The commercial real estate investment market has experienced substantial change over the years and it is questionable as to whether or not the change has been good for all participants including the developer/investor/owner, the tenant and the lender.

Before real estate became “big business” the decision makers consisted of individual investors purchasing and selling properties and mortgage lenders applying tried and true formulas to lending. These individual investors usually functioned on a formula of “one deal at a time” and may have included investor partners in the venture. Some highly successful developers were able to align themselves with major non-real estate companies as their prime investors. Corporations like insurance companies, contractors and manufacturing companies found it very profitable to be aligned with highly experienced and successful developers. Most often the developer in these ventures took on the same degree of financial risk as their money partners.

Tenants often had a direct contact and relationship with the property owner or dealt with a property manager retained by the project owner. The property manager most often was responsible for implementing policies that encouraged tenant retention. Thus responsiveness was very important.

The emergence of syndication began to change the real estate investing landscape but was focused mainly on existing projects with an emphasis on tax shelter. Tax shelter investing has some benefits for the high bracket investors but too often the only return received by the investor was the tax shelter. When projects failed down the road investors were often left with recapture provisions of the tax code that nullified the benefits of the shelter. The syndicator was more often than not taking fees (commissions + other fees) and a carried interest in the project rather than having a real cash investment at risk. Syndicated properties were frequently highly leveraged and the syndicator, not the ultimate investors, was the managing partner with all decision making power. Tenants in syndicated properties were usually dealing with someone that had little or no cash invested in the property and thus not as interested in tenant relationships as following policies that would make their “carried interest” more valuable. Also, syndicated properties were often short of additional operating cash needed to properly develop and maintain the asset since much of the emphasis was on the tax shelter aspects of the investment. Changes in the tax codes resulted in the end of tax shelter investing with a further result that projects acquired at inflated prices couldn’t be resold. This caused pain for many investors in syndicated real estate projects particularly those exposing investors to very significant recapture of tax sheltered dollars when the investment was disposed of.

Two other developments served to change the real estate investing landscape. These were the entry, on a large scale, by pension funds into real estate ownership and development and the emergence of publically traded Real Estate Investment Trusts (REITs). In both of these instances money managers earning salaries or fees made the investment and management decisions rather than the money investors who were totally removed from any buy/sell/management decisions. At the outset these institutional investors were not overly aggressive in either purchase decisions or the use of leverage. However, as time went on that changed. The changes were mainly induced by the competition for available properties as the demand for “investment grade” properties increased and the available supply decreased. The completion for property forced rates of return (capitalization rates) to decline substantially to a point where the returns did not reflect the investment risks.  There was a kind of “herd mentality” at work as each money manager feared that a failure to acquire would impact their future.

The growth of the institutional real estate owner was further expanded to include multi-million dollar (billion dollar) real estate investment funds on a worldwide basis. These funds were often promoted by investment banks where fee motivated management was operating in a highly competitive market for real estate investment.

The pension funds, REITs and investment funds were all seeking investment returns that exceeded the returns from other, more traditional investments like stocks and bonds. As the hunger for returns expanded so did the use of more exotic forms of leverage without adequate consideration of the fact that the higher the amount of leverage the greater the risk exposure. All of these investment vehicles appeared to move forward under the assumption that rents only went up. Pension fund investors went into more exotic and higher risk investments in order to boost returns like land development.

From the standpoint of tenants, the shift to money managers making investment decisions was not terrific. Many management decisions were focused on the impact on “this year’s net” rather than the long term needs of the property. Often leasing decisions were focused on the cash flow needs of the property rather than the question of market rent (the competitively attainable rent). Tenants were subject to impact from non-market forces rather than being only subject to market forces and accessibility to decision makers was more remote.

The entire class of intuitional real estate real estate investors used a discounted cash flow (DCF) model as one of the determinants of the price to pay for an asset. It is probably very safe to say that prior to 2008 no DCF model contained an assumption of declining rents in future years. It would really be interesting if all of the DCFs used in purchase decisions in 2005, 2006 and 2007 could be brought out into the open with their forecasted 2008, 2009, 2010 and 2011 shown and compared to actual performance for those years. It would probably be a very sobering experience.

Private pension funds do not generally release operating results to the public so there is no way to know for sure how much their real estate investment portfolios may have declined in value post 2008. But there is some information on “public” pension funds like those for state employees. Public employee pension funds in the State of California lost many millions of dollars invested in land as well as many millions as a participant in investment funds managed by investment banks. Large investment banks like Morgan Stanley and Goldman Sachs lost billions in failed investments and, most recently, Goldman basically walked away from its portfolio of office buildings in Seattle. These results demonstrate that for many reasons real estate is very tricky because if the really very “big boys” take really “big hits” in spite of their research and analytical abilities, what chance does the small individual investor have?

With the exception of housing and small investment properties bought by real live people, the commercial real estate market has become an institutional investment market driven by for fee managers with little or none of their own money invested in a deal. The ultimate investor is dependent on the ability of the fee manager to identify, analyze and manage acquired properties in a profitable manner. However, by its very nature, a market where competing managers are going after the same investment it is obvious that the manager has an incentive to convince himself or herself as to why they should pay whatever price is needed to “win” the property. It is suggested that this may not be the perfect model. What is needed is a model where the interests of the money investors and fund managers are aligned. Some REITs have accomplished this by requiring their top executives and directors to be substantial stockholders in the REIT. If pension fund managers and investment banks were similarly required to make substantial cash investments (say a minimum of 10%) in any property acquired such a rule might align the investor’s interests with the manager’s interests. Another change that might be considered would be the avoidance of deadlines by when the collected funds must be invested. Deadlines encourage investment mistakes as preferable to losing the funds by the operation of a deadline.

The recent implosion of the real estate market seems to have corrected the excesses that lenders became competitively involved in and there appears to be a return to more “defensive” lending with greater borrower scrutiny and higher underwriting standards. This will probably continue to be the case for the foreseeable future at least until the banks and institutions have more money available to lend than there are borrowers making demands for money.

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