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William Mack, founder of Apollo Real Estate Advisors, is worried about a trend he sees taking shape in commercial real estate. As private equity pools bulge, private investors are starting to play a role in real estate transactions with developers who put together deals leveraged with the help of private equity funds. “That creates a situation that is very competitive, but is also very fragile. We have a situation developing in this country today where, because of this high leverage, there is tremendous vulnerability.”
Mack made his comments in New York City on February 1 at the Wharton Economic Summit, where business leaders from two hot investment sectors — real estate and energy — discussed possible consolidation in their industries and other trends during two panels.
During the first panel, entitled “Real Estate: Where It’s at and Where It’s Headed. A Discussion with Three Legends,” three of the real estate industry’s best-known commercial developers described how they converted their businesses into large public companies following the real estate crash of the late 1980s. They also discussed how, after more than a decade of prosperity, a few cracks in the real estate edifice might appear.
According to Mack, the industry collapsed in the late 1980s after a period of overbuilding driven by liberal new bank-finance limits and tax incentives, including changes in the rules for depreciation. Mack noted that at one point in the late 1980s, an investor told him it was better to buy an empty building than one that was fully rented because his partners could make more off the tax savings on their losses. “There were great incentives to build and we overbuilt,” said Mack. “I would hope in the world today, with the communications we have and the information we share, that supply and demand will never get out of whack the way it was in the late 1980s and early 1990s.”
After the crash, developers needed vast sums of new capital to keep their over-leveraged properties out of foreclosure. As a result, many developers who had been operating as free-wheeling entrepreneurs took their companies public in order to tap into larger capital markets and reduce the debt on their holdings.
Going public was a big change for real estate developers, said Sam Zell, chairman of the board of Equity Group Investment LLC, adding that developers had been used to acting on their own, making deals based on relationships and bravado. They were not used to keeping their books up to the standards required by the Securities and Exchange Commission. For many, he said, it was a new idea to have any cash on the balance sheet — or, for that matter, a balance sheet. “Creating these public companies and operating under public scrutiny have changed the real estate business dramatically.”
Zell noted that before the crash, the nation’s commercial real estate business was made up of a small club of about 75 builders and lenders. “We all knew each other and the lenders knew everybody. There was a barrier to entry because the lenders were not excited about adding new names to the list. It was a great deal….This business — as gargantuan as it was — was a club.”
According to Mortimer Zuckerman, chairman of Boston Properties, the availability of capital through real estate investment trusts has allowed developers to ride out rough periods for long-term gains. “You have a very different equity position in a lot of the major real estate companies today that will enable us to get through any of the rough periods.” Zuckerman, who is also chairman of U.S. News & World Report and publisher of the New York Daily News, said he does not see another large-scale real estate slump looming, but that individual markets may be vulnerable. For example, he pointed to the problems in Silicon Valley property markets after the technology bubble burst in 2000. “What you might have is not the kind of national crisis that seized the industry, but you will have it in local markets.”
Mack says investors are buying buildings at less than the cost of capital, betting that rents will continue to rise. For the time being, rents do seem to be on the upswing although retail rents could be vulnerable if consumer spending slows as households spend more of their income on energy. “Rents are good in the retail sector and improving, until the public decides they have to heat their home rather than buy that new flat screen TV,” said Mack. “But so far, the public is still buying.” Industrial rents are balanced and hotel rents are on the rise. Meanwhile, all asset classes are vulnerable to rising interest rates.
Zuckerman suggested that today’s interest rates are low, because the expansion of the global economy and off-shoring of U.S. jobs have kept inflation down. “We are in a period in which inflation in overall terms is going to be less.” In addition, Mack pointed out, the industry today is benefiting from investors’ desire for hard assets after the collapse of the stock market bubble in the early part of this decade and fraud at companies where the true financial position was not transparent to investors. But he is worried that many people have borrowed against the equity in their homes to finance the level of consumer spending that has kept the economy growing. And, “while inflation appears benign, our expansion is being fed by other countries buying our corporate and treasury paper.” If foreigners decide for any reason to reduce their investments in the United States, interest rates could spike up. “These are danger signals,” he said.
Global Demand Driving Up Energy Prices
The energy industry has been another area of renewed interest to investors over the past year. As production has failed to keep up with global demand, energy companies have gained increased pricing power and chalked up soaring profits. At the same time, the industry is consolidating so companies can make new investments in exploration and processing to keep pace with energy demand, according to speakers on a panel titled, “The State of Energy Investing: What’s Fueling Consolidation?”
David Crane, president and CEO of NRG Energy, a wholesale power generation company headquartered in Princeton, N.J., said that so far the industry’s consolidation has been among the giant oil and gas companies, such as the merger of Exxon and Mobil. Those energy giants have shown little interest in power generation. He suggested that one or two European national energy companies might be interested in coming to the U. S. to buy some power-generation capacity, although at the moment, the consolidation is occurring within large U.S. power companies, such as the pending merger of New Jersey’s Public Service Enterprise Group and Chicago-based Exelon Corp.
Private equity and hedge funds may play a role in this consolidation, Crane added, but not in the largest deals with values at $20 billion to $30 billion. Private equity and hedge funds are snapping up individual power-generation assets and attempting to make returns off them for investors. “To some extent, that is delaying consolidation because when you get a private equity firm or a hedge fund owning a power plant it will not make investments that pay off over 12 or 20 years because it doesn’t expect to hold the asset that long.”
Aubrey McClendon, chairman and CEO of Chesapeake Energy Corp., an independent producer of natural gas based in Oklahoma City, said consolidation is needed to get the scale necessary to meet the rising demand for energy from China and other parts of the developing world that is driving up prices.
He bristled at the notion of a windfall profits tax on energy producers. “Just when we need large-scale players to step up and invest in the kind of project to create the energy the world needs, it becomes a crime to make money in the industry,” he said. “We are moving towards difficult times unless we are willing to recognize the scale of the problems our industry is charged with solving, and [unless you] let us make some money to be able to invest in the future.”
McClendon pointed to another future problem for U.S. energy consumers. Since governments control access to most energy sources, such as oil and natural gas fields, energy companies are at the mercy of foreign governments. “Over time, the contracts will be negotiated and not renewed,” he said. “It’s not good news for American consumers.” If consumers believe they are already taking a hit from big international producers, such as Exxon and British Petroleum, McClendon added, it is likely to be worse if these companies are forced out of the exploration business, and companies selected by the governments of Iran, Iraq and Indonesia control raw energy resources.
According to William Macaulay, chairman and CEO of First Reserve Corp., a Greenwich, Conn., private equity firm specializing in the energy industry, national oil companies are moving beyond their own borders to find new supply, particularly China’s CNOOC, which had attempted to buy the U.S. oil company, Unocal. “Those countries and those companies have a tremendous need to find more energy,” said Macaulay. That means “on a national and worldwide basis you will see them becoming very aggressive.”
Private equity is not a major force in the energy business, Macaulay added. While 15% of all merger transactions were done with private equity last year, the figure was only 3% for energy deals and most of that was in the power-generation sector. “Perhaps it will change, but it hasn’t changed in the last 10 years. Private equity is pretty inconsequential in energy.”
Crane commented on President Bush’s call for increased investment in sources of renewable energy in his State of the Union speech last month. Crane said policymakers must realize it will be many years before renewable sources are developed; in the meantime, dependence on fossil fuels will remain strong. “What troubles me a bit about the President’s speech and in general,” he said, is that “people are talking about clean coal and new nuclear power generation — which is fine — but you never hear that it will make a difference before 2015 or 2020. The United States is going to be in a world of hurt if we don’t address the problems that will appear from 2006 to 2015.”
Macaulay pointed out that the renewable-energy industry typically benefits from concerns about high-energy costs, and noted that renewable sources of energy gained a lot of attention in the 1970s when energy prices were high, but interest dropped off in the 1980s as new energy capacity came online and prices dropped. “Renewables are here to stay, but it takes a long time to make a difference. We are going to be in a hydrocarbon-based economy for a long time.”
The good news about today’s higher energy prices, according to McClendon, is that they have brought new attention to the fact that the world’s oil resources will eventually run out. “The geology of the world guarantees that outcome,” he said, adding that unless the nation comes to a consensus on energy development along the lines of the Manhattan Project (the coordinated World War II research project to develop nuclear weapons), renewable energy would have only an incremental impact on energy supply.
Crane noted that governments, most notably state regulatory bodies, could hurt energy consumers in the long run by denying rate-hike requests. “To the extent you don’t let those price signals go through, you are hurting the cause of conservation.” He said that happened in the California energy crisis when regulators refused to raise rates at first, but when they finally passed higher prices along to consumers, consumption declined 15% in three months.
McClendon urged governments to offer the same kind of price supports for energy companies as they do for farmers to encourage continued exploration and development. That’s the kind of cooperation he would expect from government if he lived in a “dream world.” Instead of working with energy producers, he said, Congress has subpoenaed executives to testify about whether they are price-gouging.
“We are in an enormous industry. The scale is enormous and the profits needed to go into these kinds of projects are enormous too,” he said, pointing to a proposed Alaskan natural gas pipeline that would cost $25 billion and take 15 years to build. “There needs to be a partnership. Just when we need to be getting along better, the threat is [the government] will come and take our money.”