Trend Czar

“Tough Time” Musings

I had meeting last week with the head of real estate for a household-name institutional investor which is a big player in the international markets. He likes Brazil. Another executive who works under his umbrella favors India. U.S. real estate will be an opportunity play eventually, they say, but its outlook is too murky in the short-term to jump in right now. So is this a bit of a come down for U.S. property markets? Brazil and India, two so-called emerging markets, look like better plays and the U.S.A., the world’s greatest economy and only self-styled superpower, is hands off. How high the mighty have fallen.

The big investor is realistic. The American markets will be “tough” next year, “really tough.” Values have more room to fall as the credit markets continue to shakeout. I asked him if all his gains from the last ten years were in the process of being wiped out in the U.S. “It will be tough not to lose,” he said, “very tough.”

So you wonder what goes through the mind of an institutional real estate portfolio manager under these circumstances. You may spend 10 or 15 years working with asset allocation models, buying scores of office buildings, shopping centers, apartments and warehouses. You hire various investment managers, consultants, lawyers, brokers, and investment bankers to help develop and execute strategies.   You travel to many cities in different countries, wining and dining myriad partners and prospective partners or being wined and dined. You hedge and leverage up assets. You cash in and dispose of some properties and reinvest proceeds. Returns look impressive for a while. You feel like a big hero, and the bonuses ratchet up.

And then suddenly in a year or 18 months all those gains disappear and you’re caught up in uncertainty and workouts. Headlines turn negative. Will your investment funds be able to pay out its beneficiaries? Your organization is the butt of scorn. And what have you accomplished? And what about the lawyers, advisors, investment managers, and brokers who worked on these deals with you? They took out their share of big fees and supported families in comfortable, if not lavish, style. Properties were bought and sold and new ones bought. And then at the end of the day, what’s to show for it? Is that all there is—the fees from the trades and memories of the big bonus checks?

Are we making the world a better place? That question may be too tough to answer. But are we?

Brazil and India—it may be your turn now.
 

Mixed Signals

You’d think we’re back and everything was fine. Well at least according to the chief investment officer of one of North America’s leading banking institutions. We sat in his office overlooking an expansive trading floor doing an Emerging Trends interview late last week. “It’s one of the best trading environments ever,” he explained. “Wall Street is hiring again.”

And maybe a bit of euphoria has crept its way back into the investment markets after a sustained stock market surge. Traders have certainly done well and investors feel better, making up a chunk of lost ground from last year’s severe declines.

The banker said he plans to lease more space in New York and says investment firms are having trouble “finding the best talent.” He said he’s confident of a sustained turnaround—“the worst is over.”

The housing market got more good news last week too with new home sales ratcheting up and cash for clunkers boosted the almost left-for-dead automakers.

Ben Bernanke, looking to get a second term at the Fed, wants credit for engineering policy that staved off disaster and touts the start of recovery, while much of the stimulus budget still waits for actual funding by slow-moving state and local governments.  Even so, it appears the trillion dollars plus in various federal bailout programs is having its desired effect. The delayed spending should help sustain economic momentum into next year.

The limo driver, who picked me up at the airport and took me to the interview, hopes for better times too, but hasn’t seen a pick up yet. Business is off 50% since last fall and she and her husband took a loss on their condo. He has a second job to help ends meet and they wonder if they can keep their chauffeuring business going. Insurance and gasoline costs don’t help, she said, and her corporate clients show no signs of increasing travel, cutting back on conferences and training sessions too. That all translates into fewer airport pickups.  

Then I saw the latest news about home foreclosure rates ticking up and insider reports about more bank failures.

Our bank honcho friend had mentioned prices hadn’t dropped too much on homes in his neighborhood and he thinks the REIT index is a strong buy even with recent gains.

Maybe he will start to send more of his traders on trips to help out the limo drivers… Maybe.       

Buying low and selling high

In retrospect, it's fascinating how sophisticated investors bought into the whole risk/return spectrum rationale for commercial real estate. Back in the 1980s, investors invested in real estate funds for income and some appreciation. If you wanted to take the risk for bigger returns, you did development deals. Then consultants got more involved and institutional investors began depending more on research based strategies. The pension funds had their asset allocation models. It started to get complicated.

Real estate investment managers began adapting to the market demand and realized they could sell more funds and potentially raise more money with different strategies. They distinguished between core, value add and opportunistic strategies. Core focused on well-leased income producing properties. Value add investments were touted as property enhancement or releasing plays. Opportunity started out as development and morphed into global investing, and in the end involved putting down little equity and a lot of mortgage debt on core properties.The value add portfolio managers started depending more on leverage to boost returns too and then core managers followed suit.

Of course, the capital and credit wave supercharged performance--even core funds produced opportunistic-like returns for a few years. Now the credit crash wipes out many opportunity funds, while erasing the heady gains and then some of core funds. Before it's all over the core-based NCREIF Index could lose 35-40% of its value from peak to trough. I guess that's what some pension consultant might call a risk adjusted return. Well at least the core investors have something left.

In the end real estate investors make money off the cycle, not the consultant mumbo jumbo. And investors need to remember their investment managers haven't figured out how to stay in business by telling clients they won't take their money because it might not be the best time to invest. Everyone took their eye off the ball.

Coming out of the debacle, smart real estate investors will make money the old fashioned way--riding the upcycle and selling before they get too greedy. Nobody has to worry about overleveraging, because there won't' be much mortgage debt available especially in the early going.

In the meantime, we can chuck the core, value add, and opportunistic stuff. It's all about buying low and selling high.

Hooray—the recession is over

So the economic consensus is that the recession is over—we landed with a big thud after prolonged contraction and growth--albeit very anemic---has resumed. That’s good news, of course. The costly stimulus and financial industry bailouts indeed appear to be working to stanch what might have been even more prolonged and severe distress. But now we have to dig ourselves out of a huge hole of personal and government debt, while continuing to fight two wars. Unemployment is pegged to continue to rise for a while and the American worker confronts eroding compensation—wages and benefits aren’t what they used to be. How many people do you know make more today than two years ago and who is not paying more for their healthcare?

Our Wall Street friends try mightily to hang on to their bonus system in the face of public and government push back, while the average guy just hopes to hang onto his job and keep paying the home equity line and car loans. Is it any surprise that last week’s retail sales numbers were so bad—what the worst in six decades? Surviving car dealers are a loan bright spot—thanks to more government largesse, the relatively modest cash for clunkers program (hey it’s only a few billion dollars, not much in the scope of trillion dollar deficits).

In other words, the American consumer is in no condition to start spending again anytime soon and at some point the government has to rein in its spending and tax us more. Hopes for a strong back to school season at the malls are pipedreams. Christmas promises to be equally bleak. The economists’ more optimistic pronouncements haven’t put money back in anybody’s pockets or canceled out our collective debt loads.

People now need to confront the reality that credit-card fueled lifestyles aren’t suddenly coming back—our 30 year consumer binge is over. Part of the new reality is our general standard of living will decline, not markedly, but we won’t be able to afford as much as we used to and certainly not until we get our financial houses in order—a tall order for our government and many of us.

That’s why no one in the real estate world can get very excited about prospects for any quick rebound in tenant demand and rents. The market place will be in critical care for quite a while.  Let the workouts and foreclosures begin in earnest.      
     

What's the New Model? (revisited)

The TrendCzar is currently on vacation and will return next week.  While he is away let's revisit a story from last summer about the commercial real estate investment model.  When the billions on the sidelines step back into the investing arena, what will the new model look like?

What's the New Model?  (Originally posted August 14, 2008)

Continuing on thoughts about the $300 billion said to be sitting on the sidelines, waiting to cushion the coming downslide in values, these fund sponsors who raised all this cash over the past few years must be struggling figuring out how to deliver the returns they promised investors. Their investment model was largely based on leveraging up performance in a sky's-the-limit pricing frenzy, providing 20% plus returns. It worked splendidly for more than five years in an almost free-money lending environment that suddenly evaporated 12 months ago. But without the leverage, the investment model no longer works and the sponsors can no longer make the promotes which drives their business bottom lines.

Given the depths of the credit morass, free-flowing debt will not be coming back any time soon. When lenders finally sort out all their issues and regulators finish with implementing stricter guidelines, borrowers will pay more for less. We're in a deleveraging environment for some time to come.

So what's the new model--filling the void in the debt markets, offering distressed owners loans that could provide equity like returns or loan to own features? Maybe. Or buying core-like properties in all or mostly cash transactions once the value floor looks like it's taking hold? That's a possibility. There are always homebuilder lots, going for cents on the dollar today.

But then investors will need fundamentals to improve quickly to push up rents and net operating incomes, and/or homebuyers who can obtain ready financing. Neither the economy nor the credit markets offer much hope for any sort of rapid recovery.

So either that $300 million accepts potentially lower returns than advertised in different investing schemes or maybe it goes elsewhere. That also goes for the investment bankers and advisors, sponsoring these funds. 

         

How hard the fall? (revisited)

The TrendCzar is currently on vacation and will return mid-month to begin writing Emerging Trends 2010. What's changed in the market since this time last year?

How hard the fall? (Originally posted August 19, 2008)

I will start writing Emerging Trends 2009 soon, and the challenge this year is to calibrate just how negative I should go. Will next year be a bit better than 2008, worse, or really bad? I'm sure I'm not giving away the store by revealing everyone I've talked to sees at least some rough moments, and no one expects a sudden rebound. Most people are not very sanguine, to say the least and they have been growing increasingly pessimistic.

We've had some posters comment that the markets aren't that bad and real estate has been doing comparatively well. Occupancies have held up in many markets and development has been under control except in some condo markets and, of course, in single family housing. By the numbers, the economy may not be in a recession, they say. Yes, the transaction markets have been dormant, but that's because of the credit crisis, and once that clears up commercial real estate should be in decent shape. So why be negative, they argue?

Well, there are a host of reasons to consider, at least. Most mark-to-market investors haven't felt much pain yet. The dearth of transactions has delayed appraisal recognition of the value loss picture, and sellers continue to hold out for higher prices, while buyers wait for better deals that they know will be coming. For now, many lenders have been working with shaky borrowers to avoid defaults, limiting the number of motivated sellers. But at some point they will have to clean up their balance sheets. Consumers continue to pull back and more retailers show strain. Unemployment heads higher. If companies aren't belt-tightening, they're certainly not expanding. Interest rates are pressured upward by inflation, not a good thing for cap rates, especially if fundamentals can't pick up the slack. And those credit markets, which provide nourishment for real estate businesses, appear sicker than ever. Unless investors are prepared to buy with cash, the transaction markets will remain relatively gridlocked.

Commercial real estate hasn't taken its hit yet. That will largely be 2009 event. The question remains how hard will that fall be.