Then and Now

Here's one more response to the "Then and Now" question:

These are some thoughts in response to your question as to the differences “between now and then”? My perspective is one coming from years and years in the institutional investment arena. My comments are in the context of institutional investor allocating capital to the US property markets with the objectives of earning a competitive current yield; broaden portfolio diversification and hedge inflation.

Summary what’s different between then and now?

--not mad at real estate; recognize/accept it as a distinct and separate asset class

--interests are better aligned with those of the mangers this time around; improved governance

--have access to vast amounts of timely, reliable and high quality third party information

--all asset classes in the tank; some more than others; real estate performance OK on a relative basis

--market distress caused by over-leveraging vs. over-building

First---commercial real estate is, today, an accepted asset class. Institutional investors have been through three up cycles and are now in the middle of their third down cycle. They have come to realize that real estate is as cyclical as stocks and bonds. And they have come to learn that over the longer term real estate has delivered. The investor market has matured. It is much more knowledgeable, experienced and, therefore more tolerant.

When the markets crashed in the 1990’s, investors were mad as hell at the real estate industry. They felt that had been taken to the cleaners by a bunch of slick promoters. They were mad at their managers; mad at the appraisers for failure to reflect the realities of the market, mad at their consultants for getting them into real estate in the first place.

Not this time around. Nowhere is this more in evidence than in the open-end funds. Despite large redemption queues, investors are not willing to sell shares at deep discounts. Nor are they bad mouthing the asset class, their managers or blaming their consultants. Some have evidenced an interest in buying back in, but feel values have not yet reached bottom. These are some of the same investors who are in the in the redemption queues.

Second—a significant percentage of manger compensation today is tied to realized performance, not based on asset values. Lots of different fee structures and formulas for sure. However, there is one common denominator-the better the real estate investment performs, the better both investor and the manager fair. Managers can’t get rich in a down market. (Opportunity Funds excluded)

Third—today investors and mangers have access to huge amounts of information assembled, analyzed and published by third party professionals with impressive research track records and academic credentials. Data providers include: Torto-Wheaton, REIS Reports, Portfolio & Property Research, Real Capital Analytics, Co-Star, and IPD.

In addition a number of university real estate centers-track and measure US commercial real estate and engage and publish research on commercial real estate property markets supply and demand behavior and real estate risk and return. These include MIT, Wisconsin, Columbia, USC, North Carolina, and California-Berkley to note some of the more prominent schools. In addition investors can utilize benchmarks and indexes produced by NCREIF, Levy/Giliberto, Moody’s and others. This industry information infrastructure was in its infancy in the early90’s. There is no way investors can say today “I didn’t know what was going on”. The information is out there, a lot of it in real time, and readily accessible.

Fourth---as poorly as private real estate has performed in the past year and a half--the capital component of the NCREIF Index experienced its biggest one year decline in the 32 year history of the Index- (-24%)--other asset classes, including public equities, hedge funds and private equity funds have fared even worse. A lot of institutional investors would be receptive to adding to their real estate portfolios in this cycle, if it weren’t for the denominator problem.

Fifth—this down cycle is one caused by investors loading up on too much debt, and in the process driving up prices and driving down yields. The last cycle was caused by over building. Same result. This is another reminder that leverage is a two-bladed sword.

For me, this astute commentary synthesizes almost all of what others wrote back to me on the “Then and Now” question. The perception of any individual, about anything, is based on where they play in the game so, for example, transaction brokers have one vantage point, real estate lenders (if and when you can find them today) have another one, etc, etc. 

But as I make my way around North America, speaking with investors and consultants, I’m hearing a very similar story. The tide does to be coming back in, slowly and cautiously, like on a quiet beach in Mexico. But, we can’t be too hasty to say that ‘it’s over’ and everything will be hunky-dory again. This is probably the most complex period in the real estate investment world ever and time is either our friends or our enemies, depending on our position and motivation. 

We will see. We will see. And, OMG, we’re just about to start the fourth quarter of the year that many just want to write off. But as we know, when we write stuff off, we may have to hold a reserve and some of the reserves are dwindling as the clock ticks. 

The '90's Real Estate Crash vs. Today's Meltdown

A friend of mine, Steve Felix, who is the most networked person in the real estate industry, a great guy and a talented rock guitarist, publishes a newsletter every week. The newsletter, On the Road with Steve Felix, gives his and other's insights, shares nuggets from conferences and provides great recommendations for restaurants, music and hotels around the world.

Last week, Steve asked about 30 of us to provide our comments on comparing the real estate crash of today with the debacle in the 1990's. The response was excellent which is a tribute to Steve, as well as his readers. Today, Steve published the unedited version of all the comments. In the interest of trying of trying to keep the summary as brief as possible, I culled the best of the comments for your review and comments. How would you compare what we experienced in the '90's with what we are experiencing today?

1. First, this time around--the speed with which the market came apart was unprecedented. The impact is much more personal this time. The impact is/was more widespread. Then the problem was on the front page of the business section. This time it’s on the front page of everything!

2. Second, the economy is not holding up as it did the last time around. In short, the economic fundamentals are much weaker this time and will be much slower to recover, and rents will be a long time recovering as a result, both because some of the job loss is never coming back and because the credit market dysfunctional will continue for quite some time. We have yet to see the worst of it, generally speaking, and there will be many a false dawn before we see the real McCoy.

3. Both eras experienced difficult fundamentals (today – more of a demand problem, them – more of an oversupply problem), but overall the enormity of the situation is a lot bigger and, from a value erosion perspective, much worse today than 15-18 years ago. The recovery will be slower this time around – if then it took 5 years this time it will be about 7 years (8/2007 until 2014).

4. Baby boomers were relatively young and resilient. Better able to weather the storm and rebound than today.

5. In the RTC days there was oversupply of product, this time around there is no over building but rather demand destruction-which still gets you to oversupply of all property types.

6. Lastly, the rigid debt structure of CMBS is untested and did not exist the last time around--we are all going by Braille on this and who knows where it will take us and the real estate industry.

7. The biggest difference I see is in the RTC days the banks wasted no time in taking back assets and making them REO's and the RTC just moved them.

8. Past was FAST! The pace was fantastic! The government facilitated a quick, catastrophic, over the top write down, taking many lenders and owners down and out. Smart money showed up hungry and underwrote in windowless rooms with cadres of kids and elders hand compiling data - ah, the war room! Didn’t have to be very right to win. It was all about courage. Successfully got the junk cleaned up. Constituted perhaps the greatest involuntary wealth transfer ever on the planet. Was it fair? No. Was it effective? Very.

9. Today, OMG how slow! Deal by deal, discount by discount. As long as the lenders can argue they are solvent nuttin’ needs to move. All evidence supports a slow recovery. If the economy is strong enough, “Pretend and Extend” will stop. If the economy has a gradual recovery, it won’t for a while. Therefore, the Congress has turned Citibank, B of A etc. into RTC II's. Government funds the banks, they extend and we push this mess out three years- but never resolve. Smells like Japan! As I have been telling our investors - the banks made stupid decisions when it was good and they have swung the other way and are making equally stupid decisions when it is bad - they are taking 0% risk and demanding unreasonable terms.

10.This Congress and our new President are behaving in a way that screams- "I will not be associated with the fire sale of real estate assets held by banks" and attributed to the private equity raid of the candy store at 10 cents on the dollar. The politics and egos and stopping them from initiating the very cleansing mechanism we need.

11.But in fact it all needs to move! Would be nice to see the government act a bit more authoritatively – in terms of forcing revaluations and shutting down the insolvent players, especially now that the critical stage seems past. Stop propping and start popping.

12.To that point the drop in values happened in cyber time- very fast vs. taking years to get to peak to trough. Though some may drop further the decline has been rapid- and widespread. Lastly this has impacted every market and every property type vs. RTC days when some markets/assets fared ok.

13.Commercial Real Estate 1986-1994 vs. 2008-

Similarities

a) Plentiful capital (both debt and equity).

b) Deflation in property values followed extended period of rapid increases based upon capitalization/yield rate compression (i.e., without corresponding increases in financial performance).

c) Extremely lax underwriting by lenders.

Differences

a) Prior downturn due largely to massive additions to supply coupled with disadvantageous changes in federal tax law; current problems exacerbated by sharp contractions in demand due to deep recession in the overall economy.

b) Much greater portion of capital came from public markets recently than in the prior downturn; spurious ratings of CMBS played a significant role in current situation.

c) The OCC and FDIC are now more knowledgeable regarding distressed commercial real estate than in the prior crash and thus should be more adept in assisting in market-clearing activities.

d) Recovery from the current difficulties is likely to be more prolonged due to a) the forcast slower recovery of the overall economy; b) higher interest rates caused by historic borrowing by the federal government; and c) the likelihood of significantly higher federal income tax burdens on both individuals and businesses.

14.Some thoughts:

a) Liquidity: Then-Very little; Now-Plentiful capital is available

b) Supply/Demand: Then-Too much overbuilding: Now-Overbuilding not the issue

c) Banks as lenders: Then-Major supplier of capital; Now-Banks only 30% of lending; many more non-bank players

d) Deal Complexity: Then-Could be but most deals had few participants; Now-Very complicated capital stacks; many deals with 15+ layers

e) Gov't Intervention: Then-Some Heavy; Now Propped up many financial institutions

f) Willingness to Foreclose: Then-Many had large workout reluctance; Now-Willing to have & asset management teams borrower run asset due to local knowledge and experience.

g) Workout Mechanisms: Then-Covered in loan docs; Now-Mechanisms do not work for REMICS. All are having great difficulty working out due to complexity

h) Workout Experience: Then-Many seasoned pros that had been thru 1974 down markets restructures. Now-Very little experience

i) Special Servicers: Then-Limited role: Now-Not set up for number & complexity of deals

j) j. Global Issues: Then-Very little; Now-Deals and sources of capital global in nature

15.Greed and fear are part of our sustainable, capitalistic society and both of these emotions played a role then - S & L Bailout/RTC Days, and now - Financial Bailout. To compare the two “crises” is helpful if it serves to make us wiser. And being wiser is the key! Notice I didn’t’ say smarter. Wise means finding a balance of greed and fear, and right and wrong. No regulation will make you wiser.

16.Today, real estate is ridiculously mainstream, and investors' willingness to invest anywhere, anyhow, at any level of the capital structure continues to amaze me. I'm no longer naive (or with hair), and remain skeptical that we will learn anything from this crisis. Few innovations will come from it (nothing is forcing the innovation this time), the banks will pretend they don't have massive losses long enough that things will inevitably improve (and thus justify their inaction), and we will soon return to frenzied bidding wars to buy mediocre assets at 4.5% yields (at least in Europe). Unlike the last time, when it took almost eight years for investors to re-dip their toes, I predict the wall of cash returns much sooner than is financially justified, which will of course bailout all the silly projections that underlie these future buys. And on we go.

17. In short, we were in “shit” back then. Today, we are in “deep shit.”

A couple of final thoughts:

Over twenty people responded to Steve’s call for comments and observations. Their observations were very astute, realistic and uniform. The scary part: Everyone that responded with their observations, which more insightful that I have one government official, political or bureaucrat, Fed, FDIC, you name it. This is a sad commentary and will, unfortunately, prolong the how long it takes to work out of this mess.

Finally, isn't it a sad commentary that it's been eight years since the World Trade Center event and there is still nothing built...just talk, lawsuits, politics and bullshit? Everyone involved should be ashamed of himself or herself.

Rough Ride Ahead!!

• Opportunity real estate fundraising to sink to lowest level for 4 years.

• Just $16.2 billion has been raised for real estate opportunity funds worldwide in the first half of 2009.

• Much of the negative investor sentiment falls at the door of “legacy real estate funds."

• Even if this figure were to treble in the second half of the year, it would still fall short of the $60.4 billion raised in 2005.

• The total amount of equity raised in 2004 was $24.3 billion, and $11.7 billion in 2003.

• Those investors which are still committing to real estate opportunistic investing are only interested in “distressed plays.

• "Expect an upheaval in the real estate investment industry over the next two years, as more major banks hive off “non-core” components of their businesses."

• "There’s a window of 12-24 months where we will see a reshuffling of the industry, and banks like Citi and others dispose of some of their real estate investment activities."

• The financial crisis has added to the theme for all banks to re-appraise what activities constitutes their core business."

• There will be a “massive reshuffling” among private real estate investment companies, as steep investment losses brought by the market turmoil meant “a lot of businesses are no longer viable under current management”.

• Within the $16.2 billion figure raised in the first half of the year, $7.7 billion was raised for North American strategies as investors sought to capitalise on distressed opportunities in mature markets.

• Fundraising for Asia has been worse hit with just $1.5 billion raised against $21.8 billion recorded by the firm as being raised in 2008.

• $4.7 billion has been raised in the first half for Europe while only $1.6 billion was raised for funds employing global strategies and $0.8 billion for emerging markets outside of Asia.

RCA (Real Capital Analytics) June Capital Trends Reports were published today. I offer you a few choice morsels:

1. Apartments: Some encouraging signs include some larger deals now in contract, the emergence of new buyers and the return of some investors after a year or more on the sidelines.
2. Industrial: Drop in transactions is on par with other property types but defaults and foreclosures in the have been relatively mild so far compared to other property types.
3. Retail: Sales volume languish and the inventory of properties for sale swells and defaults and foreclosures proliferate.
4. Office: Some signs that investment trends are stabilizing. Although they are not improving on an absolute basis, the pace of decline is slowing.

Barron's reports: The US home-foreclosure rate fell in May for the first time since January. But with filings on 321,480 homes in May, it hardly suggests housing is out of the woods.

Indeed, multifamily properties have begun to feel the stress of the credit crisis, with apartment defaults spiking to 3% in recent months, versus an average monthly rate of less than a half-percent in the past eight years. And with unemployment up and rents and occupancy down since the start of the year, the numbers are poised to get worse. So says Mike Kelly, president and co-founder of Caldera Asset Management, a multifamily-real-estate consulting firm: "It's the single-family world, just two years later."

First-quarter multifamily apartment transaction volume fell more than 70%, according to Real Capital Analytics. Kelly says the situation in the $880 billion multifamily debt market is likely to get only worse, with $7 billion of such asset-backed securities coming due next year.

Meanwhile, the average capitalization rate for multifamily properties has risen by two percentage points since 2007, to about 7.5%. The capitalization rate, similar to the yield on a bond, is calculated by dividing annual net operating income by total debt and equity,

Although apartment cap rates have moved closer to those of other properties, their costs of borrowing (largely from government-sponsored entities) are typically up to 1.5 percentage points lower than for other commercial properties, Real Capital Analytics noted in its May report. Its conclusion: This is "a buying opportunity."

GLOBAL SALES HIT BOTTOM: No Rebound, but Little Room Left to Fall 
“Global transaction volume continues at a remarkably sluggish rate—and that is good news. Although Q2’09 sales are now estimated at $48.6 b worldwide, a 67 % year-over-year drop, the decline from Q1 volume could be as little as 5%, indicating a plateau has been reached, although there is no recovery in sight. Quarterly volume projected for the Americas is almost negligible at $8 b, a 6% consecutive drop but an 83 % fall yoy. EMEA is likely to take the most dramatic hit from the first quarter, down 24 % at $17.3 b and 71 % yoy. But with Australia, Japan and China beginning to stabilize, Asia Pacific sales are expected to be positive with an 18 % gain on the prior quarter at $23.3 b. That’s nearly half of estimated global volume and marks Asia Pacific’s first quarterly lead in sales worldwide—even as the Americas accounted for just one-sixth of that volume.”

When people, claiming to be economists and having missed calling the downturn, say we are nearing the “bottom” of the recession, I just smile.

 

In real estate, everything is driven by JOBS.  We now have a reported 9.4% unemployment rate. We have lost 6 million jobs and now over 14 million people are out of work.  However, if we counted the people who have become discouraged and left the job market, the rate would be over 16%.

 

I do not think it is good to take what is happening in the short term and make long-term judgments.  With the exception of a few, no one saw this coming and certainly not this bad. 

 

At the moment, we do not know the rules of the game.  We do not know how to price things and, therefore, we do not see many transactions.  Unless people absolutely need to sell, everyone will stand pat and wait.  Sam Zell said it best: "I think it was Confucius that said 'Banks don't recognize securities'."

 

Everyone will be looking to get in a position of liquidity.   At the moment, the only liquidity in the real estate market is found in REIT stocks.  People may not like the values, on either side, but it is the only place at the moment. 

 

If we examine what has happened in one of the hottest residential markets, we can see that there is very little liquidity today in property.   In West Los Angeles, one of the hottest residential markets in the country, in the last three years, the number of houses sold has dropped 80% and the prices have declined 40%.