01 Dec 2005

Trillion-Dollar Fixer-Upper

by Roger Thompson


The commercial real estate business was in a shambles fifteen years ago, but just look at it now. After a complete rehab, the industry has become the darling of investors eager for alternatives to lackluster stocks and bonds. But will the good times last?

Students of recent U.S. real estate history can’t help but notice unsettling parallels between the red-hot commercial market of the late 1980s and today. Then, as now, money gushed into the market, driving office and retail property values to unprecedented heights while creating fortunes for savvy dealmakers. The siren song of real estate never sounded so sweet. Then the music stopped.

Dan Dubrowski (MBA ’90) remembers it well. “When I came to HBS in 1988, real estate was hot. When I left, it was in a virtual depression.” Classmate Hoke Slaughter (MBA ’90) recalls that jobs virtually dried up. “Real estate development companies were rescinding offers to classmates of mine.” When the job market for commercial real estate tanked, so did MBA student interest.

Today, MBA students again are flocking to real estate courses (see sidebar, page 22), lured by the prospect of exciting careers in a hot market. But the question arises: After several boom years, is commercial real estate ripe for another fall?

Some insiders joke that any time MBAs pile into a field, it’s a good contrarian indicator. Gallows humor aside, market pros see parallels, but no repeat of the 1989 crash.

That optimism rests on the knowledge that the industry today bears little resemblance to the industry of the late 1980s. In fact, real estate now is widely viewed as a new asset class that competes with stocks and bonds for investment capital. It earned that newfound status on the strength of market-stabilizing structural changes that took root after the last crash. “Everything we do today grew out of the dark days of the early ’90s,” says Slaughter, managing director and head of North American real estate investment banking for Morgan Stanley.

Some refer to the postcrash era as a paradigm shift for commercial real estate. Others call it a sea change. Whatever the choice of words, there’s broad agreement that the industry’s transformation has drained considerable risk out of a once notoriously unstable market.

A new industry emerges

Not so long ago, real estate development looked and acted like modern-day “cowboy capitalism.” “From the ’70s to the late ’80s, real estate was fundamentally driven by entrepreneurs with private capital sources,” says Dubrowski, a founding partner of The Lionstone Group, a Houston-based investment firm. They took big risks and hoped for big rewards.

The 1980s brought additional players to the table, none driven by purely economic rationale, says Lee Sandwen (MBA ’77, JD ’78), the former head of real estate for Fidelity Management & Research Company in Boston who now handles special projects for Fidelity. Real estate syndicators essentially sold tax losses to their well-heeled clients. Savings and loans, desperate for high returns, made risky loans a business staple. And the Japanese, buoyed by a strong economy and low interest rates at home, swept in to buy up trophy properties at almost any asking price. “The total effect of all that money and lack of focus on the intrinsic economics of the situation led to a major collapse,” explains Sandwen.

Almost immediately after the crash, a chastened industry began to emerge. Congress rewrote the tax code and put tax-loss syndicators out of business. The S&L industry tanked, forcing a massive federal bailout. And the Japanese ultimately sold virtually all their U.S. properties at a loss.

Repairing the damage done by the crash created opportunities to rebuild the business and make it stronger. Morgan Stanley’s Slaughter cites three fundamental, lasting changes that, for the first time, made commercial real estate an investment attractive to Wall Street and Main Street.

REITs take off. Starved for capital in an environment where all the usual money sources had dried up, many major commercial property owners took their companies public in the form of real estate investment trusts (REITs), heretofore a little-used option. Between 1992 and 1997, roughly 150 REITs went public, rocketing the aggregate equity value of these companies from $10 billion to more than $175 billion in just five years, says Slaughter. Today, there are approximately 180 publicly traded REITs in the United States, with equity assets totaling $375 billion. Nine are large enough to be listed in the S&P 500.

Wall Street goes shopping. Wall Street surveyed the mountain of defaulted S&L loans taken over by the federal Resolution Trust Corporation (RTC) and saw an opportunity to get into real estate investing in a big way. Morgan Stanley’s experience is typical of other investment banks at the time. “We got into the investing side of the business primarily because the opportunity was there to buy nonperforming loan portfolios from the RTC,” recalls Slaughter. From a merchant banking standpoint, Wall Street barely paid attention to commercial real estate prior to 1990. Since then, almost every major Wall Street firm has become active in real estate private equity. “Morgan Stanley alone has gone from zero dollars under management to almost $40 billion over the past fifteen years,” says Slaughter.

Securitized debt finds a market. Wall Street helped the RTC solve another big problem: how to dispose of billions in S&L loans that were not in default. The agency came to Wall Street with a proposal to sell loan packages rather than one property at a time, an impractical approach given the volume of loans on the RTC books. Wall Street responded by creating commercial mortgage-backed securities (CMBS), which are similar to, but more complex than, the mortgage-backed securities long used to bundle and sell packages of residential loans. “Commercial mortgage-backed securities did not exist in 1990 and were not thought to be viable,” says Slaughter. Today, CMBS represent a $550 billion market.

It’s hard to overestimate the impact of this market restructuring. In fifteen years, the public equity and debt markets for commercial real estate have gone from financial infancy to trillion-dollar status. If the old market was driven by hard-charging entrepreneurs wielding private capital, the new one is driven by professional investors working for or on behalf of deep-pocketed institutions, like pension funds and endowments. Even individual investors can buy a piece of the action. Real estate mutual funds, for example, took in $2.8 billion in new investments during the first six months of this year.

The new, public nature of the commercial real estate market thrives on information, once a precious commodity, now an industry fixture sustained by legions of analysts. “When I started in real estate, we’d go into cities and figure out the market by driving around with a map and sticking little dots on it to represent different types of property,” recalls Lionstone’s Dubrowski. “I’d identify tenants in a building by walking into the lobby and reading the directory.” Not surprisingly, the largest companies with the most people had the best market data. But not anymore, says Dubrowski.

Today, his 22-person firm pays upward of $400,000 a year for subscription data services, the same services that are available to large and small industry participants alike. “Now that we all have access to the same information, the emphasis has shifted from collection to analysis,” he explains. “And that’s a sea change. It allows a small firm like ours to compete equally from an information standpoint with a giant cargo ship of an organization. That’s a permanent change that has altered the playing field.”

How the tech wreck helped real estate

The commercial real estate market’s transformation, profound as it was, took place over the 1990s without much fanfare. For insiders, it was a good time to be in the market. “A lot of money was made from 1990 to 1995 picking up the pieces of the crash,” says Fidelity’s Sandwen. “Prices adjusted and real estate became more attractive. And we got back to relative equilibrium through the tech bust in 2001. After the bust, a lot of money began to pour into real estate.”

Suddenly the old economy looked good again. “People didn’t know where else to invest,” observes Jeff Furber (MBA ’84), president and CEO of AEW Capital Management, a Boston investment advisory firm with $30 billion under management. “Certainly my clients — pension funds and endowments — aren’t that optimistic about the stock and bond markets, so they are moving money into real estate.”

“After the tech bust, people wanted real assets they could see and touch and real dividends,” adds Stephen Lebovitz (MBA ’88), president of CBL & Associates Properties based in Chattanooga, Tennessee, the fourth-largest mall REIT in North America with a market cap of $8 billion. “REITs at the time were paying dividends in the high single digits, so money started flowing in.” (By law, REITs must annually pay out 90 percent of their net revenues, generated largely by rents and leases that make them — in good times — cash conveyor belts for their investors.) Says Lebovitz: “Investors now understand that with real estate you have an asset with stable cash flow plus appreciation over time. It’s proven to be a good investment.”

So good in fact that money managers now regard real estate as a new asset class. Cynthia Foster (MBA ’90), executive managing director of Cushman & Wakefield, the world’s largest privately held real estate services firm, regards this relatively recent change in attitude as a paradigm shift. “People now look to real estate as an alternative to other investments,” she says. Perhaps most telling is that large institutional investors, known for their caution, have been increasing their asset allocations to commercial property holdings.

Until recently, says Dubrowski, institutional investors limited their commercial real estate allocations to between 3 and 5 percent of their portfolios. “Now most of the allocations are going to 5 percent to 7 percent because they perceive the risk has become lower.” It’s not just institutional investors who have turned to real estate. “Whether you are an individual investor or a hedge fund, having another asset class whose performance is not tied to stocks and bonds is very important,” says Slaughter. “Real estate has become part of the fundamental allocation exercise.”

Bubble on the horizon?

All that cash pouring into commercial real estate since the tech wreck has fueled a dramatic run-up in prices for prime properties. “Prices are at levels I never would have guessed a few years ago,” says AEW’s Furber. But he does not see a market-distorting bubble. The big difference between now and the late 1980s is supply. “Oversupply is kryptonite to the real estate market, and I don’t see an oversupply situation,” he notes. Nor do other market insiders, whose consensus assessment is that new construction has not run ahead of market demand. With national vacancy rates still in the 14 percent range and the economy generating fewer new jobs than in previous recoveries, no one sees much chance of a speculative building bubble for office space. “New construction just hasn’t gone crazy like it did in the ’80s,” says Fidelity’s Sandwen. “So while we see prices getting ever higher, they haven’t caused that much new construction.” For his part, Furber characterizes the market as “frothy,” which warrants caution but not retreat. “There are always interesting opportunities out there, even in a frothy market.”

Even retail, the hottest performer in the commercial market, has escaped overbuilding. “The money supply coming into our business is unprecedented, but I don’t see risks that you would associate with a bubble,” adds CBL’s Lebovitz.

If there’s one thing that concerns market pros, it’s interest rates. A sudden spike in long-term rates would deliver a serious blow to the market. To most observers’ surprise, however, long-term rates remain near the historical lows set a few years ago and remain highly favorable to the commercial property business. When rates finally do move upward, property price increases are expected to slow or even shift into reverse, but without disastrous consequences. “Higher rates would moderate the froth in the market,” says Furber, who sees no harm in knocking out players who depend too much on easy credit. “An upward movement in long-term rates also would drive prices back down a bit, but I don’t see a repeat of 1989,” he adds.

In fact, overpricing, not overbuilding, is the market’s biggest problem, says Joseph O’Connor (MBA ’70), the founder and president of Singleton Associates, a real estate development firm based in Boston, and former chairman of the Urban Land Institute, a nonprofit education and research institute. “Excess liquidity is the name of the game today. With a lot of cash chasing too little product, the question is, are people paying too much?”

That question is at the heart of a long-running debate within the profession. As property prices have risen, returns on investments have fallen. Today, returns, expressed in real estate parlance as cap rates, have declined to levels last seen just before the 1989 crash. (A property’s cap rate is calculated by dividing cash flow from operations by the purchasing price, yielding a percentage annual return. Thus, a $1 million property that generates $100,000 in cash flow would have a cap rate of 10 percent.) Historically, the cap rate for commercial real estate has averaged 9 percent. As property prices soared in the 1980s, cap rates sank to between 5 percent and 6 percent. After the crash, they rose back to the norm until recently. “Over the past 24 months, cap rates have dropped probably 200 to 300 basis points,” says Furber. “That’s a monster change and somewhat unprecedented.”

Up for debate is whether the structural changes of the past fifteen years have drained enough risk out of the commercial market to justify the lower returns. If the answer is yes, then buyers aren’t overpaying even at today’s record-setting prices. If the answer is no, the market may be in for a round of downward price adjustment.

O’Connor places his bet on a return to relatively high historic cap rates, perhaps not 9 percent, but higher than today’s 5 or 6 percent. He finds wisdom in a quarter-century-old article titled “The Answer Is Nine” by Stephen Steppe, who argued that returns on commercial real estate may dip during cycles but will always rebound to the historic average. “The gist of that article remains as true today as it did then,” says O’Connor. Thus, if interest rates continue to rise, as he expects, O’Connor sees the possibility of a substantial downward adjustment in pricing over the intermediate term.

Lionstone’s Dubrowski takes a different view. While he foresees downward pressure on prices as long-term rates rise, he doesn’t expect a return to 9 percent cap rates. He argues that structural changes in the commercial real estate business have permanently lowered investor risks, justifying a lower return. “The efficiency of information, the specialization of capital, the domination by institutions instead of entrepreneurs, all these things have produced lower risks. If you have lower risks, you should not expect to get the same returns you got a decade ago. We will never go back to a 9 percent world.”

Time, of course, will tell who’s right. Meanwhile, Sandwen stakes out the middle ground: “As long as the stock market trades within a narrow range, and long-term interest rates don’t go much higher, I think real estate is here to stay as a very important place where people want to invest. Everyone wants more real estate.”

Featured Alumni

Featured Alumni

Class of MBA 1990, Section B

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