While many Americans are worried that real estate prices have flattened and may even turn downward, some of the country’s top commercial developers say there always is opportunity for those who manage their projects efficiently in a global market, focus on areas with growing demand and have the staying power to wait out the downturns.
After record growth in 2006, how does the commercial market look today? “Let’s just hang on and hope these times continue,” said William L. Mack, referring to the current era of low-interest rates, rising rents and soaring real estate investment. Mack is managing partner of Apollo Real Estate Advisors, a New York-based real estate firm with office, retail, hotel and other projects in 20 countries.
Investing in commercial real estate hit a record $306.8 billion in 2006, up from $276 billion the year before, according to the National Association of Realtors. The NAR says the market may level off this year, with vacancy rates edging up and rent increases slowing as the market absorbs new space. But there is little reason to think a serious downturn is imminent. “The bubble really didn’t happen,” said Jeffrey S. Katz, CEO of Sherwood Equities, a major developer of the Times Square area in New York City. “The market is not frantic.”
Mack and Katz were members of a panel titled, “Real Estate: Where It’s at and Where It’s Headed,” at the recent 2007 Wharton Economic Summit. Also on the panel was Jay H. Mantz, managing director of Morgan Stanley’s Direct Investing Group, which runs the securities firm’s real estate investing funds.
One Global Market
Many years ago, Mack said, real estate was an opaque industry that was difficult for outsiders to enter. But in the information age, that has changed and the industry has recently been attracting new investors, including hedge funds, who are helping to bid prices up. “Real estate has become very, very transparent. The investment bankers, with all due respect, will sell whatever the market will buy.” In addition, he said, the capital markets now operate worldwide. “The entire world of investing is coming closer and closer to becoming one market.”
Markets that used to be the exclusive preserve of local developers are, in many cases, now open to investors from anywhere, Mack noted. More and more real estate firms are setting up offices in foreign countries rather than just flying executives in for meetings. “The performance has been so good,” Mantz said, explaining investors’ eagerness to put money into real estate. “You just can’t get away from that. People have made a lot of money.”
But if real estate is so attractive, why are so many publicly traded firms going private, asked moderator Peter Linneman, real estate professor at Wharton. A public-to-private move has often been a last resort for a company in trouble. A chief factor, said Mantz, is that private markets currently give many real estate holdings higher values than public markets do. Public markets, he said, tend to rely on appraised values which, because they are based on prices of previous sales, generally take some time to catch up to market changes. Since real estate prices have been rising, appraisals tend to value properties too cheaply.
In addition, he said, “financing rates are very attractive,” making it cheaper for investment groups to borrow funds to buy out public shareholders. Private companies can finance 75% to 85% of a project’s cost, public ones only 40% to 50%. Finally, he noted, there is lots of money in private hands waiting to be invested, and government regulations are less onerous for private firms. “Being a public company costs more than it ever has.”
Mack added that many firms which go private intend to return to public ownership in the future as conditions change.
Linneman asked the panel whether the fact that Chicago developer Sam Zell is selling properties is a sign that others should follow suit. “For us, it’s not going to be a time to sell,” said Katz. His business model takes a “generational, long-term view,” with the firm often holding a property for 20 years before developing it. Much of his firm’s profit comes from operating properties rather than developing and selling. By keeping that perspective and avoiding heavy leverage, the firm can wait out the downturns. “In our model of development, we are allowed to make mistakes,” Katz said.
Linneman noted that in some hot markets, such as New York City, rising prices have driven capitalization rates down as low as 4.5%. Cap rates — net operating earnings divided by a property’s sale price or value — are similar to yields on fixed-income investments. With a 4.5% cap rate, and assuming rents can be pushed up at an inflation rate of 2% a year, real estate owners can expect returns of about 6.5%, Linneman said. That is about what junk bond investors expect today. “Do you expect much more in real estate?” he asked.
Mantz predicted that rents will rise faster than inflation because real estate is a higher-quality investment than junk bonds. Even so, according to Mack, cap rates probably will not rise above 6% during the next five years.
The Hedge Fund Factor
All the panelists acknowledged that their market will experience a downturn at some unpredictable point. “The liquidity will probably dry up faster than any of us believes,” Mack said, adding that in many downturns, prices need to drop by 30% to 40% to clear out the excesses from the preceding run-up. But the drop might be only 15% in the next reversal because the market has evolved.
One factor is the heavy investment by hedge funds, which create a demand that can shore up prices, Mack noted. A second factor, he added, is securitization — the bundling of real estate loans into bonds sold on the secondary market to investors around the world. This means the initial lenders, such as banks, are not hit as hard when borrowers default on payments. “Certainly, securitization will help ….The banks will not have to pull back entirely…. Maybe the bumps in the cycle will be milder.”
According to Mantz, some recent downturns have been reversed quite quickly. One in Germany turned around in only 12 months. He wondered, however, whether bankruptcy trustees will get bogged down, slowing the work-out process, because they are unfamiliar with securitization.
“What is the best way to weather a downturn?” Linneman asked. “For inventory, the answer is very simple: low leverage,” Katz said. One of his firm’s projects, Hudson Yards in New York City, is insulated from downturns because the land, acquired before being rezoned for the project, was inexpensive. Also, much of the project was pre-leased.
Mack joked that “our timing was perfect” with his firm’s Time Warner Center project in New York City: Condos went on the market just before the 9/11 attacks. The key to surviving such an unexpected jolt, he said, is to have a good product, a well-executed project and the ability to wait out a downturn. “If you hold it, over time you will come out [okay].”
And what’s the best way to make money in today’s market? Katz said developers should look at markets that will be strong in five to 10 years. In the U.S., he said, the rule is to “stay on the two coasts.” New York will continue to be a hot market, he predicted.
Mantz agreed, noting that during the past 15 years his firm has done best with higher quality properties. The best opportunities are in “high quality” cities and gateway cities. Although Tokyo has already boomed, it is still a hot prospect because its population and employment are growing, while that is not the case in many other parts of Japan.
Mack sees good opportunities in central Europe, China and India. In the U.S., he said that Harlem and the Bronx, Los Angeles and San Francisco are all attractive. “Look for the high-growth areas. Look for the changing neighborhoods.”
