Trend Czar

Sleeping Better

I’ve been up in Canada over the past week, and it’s obvious Americans could learn a few things from our neighbors to the north. Canada’s economy appears to be (really) stabilizing after a comparatively mild downturn and commercial real estate markets should follow suit—value declines have been in the 10-20% range in contrast to losses in the U.S. headed on average well above 40%. Housing markets in Canada suffered mild buffeting, but prices in prime neighborhoods have more than held their own, and appear to be increasing again. Foreclosures, defaults, and dislocation aren’t part of the local landscape anywhere from coast to coast.

Vancouver ranks as the top North American commercial property market after Washington D.C. on the Emerging Trends survey. Toronto suffers from increasing office vacancy—a result of new development in the downtown core. But deep-pocket institutional owners are well positioned to ride out any market softness. This global gateway has also grown into North America’s largest condo market, as more people look to settle in and around its attractive urban core. Hot growth Calgary suffers from overbuilding and hopes natural gas prices ratchet up to bail it out. Elsewhere the real estate scene shows few signs of any distress. On the property sector front, the U.S. automaker morass drags down the Southern Ontario industrial belt and hotels suffer from markedly reduced business and tourist travel from the U.S.

In general, Canadian real estate investors appear buoyant next to depressed U.S. counterparts. “It’s really a tale of two cities or shall we say countries,” a major Toronto developer told me. “We’re sleeping much better at night.” So what’s put Canada in a better position? Abundant natural resources (oil, gas, water) certainly help. But Canada and its citizens have also been much more fiscally conservative and responsible. The country paid down its debts after a severe early 1990s recession through a combination of spending cuts and higher taxes. Banks and financial institutions are highly regulated—capital reserve requirements and other mandates kept lenders and investors out of exotic mortgages, overleveraging situations, and hair brained securitization structures. Homebuyers typically must put down at least 30% equity to get mortgages. And consumers never got out of control either—people live more within their means without resorting as much to plastic.

Canadians react with surprise when they hear that their socialized health care system is held up as something that Americans should want to avoid. It’s not perfect, but people get good care, and no one goes without seeing doctors or getting prescriptions.

In the meantime, any Canadian worries focus back on the U.S. If our economy stays down, their recovery will be stanched and the falling U.S. dollar makes the Loonie more expensive and hurts their U.S. exports. If more U.S. retailers go bankrupt after Christmas, stores could go dark weakening shopping centers. And Canada needs more U.S. travel to its big city hotels and resorts.

But your average Canadian can rest easy these days… unless that is he or she invested in the U.S.   

Musings before the release of Emerging Trends

Emerging Trends in Real Estate 2010 gets released on Thursday at the Urban Land Institute’s Fall Meeting in San Francisco.  I’ll have more to comment about the forecast, which I author, after PricewaterhouseCoopers and ULI unveil the report. But here are a couple of observations coming off several months of interviews (more than 900 industry leaders participated in this year’s survey—a record!) and writing the 2010 outlook:

The past decade of deal mania, owner flipping, securitized mortgage markets and ensuing bank failures has effectively delocalized much of the real estate business. Many borrowers no longer know who their lenders are, most CMBS bondholders don’t have a clue as to what assets back their bonds let alone where the assets are located. Many owners, who overpaid for and overleveraged properties, don’t have local roots in markets where they invest, and now scramble to cut losses and exit these markets no matter the local consequences.  And increasingly local banks become part of larger national and international institutions with no particular local focus. When real estate owners and lenders don’t have a stake in communities and neighborhoods, and use real estate investments as fungible assets to play against market cycles, the underpinnings and long-term prospects of these markets can be undermined.

Now tenants consider playing their own musical chairs, pulling up stakes and moving into new buildings to secure better rents and deals. But they must wonder about the creditworthiness of landlords and understand whether properties will be subject to battles among CMBS tranche holders, whoever they may be. Tenant heads had begun to spin with all the ownership changes earlier in the decade—now they must brace for bank takeovers or dealing with special servicers or maybe even the FDIC. It’s a tenant’s market all right, but who knows who your landlord will be.

And needless to say tenants need to be concerned about whether building services will be maintained. Given cash flow squeezes and the dire operating circumstances of many owners, repairs and basic maintenance may be delayed to cut corners. Forget about capital expenditures.  Properties are bound to show more signs of wear and tear, some may just turn shabby from neglect.

Clearly, owners with more liquid balance sheets and manageable debt service can poach tenants from compromised competitors. They’re in better position to negotiate deals, provide tenant improvements and other signing inducements, or just hold out until rents start adjusting up again. Obviously, the cash-rich will be in exceptionally strong position over the next months, not only in retaining and securing tenants, but also in acquiring distressed assets as they come to market.

And make no mistake--the next 12 to 18 months will be a great time to buy a cyclical lows—if you have the dollars to do deals. And for many players, that’s a big if.

See you in San Francisco!   

Trying to Find Silver Linings

I’m preparing for next week’s unveiling of Emerging Trends in Real Estate 2010 at ULI in San Francisco. I won’t be giving away the store to say next year won’t be the greatest in industry history…  I know audiences don’t want to hear all gloom and doom (who needs to sit through a downer?), and there will actually be some positive things to say. But can anyone feel good about where the economy is headed right now and especially the jobs outlook?

One of my colleagues, who knows I’m a glass-half-full-kind-of-guy wants to showcase an upbeat view and argues with me that the last six months of outsized stock market performance is a leading indicator of better times ahead and the “statistical” economic recovery is more good news. Certainly, the economy has bottomed and companies are producing better results by comparison over a year ago’s dismal performance. This has been accomplished in large part through productivity gains—slashing jobs and occupancy costs. And finance stocks have bounced part way back thanks to government infusions and trading gains off market lows.  But hate to say it, government prognosticators, who always look for a silver lining, are certainly under-promising in recent pronouncements—they see unemployment continuing to increase well into next year even with stimulus spending having an increased impact on creating new jobs.

And although the stock market, in fact, did its usual good job in predicting the end of recession with a six month performance spike, the surge appears to be over unless companies show they can ramp up production and their markets start buying again.  Now stocks shouldn’t collapse, but it looks like they’re sputtering—the dollar slide, the prospect for higher interest rates in the future, state and local government cuts, and long-term consumer and government deleveraging don’t paint a rosy picture.  The recent increase in house buying has been helped along by government tax credits and the cars for clunkers program temporarily boosted the automakers. The rate of jobs losses ebbs and more companies finally will start hiring next year as inventories need to be restored. But do we think the economy can stand on its own without all the government supports? For an answer, Congress extends unemployment benefits and considers extending the home buyers’ credit. Most realtors think home sales could go into a winter deep freeze without the tax break.

And then there are our in-full-scale-free-fall commercial real estate markets, which every week help to take down more community and regional banks. Capmark, aka GMAC Commercial Mortgage (a former employer of mine), once the largest commercial real estate lending organization, finally entered bankruptcy over the weekend.   In 2006, two private equity firms (Five Mile and KKR) bought a majority interest in GMACCM and did what private equity firms do—gutted the company of employees (productivity gains) and heaped on debt in a bond refinancing (to pay themselves an early return on their investment). These investment playmakers ran out of time to make their planned highly profitable (for themselves) exit in an IPO when the market collapsed—and ended up with the worst of both worlds—an overleveraged debt business that had lent too much just before the market cratered. And now we wait anxiously for the inevitable--more Capmarks and more Peter Cooper/Stuyvesant Towns.

So to put a good face on what’s happening--the economy may be at the start of recovery after bottoming. But that translates into things can only get better. And right now that’s still not saying much.

Dealmaking or Operations

Of course, the push back on government financial regulation over trading businesses isn't surprising. The people who run the big financial firms and who dole out massive political campaign contributions have had a good thing going--massive compensation with little downside risk to their personal fortunes no matter the recent credit market meltdown. Who wouldn't want that game, supported when necessary by bailouts and cheap Federal borrowing rates, to continue. Sure some big shots--Lewis, Thain, Fuld, Grasso-- have been washed out with damaged reputations. But on the Wall Street scorecard--how much money you make--these guys are still well ahead of the game.

Real estate players don't want to see big changes either--they want the Wall Street firms to rebound and fill up office space especially in New York and other major markets. And most of all they want the CMBS market to revive to float transaction volumes again. Deals mean fees and promotes and big compensation numbers.

But all this activity is about brokering and trading, not creating anything. Our economy and the real estate business can't sustain itself off dealmaking.  We learned the recent value gains from ramped up transaction volumes were a mirage. Office rents in many markets are back to 1980s levels and most of our jobs gains over the last decade have been wiped out.

The next five years climbing out of the current debacle will be about whether real estate backslides into a transaction-fixated business or orients more to operations and development. If the government implements only lackadaisical reforms and allows unrestrained capital to flood the financial system, transaction markets will come back in full force and middlemen will be back in business. But more regulation would restrict debt capital from higher risk plays and tamp down on transactions. Real estate investors would go back to earning profits off of down-and-dirty asset management, leasing and development strategies, not so much ephemeral financial structuring and trading. It will be a more boring business and less lucrative, but with less risk to the system.

The traders argue bringing back their business will create more jobs to fill buildings and their high incomes will fill tax coffers and support the consumer economy. It's the transaction business, they say, that made the good times so good for many people in our business.

But it's the transaction dominated business that has precipitated such bad times today and taken the banking system to the brink. Asset values haven't been enhanced, we haven't produced anything lasting that advances the world or the economy. The only leftover gains come from transaction fees and promotes, extracted from the deals.  America can't sustain itself going back to this. Neither can the real estate industry.   

The reality of austerity

No politician would dare say it--Americans spend (waste) too much and aren't taxed enough. But we need to spend less and save more at the personal level, and should be taxed more to pay for programs we all want like social security, medicare-health care, and defense. And we must insist on getting better value for every dollar we spend personally and by elected officials. Our freely elected government has led us into the ditch of huge deficits and massive debt service payments to foreign countries, because we bought the Kool Aid about having more by getting taxed less and borrowing to make up the difference. Now that the bills have come due it's doubly hard to change--it means a period of difficult austerity. But neither Democrats nor Republicans want to own up to it--since they want to get re-elected. Who has ever won on a platform of higher taxes and reduced programs?

But essentially that is what is going to happen to us. We can see the future by looking at state and local governments, which are forced by law to balance budgets. Property and sales taxes increase, the number of user fees expands. You pay more for car registrations and fishing licenses. Tolls go up. Cigarette taxes and parking fees increase. We get nickle-dimed and quartered everywhere. But people scream to keep schools funded and sanitation and police service untouched. They want roads repaired. So income taxes may have to increase too. And no official wants to see  the state bond rating go down, which would boost borrowing costs and dig a deeper fiscal hole. So governors and mayors close parks and slice at welfare spending.

At the personal level we can't afford to buy bigger houses that cost more to heat and cool, and we can't afford to spend as much driving around to get everywhere not only because it wastes a lot of time in traffic, but also because it costs so much--gasoline, insurance, repairs et al. And we won't be able to buy as much in malls and lifestyle centers or even on line, because we just don't have as much to spend and can't get as much credit. Although at least if we shop on line, we can save time and gas costs.

Now it would help everyone if our economy started to cook, more jobs were created and we could pay off our debts more quickly. But nobody and I mean nobody is talking about a sudden rebound.

So the trend lines are pretty clear--living closer to work in smaller homes, shopping less at malls, and saving more, while paying increased taxes. The politicians and the ideologues can yack all they want and throw blame around. It won't change the realities.