Lloyd Hanford

This week the national media (including the WSJ) carried stories about the changes, at Calpers, in their housing investment strategy.  The changes involved a divestiture, at a substantial loss, of 28 housing communities, including 16,300 unbuilt home sites and “thousands” of acres of undeveloped land in 11 States representing about 20% of its land portfolio. This divestiture is part of a “winding down” of a two decade program as “the pension world’s biggest investor in the U. S. housing market. This isn’t the first big real estate loss for Calpers.  In 2010 they wrote off a $500 million equity investment in two major Manhattan apartment complexes Calpers also wrote down an almost $1 billion investment in a venture that owned thousands of acres of land in Southern California.

Calpers is a gigantic pension fund with over $200 billion  to fund the pensions of State employees.  This suggests the question – what were they (and other pension funds) doing speculating (buying undeveloped land and unbuilt lots with no income stream) in land and other real estate deals and why?  Observation of the market over many years suggests that the answers are related.

Pension funds like Calpers hire investment management firms to place the money and manage the asset after acquisition. They do not ordinarily provide these functions themselves other than indirectly through outside asset management advisors.  There are many companies and institutions nationally that provide real estate asset management services and the fees are very profitable for the manager. Thus, as should be expected, the competition for business is very fierce.  In many situations the retention of an asset management firm begins with a RFP (request for proposal) from the pension fund with various proposers competing with each other. Among many things the manager must convince the pension fund of is their performance ability. Accordingly, a good “track record can be important”.  More importantly, once an asset manager is retained, performance on various levels must be maintained at a satisfactorily high level if the manager expects the contract to be renewed. Herein lays a root of the problem.

Of all performance items that can be measured objectively, yield or return is the easiest to measure.  Most other performance criteria are much more difficult to measure and can only be measured subjectively.

At some point in the past, asset managers began to look at the performance of real estate in comparison to stocks and bonds and liked the apparent higher returns.  Seeing that, they sold their clients into diversifying some of their assets into real estate and a means of boosting returns (and at the same time improving their performance). Naturally, in a very competitive environment, a “herd mentality” drives other asset managers into diversifying into the same asset class lest their performance might fail in comparison to others.

The supply of what is referred to as “institutional grade” real estate is very limited and, by virtue of the laws of supply and demand, the excess of demand over supply must result in price escalation. When this occurs, the only way to participate is to reduce the criteria for classification as “intuitional grade” resulting in the acquisition of more risky properties and then into non-institutional grade assets such as undeveloped land or properties in the process of development, including the use of leverage, to maximize returns.

Taking risk is what developers do and success is very rewarding.  But, success is far from a sure thing. Should pension funds, using money belonging to their ultimate retirees be making speculative or high risk investments?  That is a central question and the answer is probably not. Moreover, are the pension funds themselves completely conversant with the risks involved? The answer is probably not as they often look to their asset managers to make that analysis. The asset manager, operating under pressure to “perform” has greater incentive to complete a deal as opposed to killing a deal.  Sophisticated individual developers or investors, using their own money, will often reject a transaction if, to them, it “doesn’t feel right” regardless of what the numbers show, if they perceive possibly unwanted risks. Pension funds and asset managers lack that emotional evaluation as they are risking someone else’s money and not their own. All of this points to the possibility that the model for real estate investing for pension funds may be “broken”.

Risk analysis should begin with the realization that selling real estate can be very slow even under good conditions and particularly under adverse conditions. This lack of liquidity presents major risks to investors. In the stock and bond markets a sale of securities is ordinarily easy and, most importantly, very rapid. Thus, by comparison, there should be a measurable risk premium attached to real estate to account for lack of liquidity. As an example, suppose a pension fund had acquired a property leased to Eastman Kodak a few years ago when the market was “hot” and, in the bankruptcy, the lease is “rejected” meaning the property will be vacated. Not only will income cease but divestiture will be very difficult and sale at a loss a distinct possibility.  Not even the safest leased asset has a safe and sustainable income. There are many variables that can adversely impact the value of a parcel of real estate and the investor is not always able to divest when conditions indicate that performance of the real estate will fall. In the ownership of securities, it is relatively easy to divest when the investment no longer attractive.

Pundits in the stock market are preaching that the days of “buy and hold” are gone and the current vogue is to trade in and out of securities based on short term observations and expectations. Real estate, by its nature, is a “buy and hold” asset with a target sale forecast into the future.  Real estate cannot be readily traded when short term events negatively impact the performance set forth in the cash flow model.

At the top of the list of high risk assets are undeveloped acreage, unsold home sites and properties dependent on the execution of plan that has yet to be implemented. Calpers were involved in all three. Calpers lost $500 million in apartments in which the plan was to convert rent controlled units into market rate units. For a variety of reasons someone should have done a better job of “due diligence” to make sure that plan could be executed

The December 14, 2011 issue of the Wall Street Journal contained an interesting article about the problems facing the Morgan Stanley global real estate fund. The article points out that Morgan Stanley (MS) was forced to return about $700 million to investors and to reduce fees in order to persuade investors to stick with them after a lack luster performance. This, in and of itself, is not newsworthy. Morgan Stanley did what it had to do to retain the management (and management fees) of its $4.7 billion fund. What is noteworthy is the fact that, as part of the deal, the investors gave the fund (Msref VII) an additional year (to June 2013) to invest instead of being required to return billions to investors. The fund, apparently has invested only $2.5 billion of the committed funds leaving $2.2 million un-invested with a deadline of June 2012. This leads one to question the sanity of the investors in imposing a deadline.

There is no indication as to who the investors are but it is possible that a large number, if not the vast majority, are institutional investors managing other people’s money OPM) such as pension fund managers, rather than being representative of individual investors investing their own money. In any event, the imposition of an investment deadline does not appear to be a decision, or strategy that a knowledgeable, sophisticated individual investor would make.

The reasons for failing to invest the money should be carefully examined. There is no question that conventional wisdom suggested that there would be unlimited buying opportunities to acquire high quality real estate arising out of the collapse of worldwide investment real estate values. However, conventional wisdom appears to have been wrong. Even though many superior properties went into default due to the inability to be able to refinance or because of a drop in value attributable to reductions of rent, these properties were not offered to the market at “bargain” prices because the institutions controlling them made a decision not to sell into a falling market and instead to hold and manage the assets through a turn-around. Real estate is not a highly liquid asset and the key to successful investing is one of timing. Real estate professionals know and understand that the profits are made on the “buy side” of the transaction and not the “sell side”. In other words, if the property is acquired at a “good” price the ability to profit is more certain. On the other hand, if a property is acquired at an over-market price, the investor is dependent on luck for a profit at the time of sale.

The investors in the MS fund seem to be punishing management for acting prudently by refraining from paying over-market prices for available offerings. Action might be justified if MS were not making all reasonable efforts to place the money. But, if a substantial effort was being made but was thwarted by unwilling sellers, then the question of time limits or punishment were probably not appropriate strategies for the investors. Instead, the investors, along with MS should have examined the market and determined when and under what conditions would buying opportunities begin to surface and whether or not it was worthwhile waiting for those opportunities. Imposing an investment deadline makes no rational sense.

Why is an investment deadline an erroneous strategy? To start with, a fund manager, operating under a deadline, will be highly incentivised to buy something – anything even if the long term outlooks for the acquisition(s) are questionable. The fund manager, by failing to invest will lose the contract and all that goes with it. Thus, the fund manager may feel forced to make questionable acquisitions and pray that, by the time sale is indicated the market will have improved enough to override any overly aggressive buying decisions. It is also probable that others like MS, who raised money for opportunistic investment, are having similar problems. If they too feel investor pressure, the result can be a “herd mentality” resulting in many making overly aggressive purchases for fear of being subject to investor criticism. When this happens, property acquisition becomes a very competitive sport where “getting the deal” becomes more important than the economics of the deal. This “herd mentality” was evident in the period leading up to 2008 when the frenzy of activity pushed real estate prices beyond the outer edges of the envelope.

There is substantial uncertainty in the investment markets today. Much of the uncertainty is attributable to global economic problems as well as domestic problems. The volatility of the stock market indexes underscores that uncertainty. Unlike stocks and bonds real estate cannot be traded on a daily basis. It takes a substantial amount of time to either buy or sell a large piece of real estate. Real estate investors can’t hedge against adversity by placing “stop loss” orders. Once a property is acquired it becomes subject to the vicissitudes of the market, whether good or bad.

The bottom line for investors should have been whether or not MS was best qualified to execute an opportunistic purchase strategy when market conditions were conducive to acquisition and then deciding whether the timing was going to be within their anticipated time horizon. If the answer to either of these questions had been NO then, a return of the uncommitted money in the fund might have been a good decision. But, putting intense pressure on MS to invest the money was probably not the best or wisest decision.

Buried on Page B 16 of the WSJ on Saturday, June 10, 2011, there was an article noting that Goldman Sachs suffered a major loss on its investment in the office building at 230 Park Avenue in Manhattan. This investment was part of the Goldman Sachs Whitehall real estate funds. A venture of the fund and Monday Properties purchased the building in 2007 for $1.15 billion (about $821 per square foot). According to the article, the value of the building was “about $300 million less than what it invested. Monday Properties remained in the deal and was recapitalizing the property, bringing in a new partner. Goldman’s exit from the property was part of the deal. The article also pointed out that Goldman’s Whitehall Funds surrendered to lenders the office building at 301 Howard Street in San Francisco and the La Costa Resort-Spa in Carlsbad, CA (near San Diego).

This news story, taken by itself, is no “big deal” but taken in the context of the major financial losses suffered by other investment banks invested in real estate as well as losses suffered by some public real estate companies, the story raises some interesting questions.
General Growth Properties, one of the largest publically held REITs invested in shopping centers went through bankruptcy. Morgan Stanley walked away from its investment in Crescent Properties in 2009 and took over $5.5 billion in real estate losses in 2010. Lehman Brothers failure was attributable, at least in part, to failed bets on mortgages as well as commercial real estate projects. Bear Stearns collapsed under the strain of mortgage investments and major banks took billions of losses on toxic residential and commercial real estate debt.

While much of the heavy property losses impacted private equity funds, those funds used investments from pension funds and thus, the spillover to the man on the street is recognized when the pension fund losses destabilize the ability of the funds to meet their pay out commitments. But, it seems that, with the possible exception of REITs, where individual investors play a roll, the common denominators were “other people’s money(OPM)” and size. The pension funds were investing OPM with private equity firms who then invested OPM. The private equity firms were fee driven as they earned placement fees, management fees and advisory fees. The same was true of the residential mortgage market where all “players” in the chain, except the hapless investor in mortgage backed securities, were fee driven.

The recent track record of the “players” brings into question the wisdom of trusting the judgment of investment vehicles managed by fee driven people who will have no personal “skin in the game”. Part of the problem is size. As the amount of money available for investment grows, so does the pressure to place that money. And, pressure (or a herd mentality) induces managers to “compete” for the few offerings available. This leads to overpaying and/or undertaking more risk than the investment warrants.

The same problem impacts publically held REITs which feel pressured to demonstrate portfolio and value growth. This, in turn, leads to “competitive” investing and the undertaking of more risk than the investments warrant. The dividend yields on REITs have been driven down by investor’s desire for dividends and the REITs have enjoyed excellent appreciation over the last several months. There are a limited number of ways in which the value of REIT stock can appreciate. The first, is increasing rents/and or decreasing expenses leading to an increase in dividend payout (REITs must pay out 95% of their net income). Next is an increase in the value of the portfolio by virtue of improved operating fundamentals and/or a market acceptance of a lower capitalization rate. Finally, growth can be achieved by the acquisition of new properties, accretive to earnings through direct purchase or merger or both. This kind of information is not always transparent in REIT annual reports and it is questionable as to the depth of understanding possessed by analysts as to how real estate works. What is obvious is that executives in some REITs also feel pressured to “compete” for property offerings.
Moving to the size issue, the larger the funds become, the more difficult it is to manage individual property operations. Investment real estate has always been very management intensive and good management requires quick decisions when problems arise. However, with very large portfolios many major decisions require centralized authority and result in delays. There is a risk that decisions will be based on their impact on earnings rather than the needs of the property. The same risk impacts leasing decisions where the market may be ignored in favor of unsupported or unrealistic potential outcomes.

The bottom line in all of this is that the big investment banks, commercial banks and private equity funds may not have earned the credibility and respect that they are accorded. But, greed will continue to induce them to create investment vehicles to entice the big money players, whether the investments are viable or not. The next market collapse will be attributable to different causes but the same players will be involved.

A recent Wall Street Journal article described the migration of major U. S. retailers to Hong Kong as one of the worlds “top luxury shopping cities” and the fact that this surge is driving up rents for retail space. Hong Kong has great appeal as the Mecca for shoppers from mainland China because luxury goods can be purchased cheaper than in mainland China. Walking along Canton Road, past the Harbour City complex, one of the largest shopping centers in Tsim Sha Tsui, creates the illusion that there is “no tomorrow”. Shoppers (mostly young) line up on the sidewalk outside of stores like Louis Vuitton, Yves St. Laurent etc. waiting for their turn to enter the store. This is by no means a universal phenomenon. There are more than ten, major urban shopping centers in Hong Kong. In fact, walking around the environs of Nathan Road in Tsim Sha Tsui and around Central in Hong Kong the impression is created that the City is one gigantic shopping center. Major international retailers do not confine themselves to one of the major centers but, rather have units in multiple centers.
Walking through the many centers suggests that, unlike the U. S., vacancy is not a serious problem. Rents are rising to dizzying heights and if the trend continues, the more marginal retailers will be forced to exit the market. Abercrombie & Fitch reportedly leased a 25,000 square foot store in the Pedder Building, across the street from the Landmark Center in Central. The reported rental is $901,000 U.S. per month or $10,812,000 U.S. per year. This rent translates to $432.48 U.S. per square foot per year. If one applied the unbelievably high percentage of 12% to this rent, volume would have to reach $3,604 U.S. per square foot per year. The Gap is reported to be opening a 20,000 square foot store at a price of HK$5,000,000 per month which translates to over $645,000 U.S. per month, almost $7,742,000 U.S. per year, which indicates an annual rent of $387+ per square foot. Again, using the yardstick of 12% suggests that volume would have to reach $3,226 U.S. per square foot per year. Similarly Forever 21 is reportedly opening a 50,000 square foot store at a rental of HK$11,000,000 per month in Causeway Bay or $1,419,355 U.S. per month translating to $17,032,258 U.S. per annum which reflects a square foot rent of $340.65 U.S. per year. Again, at a volume figure of 12%, this rental would necessitate sales of almost $2,839 U.S. per square foot per year. Finally, the WSJ article reported that the average rent for retail spaces in the Causeway Bay shopping district were up 34% in the last two years to $1,849 U.S. per square foot, a number that sounds almost impossible based on the sales volume that would be necessary to sustain that rent. If a measure of 12% of sales for rent is used, this rent level would mandate sales of $15,408 U.S. per square foot per year.
These numbers have the earmarks of a bubble based on irrational expectations. There are reasons for this concern. First, an allocation of 12% of sales volume to rent is very substantially above anything seen in the United States where the majority of retailers have traditionally used a yardstick of 5% – 10% at the high end. Thus, the sales volumes needed to sustain the rents reportedly being paid would, in reality, have to be much higher than the examples above. Secondly, shopping center sales volumes, across the spectrum in the U.S., do not reach levels of over $1,000 per square foot for large stores. As store size increases sales volume per square foot tends to decrease which is one reason in-line shops pay substantially more rent per square foot than department store/large store anchors. Thus, sales of over $3,000 per square foot per annum would be very optimistic for a 20,000 square foot store. Retail sales in Hong Kong rose 20% in the first quarter of 2011 from a year earlier. That, in and of itself, is very impressive but it does not mean that same store sales universally increased by that amount. The sales boost is attributed to the surge of mainland Chinese tourists to Hong Kong where prices are lower because Hong Kong does not tax retail sales. If that is a driving force, it would be good to keep in mind that the Chinese government, if nothing else, is very pragmatic and could, in an instant, adopt policies to bring that buying power back to mainland China.
Another area of concern is the fact that the American retailers paying extremely high rents to enter the Hong Kong market may be buying into the illusion created by people waiting in lines to gain entry to a luxury store as if they were going to be able to buy a ticket to a major sporting event where tickets can only be obtained from scalpers. A walk through of many of the major Hong Kong malls during five good weather days at the end of March provided a picture of many beautiful stores with no customers in them rather than one of abundant customers.
Foot traffic in the public corridors of the malls seemed relatively heavy but, much of the traffic appeared to be destination oriented rather than shopper oriented. Because many of the malls have connections from Point A to Point B or to the MTA (as is the case with malls developed by the transportation authority) people find it more comfortable to walk through the malls rather than staying out on the street even when weather is not a factor. In a visit to Elements, a major mall developed in conjunction with the MTR Kowloon Station, the absence of in-store shoppers was very noticeable. The same was true of Pacific Place, Harbour City (interior) and Landmark. The time of day did not appear to be a factor. It is possible that the time of year may have been a period of low tourism but there was a major rugby tournament taking place at the time with visitors from all over the world.
As said earlier, many of the luxury brands have multiple stores in Hong Kong leading one to question whether they end up “cannibalizing” their own trade. On a different note, real estate people quoted in the news article suggested that retailers may be allocating part of their marketing budgets to rent because it makes the rent appear more reasonable.
Is it possible that a “herd mentality” may be inducing American brands to compete fiercely for prime Hong Kong locations? Experience in dealing with retailers of all sizes over the years points to a much different leasing mentality from the period when the retailers were still family owned and managed. In that era, if the retailer did not think a store would turn a profit (after a period of development) based on sales, then a lease usually didn’t happen. With corporate and public ownership the pressure to continuously demonstrate growth may drive managers to “stretch the envelope” in a search for growth opportunities. As has been seen in the U.S. not all retail brands remain viable and, with viable brands not all individual stores remain successful. So, the jury will be out for sometime before it is known as to whether this overseas expansion strategy will prove good or bad for the retail companies taking the leap.

A recent newspaper article described the high apartment rental costs faced by tenants in many American cities, sometimes reaching 50% of their income. There is little doubt that high rental costs cause people to forego other necessary spending on items that, at the time, such as health care, do not have the same urgency as shelter. Despite the large number of vacant homes the rental market remains very difficult. Understanding the reasons behind the high rental costs may provide suggestions for alleviating the problems.
The imbalance of supply and demand is common to all markets but the causes are probably not the same. When there is greater demand for rental units than there are units available for rent, under normal economic circumstances, rents will rise until a strong resistance level is reached. Conversely, when there is a surplus of units available for rent, rents will decline. The solution to rising rents lies in increasing the supply. Thus, it is worthwhile visiting the root causes of supply shortages.
The collapse of the mortgage markets in 2008 effectively acted as a brake on financing for new projects. Thus, many markets facing rising rentals have not had any new supply of housing units commenced in three years. Home foreclosures forced former homeowners to become renters. These factors assured absorption of any surplus supply of rental housing in most markets. If the foreclosed homes had immediately become part of the rental supply, the problems would not be so pronounced. But, for the most part the units in the process of foreclosure or those already foreclosed remain vacant awaiting sale.
Some causes of supply shortages may be artificially induced by restrictive land use policies governing the construction of multi-family housing and allowable densities. For example, many years ago, when apartment construction was booming, San Francisco, in response to political pressure, substantially reduced allowable density in many residential neighborhoods, by 50%. Height and bulk limits in many jurisdictions plus open space requirements also contributed to density reductions. These kinds of controls are subjective and wholly artificial. Cities must revisit their land use policies in recognition of the fact that the population is growing and putting pressure on housing demand. Restrictive land use policies of the past may not any longer be appropriate either now or for the future. Cities can control development but they must recognize that they cannot control population growth and must act to assure available shelter for all. Planning must cease being a political process where the decisions are based on an idealized set of criteria reflecting the desires of current influential citizen groups and become a true process of planning for the future.
Another factor contributing to shortages in many markets is the time consuming and unbelievably expensive process of obtaining entitlements. These not only discourage developers because of the costs and risks but also substantially delay the introduction of new supply in addition to adding artificial costs to that supply. Much of this problem lies in the political process involved in obtaining entitlements. Cities must address this problem and create responsible zoning and land use ordinances that allow a quick project review and granting of entitlements without the accompanying political theater.
Creating avenues for increasing supply will not, alone, resolve the problem of escalating rents. Other artificial policies need to be changed as well. In some jurisdictions, every new project is required to include a percentage of “affordable” housing units as defined by local code. The original theory was that the developers would, thus, help contribute to the affordable housing supply. But, what the rule makers overlooked was the fact that the developers don’t pay for this. Rather, the cost is passed through to the market rate consumer who, in the end, subsidizes the “affordable” renter. Increasing property taxes, which are ordinarily passed on to tenants also increase the burden of rent.
In cities with residential rent controls, supply is artificially constrained as tenants with protected low rents are hesitant to move and give up their advantageous position unless there is no other choice. In most cases, because there is no shortage of labor and materials to build new projects, rent control is no longer necessary but has become a political entitlement that has spawned tenant’s rights groups to continue pressing for retention of controls. The best way to enjoy level rents is to maintain a steady supply of new units in a given market. Local government should search for methods of incentivizing developers rather than enacting land use policies, codes and ordinances that discourage risk taking by them.
It is inevitable that cities will experience a dominance of multi-family housing as population growth continues its natural course. The vast majority of the population can’t afford to own an urban single family home. Land is just too expensive to make that option a reality. With expensive land comes the need to use that land more efficiently. Allowing increased densities is a step toward more efficient land use. But, this needs to be done in concert with the development of efficient and convenient public transit in order to eliminate the traffic congestion caused by the proliferation of private automobiles. If municipal transit was efficient, most people would not need their autos and, instead might park them in large parking facilities on the periphery rather than in their building. However, this type of planning would also bring the need to permit residential projects and neighborhoods to become mixed use projects with essential retail and health care services to be located close by. Land use policies of this type would end the ban against retail uses mixed in with residential uses as those bans now appear in many single family neighborhoods.
What all of this suggests is that it does no good to complain about rising residential rents It would be a better use of time and energy to work for a major revision of land use policies that focus on the most probable future needs of a given community. Whatever changes may be enacted should be flexible enough to accommodate future, unknown or unidentified changes without cumbersome bureaucratic delay. Most importantly, planning for the future should not be a political exercise but rather should be only a planning exercise.

Recent articles have suggested that a commercial/investment real estate recovery may be underway but, is that really the case or is it wishful thinking?

Much has been written about the potential value recovery of the rental apartment sector with that recovery tied to four things: 1. Increased demand from dispossessed, former homeowners. 2. The availability of relatively cheap financing. 3. The lack of new, competitive construction in the last three years. The increased demand is touted as the engine that will cause rents to rise causing yields to increase. 4. The perception that existing properties can be purchased at prices substantially below their replacement cost new. Cheap financing will obviously serve to increase yield and the lack of new product eliminates alternatives for the renter. Taken all together, these factors suggest that apartment investments may be warranted but, there are downside arguments. In the short term, everything could work out well. But, real estate, unlike shares of stock, is not highly liquid and the real profit doesn’t emerge until the property is sold. Overall changes are not instantaneous and timing is everything. It is easy to get caught in the euphoria of a rising market and miss the opportunity to exit before conditions turn negative.

On the negative side, not necessarily in any order of importance, are the following”
As soon as vacancies begin to disappear, with the consequent increase in rentals, the apartment developers will leave the “sidelines” and begin to build again to satisfy the demand perceived to exist. This new building cycle, will increase supply and bring about an eventual decline in effective rentals forced by increases competition.
There are millions of unsold homes hanging over the market at bargain prices by comparison to the past. As the economy recovers, the ability of former homeowners, who are now renters, to move back into ownership, will take place. And, the lenders holding the distressed housing inventory will be anxious to reduce their exposure and will be helpful in facilitating sales. This will reduce rental demand.
Unemployed people, despite their need for shelter and despite their numbers, will not add to any real demand for rental housing. So, until employment picks up materially, real demand for housing should not be expected to increase.

The ability to purchase at prices below replacement cost new is not necessarily a good economic justification for purchasing. If the property is not producing adequate net income or will not produce adequate net income in the immediately foreseeable future, to economically support the purchase price, then purchase may be a bad idea.

Most importantly, interest rates are being kept artificially low as a strategy for increasing economic growth. Once growth is clearly established interest rates will begin to increase and, if inflation becomes a danger, pressure to increase rates will accelerate. Thus, when it is time to exit an investment, the value may become depressed for no reason other than higher financing costs that will cause yields to drop.

In the office sector, in spite of arguments to the contrary, occupancies should not be expected to increase absent demand caused by a substantial improvement in the job market, particularly in the service sector. Increased blue collar employment does not translate directly into service job increases. The office market is location specific and, obviously, some markets are currently behaving much better than others but, isolated improvements in specific markets do not spell improvement in all markets. The fact is that the service sector in most markets is still depressed.

The retail property market remains in a danger zone and faces continued contraction as chains reduce their exposure by closing underperforming stores and as other large retailers like Office Depot, Circuit City, Mervyns etc encounter depressed sales. And, the impact of on-line purchasing is expanding and becoming a major competitive factor for all traditional retailers, many of whom have their own on-line sales programs. On-line merchants do not need expensive store space to survive. Catalog sales both via the mail and via the internet reduce sales available to the traditional merchant. All of these observations suggest that a recovery in the retail sector may be a long way off with demand and rents continuing to decline.

Reportedly, the hotel sector is beginning to recover but the recovery signals may be false signals. Highly discounted room rates are still available in most markets save at times when a major convention or conventions hit town. Resort properties are still experiencing difficulty and foreclosures are still worrisome. Business, and government, in particular, is still in a mode of cost cutting and most well run companies are carefully watching their travel and entertainment expenditures. The vast improvement in video-conferencing and computer cameras has provided the ability to have “face” meetings without leaving home. And, during the boom years, a substantial over-supply of hotel rooms and resort properties destabilized the market. On the other side of the equation, operating expenses and labor costs appear to have continued to escalate as ADR’s and occupancies declined. Any material improvement in hotel economics will probably have to wait for a very significant improvement in the job market and economy. Vacation travel away from home is very low on the list of spending priorities and probably at the bottom of discretionary spending items after dining out, local entertainment, gifts etc.

Real Estate for the vast majority of the public means a home or a condominium. And, that residential market is completely different, with a different set of dynamics, from the commercial market. The purchase of a home or condo is probably the last bastion of individual decision making, where the wrong decision has an immediate adverse impact on the purchaser. The commercial real estate market is no longer dominated by individual purchasers. Rather it is dominated by REITs, institutional investors, investment bankers and pension funds. The individual investor participates indirectly as a shareholder, pensioner, or investor in a pool. The investment decisions are made by money managers. Money managers usually do not have a substantial amount of their own money invested in any acquisition (no real skin in the game) and may be motivated by competitive pressures (a herd mentality) rather than sound economic analysis. In the current market environment, it has been relatively easy to raise substantial amounts of money to invest in “distressed” real estate at bargain prices. However, with the money raised the job of investing it places pressure on the manager. So far, the anticipation of abundant opportunities has not come to fruition as evidenced by a recent article suggesting that the money was beginning to look off shore for opportunities. The reason for a lack of product is two-fold. First, those with good assets and no debt problems are unwilling to sell in an adverse market even though their values have been eroded. Secondly, the institutions foreclosing properties will generally try to re-position the property before selling and are usually unwilling “fire sale” sellers.

Given the foregoing backdrop, it should be expected that money managers have a vested interest in creating the illusion of improving market conditions in order to justify their purchase activity and decisions. Also, with vast pools of newly raised money, the investors want “action” so, for the money manager, sitting on the sidelines patiently awaiting a really good opportunity, is not an option. All of this means that the investor should be skeptical of pronouncements indicating improvements and should focus on real signals of a market turn through vastly improved employment statistics as a main driver coupled with material increases in corporate earnings as the engines of economic growth. Programs like the home buyer tax credits artificially improved sales but did not serve to provide lasting stimulus despite the publication of statistics indicating improvement in the residential sector. Investors should be mindful that many major investment banks, REITs and institutional investors (managed money) made some very cataclysmically terrible judgment errors that ended up costing them billions. Thus, there should be no confidence that the same errors will not be repeated. It is predictable that under competitive pressure to invest, money managers will again get caught in market euphoria and over pay to be a player.

The January 5th New York Times Business Section contained an interesting article reporting resurgence in office building transaction activity. The article pointed out that the activity was pretty much confined to primary markets like New York and Washington D C and involved not only well leased properties but also those with substantial vacancy. At the same time, the article indicated that rates of return (capitalization rates) were dipping below 6.0% while overall office vacancy was above 16% nationwide. Finally, the article suggested that investors were “betting” on increased rates of return as the office market improves while noting that the key to increased occupancy was improvement in the job market.
Does all of this mean that the office sector is climbing out of the doldrums of recession? Probably not! What it most probably shows is that there is a substantial excess of investment capital searching for opportunity in an opportunity thin environment. It also probably shows that REITs and investment funds have been able to raise large amounts of capital at relatively low interest rates that permit returns below 6% to produce positive cash flow. On the other hand, the office sector is still fraught with vacancy, mortgage delinquency, foreclosure and falling rent problems. So, is the optimism rational or is it wishful thinking?
In certain select markets the optimism may be rational but in the majority of markets it is wishful thinking. There is no question that occupancy rates will not begin to improve to a point where vacancy is below 10% (the level where recovery is most probable) and that should not be expected to happen until the employment statistics show sustained improvement indicating hiring resurgence. However, there are other factors besides employment levels to consider. It must be expected that the number of employees working from their homes either full time or at least part time will continue to expand. This portends a change in the amount of space needed per employee. With employees working from home, a dedicated private office or cubicle for each employee may no longer be part of space planning. Rather, off-site workers may spur an increase in the use of “guest offices” as the probability of the entire staff being on-site at the same time diminishes to a percentage approaching zero. If these things come to pass, new demand may not push rentals upward as quickly as anticipated. Another problem that could impact office demand in some markets is the lack of affordable housing and efficient municipal transportation. These factors could induce management to relocate clerical staffs to secondary communities where there is affordable housing and where transportation (parking) is not problems.
One final observation may be valid. The money flowing into office building investments represents “managed funds”. When managers, working with other people’s money (OPM), dominate market activity does it necessarily mean that they purchase decisions are sound? Not always! Experience indicates that when money managers have substantial cash or access to substantial cash, they are competitively induced to find an investment outlet for that cash as was evident pre-crash. In the boom leading up to the financial collapse, major, sophisticated REITs and investment funds made catastrophic errors and lost billions of dollars with the lenders taking most of the losses. There is an appearance of a “herd mentality” and that could lead to the same kind of excess that led up to the recent market fall.
It is, therefore, concluded that in the current economic environment, commitment of major funds to office building investments may be premature

The Wall Street Journal of Thursday, November 10, 2010, carried an article by Anton Troianovski reporting that REITs are going global to find deals. The article cites the fact that many analysts question this strategy but also points out that the impetus is fueled by the enormous amounts of cash that has been raised by public companies in the last two years.

Money was raised ostensibly to take advantage of the “bargain” prices anticipated from the fallout of the collapse of the commercial real estate market. However, the expected flood of properties did not materialize for three reasons. First, the holders of good properties resisted selling in a “down” market. Secondly, the holders of properties acquired through foreclosure focused on trying to improve the properties before taking them to market. And, thirdly, lender/holders of foreclosed properties have a habit of “studying a property to death” before facing reality. Thus, it is not surprising that there are not abundant opportunities for opportunistic real estate money.

With that said, one must still question the strategy of looking “offshore” for real estate opportunities. It is not like the U S REITs are the only ones on the planet who understand real estate. The article points out that the path to overseas real estate investments is a somewhat well traveled path by both overseas investors and U S investors. Thus, why would anyone be convinced that foreign opportunities are any better than those at home? It is suggested that investors look at the history of investing in real estate outside of the country of expertise by both U S investors and foreign investors. The beating that Canadian investors took in the real estate market, when they moved into U S real estate in a major way should not be lost. Nor, should the drubbing taken by the Japanese in U S real estate be overlooked. Those in the brokerage business at the time privately laughed at the over-inflated prices being paid, for whatever reason. For the Japanese, in particular, it was a double edged sword in that they bought when they paid over 300+ yen for the dollar and sold when the yen was at less than 150 to the dollar. More recently, funds invested in foreign real estate haven’t faired so well either.

The desire to find global investments seems to be driven by the fact that these REITs raised money and now have to find investment outlets for that money. Finding none at home, they are looking elsewhere. But, that search may not be the result of an abundance of opportunities outside of the U S but, rather the pressure to invest the money raised. This may be an example of “other people’s money” driving the search and could result in money managers making the same “competitive buying” mistakes as were made during the bubble market.

When companies stray from the ‘basics” investors in the stocks of those companies should be extra cautious. There is a risk that the overseas property markets may not be as well understood as the markets at home, which, in and of itself, can cause over reaching. But, there is also the currency exchange rate volatility risk. Global real estate may not be a good answer.

Since this site began, comments cautionary about REITs have been posted. Not surprisingly, the market behaved exactly opposite to the cautionary observations. Despite negative signals, REIT shares outperformed the S & P 500 for the third quarter. However, on October 20, 2010, an article in the Wall Street Journal by A. D. Pruitt titled “Caution on REIT Earnings” a new alarm bell sounded.

There are interesting observations in the article such as “Hotel and apartment companies are expected to be the strongest” and Host Hotels & Resorts Inc., last week said third quarter funds from operations were flat.” And, Mike Kirby of Green Street Advisors was quoted as saying “I think earnings will be weak. The idea we’re going to have robust earnings is just not going to happen.

The article cites as the reason for the relatively strong performance of REITs that “investors are looking past the current weak fundamentals and into next year where a strong recovery is expected to take root”.

Next there is the observation that dividends at some REITs may come under pressure if rents and occupancy rates continue to fall and there is an observation that office vacancies are at a 17 year high..

Finally, one REIT analyst is quoted as saying that earnings by apartment operators should improve sharply because demand for rentals has surged amid the housing crisis.

What does all of this mean? Most importantly, the article alerts the reader to the fact that there are still problems in the commercial real estate sector and there is anticipation of an improvement in 2011 but no solid evidence to support that anticipation. REIT performance can not improve until occupancies increase and rents begin to move upwards. Upward rental movement in office space can not be assumed to be meaningful until vacancies in a particular sub-market fall below 10%. Vacancy is the main factor limiting rent growth followed by increased supply through new construction. Right now, there is very little threat of increased supply by virtue of new development but, rest assured that when occupancies exceed 90% the developers will begin to work again.

Office vacancy will not decline until business growth is established and the signal for that event will be measurable declines in unemployment in the service sector. There is no current indication of massive change in 2011 or in the immediately foreseeable future.

Many office building still have old leases at above current market rates that are “burning off” and the downward adjustment of those leases at renewal will negatively impact REIT cash flow.

The retail sector must be expected to continue facing “infill” problems as vacated department stores and in-line shops look for tenants. Changing retail patterns such as increased internet transactions will continue to erode traditional store sales. Strip malls face challenges as changing supermarket sizes and competition from operators like Costco, Wal Mart and upscale chains like Bristol Farms cut into the traditional market customer base. Older, small supermarkets are being closed in favor of newer and larger stores as the leases terminate leaving some strip malls vulnerable to a complete loss of viability. A major upward movement of consumer spending may be the catalysts needed to resolve the challenges facing the retail sector but will probably require a major surge in employment and payrolls. These factors make investments in retail REITs tricky at best.

Despite optimism for increased apartment demand, those forecasting that demand may be counting too heavily on the fact that people are not buying homes and will become renters. However, the foreclosed homes, by default, become part of the rental pool competing with apartments. And, there is every reason to fear that the pace of forclosures will rise in the near term. Plans will be developed to cause absorption of vacant homes by linking rental with a purchase option. Most importantly, rental demand of any kind, apartment or residence, is absolutely linked to employment. Unemployed people may be ready and willing to occupy a home or apartment but, without a job, they are not financially able to do so.

The bottom line is that real estate is very local in nature and not all sub-markets will experience the same dynamics at the same time. Thus, macro statistics are of little help in analyzing a REIT owning properties in several markets with varying types of debt structures. Further, every REIT has a different portfolio of properties and it is those individual properties, along with debt structure, in a given REIT, that provide a guide to the future performance of that REIT. So, no reliance should be placed on industry wide statistics in selecting a REIT investment. Finally, dividend yields are not yet at a level where there would appear to be a good reward vs. risk ratio. Successful investing in REITs today requires much more than a shotgun approach. It is essential to focus not only on the balance sheet and current dividend but also on the types of properties in the portfolio, the leasing structure of the individual properties and the debt structure

REIT investors should be very cautious in this market environment.

A few days ago, while eating lunch, I caught an “infomercial” on television sponsored by Armando Montelongo of “Flip This House” fame. Armando was promoting his course that is described as teaching how to make millions in the residential foreclosure market. He refers to his list of bankers who will lend money for transactions and suggests that it can be done without having any money of your own. He refers to his sources for finding foreclosure sales that are not generally available to the public. These claims are supported by a cast of people purporting to have made tons of money, on a repetitive basis, following his teachings, including people who were involved in multiple deals simultaneously.

The fact that people pay good money to attend these courses is a testimonial to the belief of gullible people that there is really a “tooth fairy” and that taking a “smart pill” is all that is necessary to unleash riches. Teaching people “how to get rich quick” has been around forever. What is absolutely astounding is the fact that people are willing to pay money to attend these kinds of courses without undertaking any kind of research to find out whether or not what is being advertised has a reasonable chance of working.

The first “red flag” is the inference that the strategy can be implemented without using ones own money. That may have worked in the years leading up to 2006 when zero” down payments, liberal loan terms, no-document loans and relaxed loan underwriting standards were in vogue. But, since he collapse of the mortgage market it is general knowledge that lending standards have changed and zero down – no-doc loans are no longer de rigueur. So, question number one, before paying money for a course, should be to ones banker asking if these claims are reasonable.

The next question should be addressed to an experienced residential real estate broker to ask if the market is such that it is easy to identify and buy foreclosed properties with little or no down payment as well as to find out if the broker (brokers) had any knowledge of the “Flip This House” strategy working in the present market.

Finally, research needs to be done to determine whether lenders selling foreclosed properties are required to make the same disclosures relative to condition that a typical seller is required to make or whether a sale would be “as is”. Anyone buying homes in California, with the intention of “flipping” should be aware of the disclosure required of sellers and their brokers. Failure to disclose could result in costly remedies after the sale has closed. Buying “as is” becomes a very dangerous undertaking for the inexperienced buyer. Before buying “as is” a purchaser should have a thorough home inspection to identify any serious problems like mold, lead paint, termites, and wood destroying organisms, as well as structural problems, major deferred maintenance (like roofs) etc. The cost of putting the home in salable condition may erase any potential profit. “Fixing” the home to “flip” it may well involve much more than just a coat of paint. When purchasing foreclosed property, the buyer should assume that the foreclosed owner who couldn’t meet the required debt service payments also couldn’t afford to take care of any maintenance problems.

Going into the business of buying foreclosed properties should be approached in the same manner as going into any other business. First and foremost the buyer must learn the business. Learning the residential real estate business can not be done in a short “get smart quick” course. There are capital needs. The money to make the initial purchase, the money to ready the property for re-sale and the money to hold the property during the time between acquisition and final re- sale. It may be possible to buy with nothing down and, if so, what about the rest of the capital needs? Next, how does one learn the market? It can not be learned in a short course. What is needed is a fairly intensive study of neighborhoods and recent sales within those neighborhoods in order to develop the necessary judgment that will allow identifying a “bargain”. This takes a lot of perusing of “For Sale” ads, visits to “Open Houses” and follow up on closed sales. There is no “smart pill” for this.

When one sees a picture of a classroom full of budding real estate speculators one should consider what will happen if all of these people go out into the market at the same time and are ready, willing and able to buy. That amount of activity would cause at least a temporary excess of demand over supply which in turn would tend to destroy bargain prices. The answer is that the strategy most probably can not be implemented by everyone for one reason or another.

Before spending hard earned money on a “get rich quick” promise be very skeptical that the “promise” may be nothing more than to induce the spending of money to register for a course and may lead to nothing more than a few interesting lectures that may resonate like the selling of “snake oil”. There is no quick way to riches other than lots of luck. Otherwise becoming rich takes a long time and much hard work and study. Buying and fixing homes for re-sale should not be expected to be done on a part-time basis and successfully implementing a strategy is a time consuming process. That is not to say that someone couldn’t start from scratch and buy foreclosed property and successfully “flip” the property. It is just very unlikely that lots of people could do it without substantial training. Just ask – if it were so easy why wouldn’t every real estate broker who spends 40-60 hours a week in the market be doing it too, in competition with the inexperienced buyers? If you feel lucky and want to get rich quick – buy a lottery ticket but don’t quit your day job.