rates don’t always rise in a vacuum,” he says. “They go up when economic growth is heating up.” High net worth commercial investors, in particular, are not as leveraged as people at the lower end of the housing market, he adds. “They have more equity in their investments. They currently have a lot of money and no [other] place to put it.”


Todd Thomson, chairman and CEO of Citigroup Global Wealth Management, offers a bird’s-eye view of real estate investing. He oversees The Citigroup Private Bank, Smith Barney and Citigroup Investment Research, which have client assets of $1.3 trillion and a network of 26,000 employees across 600 offices worldwide. According to Thomson, real estate cannot be treated as a single asset class, and distinctions are sharp between the office, industrial, residential and retail spaces. He says real estate is not a national market like that of a GE stock that trades at one price, but is “very much a local game.” Those factors, combined with the relative inefficiencies of real estate as an asset class, make it possible for smart investors to find pockets of profitable opportunities. It’s also not easy to say when one is overpaying for real estate. Referring to the New York City commercial real estate market, Thomson says “investors felt there were high prices for real estate two years ago, one year ago and feel the same way today.”


Stephen Coyle, chief investment strategist at Citigroup Property Investors, is particularly bullish on the U.S. office, industrial and hotel sectors over the next three years. “Right now, we are at a national vacancy rate of 13.6% in the office markets,” he says. “That’s about the point where rents start to rise.” Coyle adds he has “a hard time getting excited” by opportunities in the multifamily housing market, which historically has been the least volatile market and therefore draws investors in hordes. He says that one plus for the sector is that if interest rates rise, homeownership levels will fall, resulting in increased occupancy levels for multifamily properties. “But they don’t get pricing power,” he warns. He says capitalization rates — the relationship between the income stream from a property and its present value — for multifamily properties are very aggressive, currently 4.9% on average, according to the property index compiled by the National Council of Real Estate Investment Fiduciaries.


Despite the compounding warnings about a potential crisis in real estate, Peter Linneman, professor of real estate, finance and public policy at Wharton, is convinced the economy is on “a strong and sustainable” growth path. “We just went through a horrible economy, a horrible meltdown, and the real estate returns were great,” he says. “Tenants will pay their rents before they pay their lenders because if they don’t, they will get thrown out of their space.”


Linneman feels that those who do nothing more than buy cash streams can’t reasonably expect big returns. “Are you taking a company out of bankruptcy, are you redeveloping some property, are you getting entitlements to property faster than somebody else, did you take the risk of getting entitlements?” he asks. But he cautions that such plays are not for everybody, and that half of the battle is picking the right horse. “There are probably 120 opportunity funds out there in real estate, and 12 or 15 of them are worth being in,” he says. “The trick is identifying them and getting access, because some of them aren’t taking money from new investors.”


Citigroup’s Thomson says the best avenues for real estate investing are in value-added deals involving the redevelopment or restructuring of an existing space, as opposed to just another property. All the same, he stresses the need for an asset-allocation strategy that counts real estate among many components. “It’s time to reassess your allocations, but I would stay invested in real estate to some degree,” he says. “You have to start with the right asset allocation and make adjustments from there.”