An article in the Wall Street Journal this week suggested an increase in foreign investment in U S real estate. While much of the investment reportedly comes in the forms of financing for U S projects rather than direct ownership or development, the move may suggest hitting the “warning gong”. There is an old saying that goes something like “he who doesn’t read history is doomed to repeat it”. Those readers old enough to remember the 20th century will be reminded of the debacle of Investors Overseas Service (IOS) and the later invasion of Japanese investments in the U S real estate market. Both of these investment moves preceded recessions in U S real estate values. Was this a freaky coincidence or was there a structural reason? Are there parallels as to what might be expected in the foreseeable future? The short answer is that there are most probably parallels that should lead to caution but the opposite may be the case.
The current crop of foreign investors appears to be “institutionally” rather than individually driven. The individual investor is not the real player. Thus, the investment decisions are in the hands of “money managers”. These foreign investors are reportedly using more liberal loan underwriting criteria than the U S financial institutions that were burned by the 2008 financial meltdown. That, in and of itself, translates into a gigantic risk factor for the lender and their pool of investors. Secondly, this increase in money from abroad comes at a time when the real estate market has undergone explosive value increases coming after the 2008 market collapse. So, there is a market timing risk. Some may say that it doesn’t make any difference if these foreign investors are wrong. However, it may not be that simple.
If the foreign investors are financing high profile properties using liberal underwriting standards, then there is a market risk that failed projects individually or in the aggregate may induce a down trend in U S values.
Next, the currently low U S interest rates have contributed to the rising real estate prices. If, as expected, domestic rates rise, the rise may dampen the U S values.
But, the most worrisome problem may be a lack of understanding real estate development and ownership risks by the investors.
In the second half of the 20th Century (1955) a gentleman named Bernie Cornfeld started Investors Overseas Services (IOS) headquartered in Geneva (the money was held in Canada) with 25,000 salesmen covering Europe selling their real estate fund investments to ordinary people. In the 1960’s IOS started the Fund of Funds (which held the other funds previously marketed) and raised $2.5 billion with dividends guaranteed. To make a long story short, a “blip” in the market left the Fund without income sufficient to cover the dividends so capital (newly raised funds) had to be used. This step made the Fund a Ponzi scheme (the funds from other investors used to pay dividends to current investors). The bottom line was that the investors lost all of their money. Bernie Cornfeld probably never intended this result and started off with good intentions. However, the seeds of failure may have been the ease of raising money which put pressure on management of put the money out in the market resulting in chasing higher and higher prices as the pressure of their money met competition from domestic investors. In other words, IOS was paying premium prices to acquire assets. If they had not been able to buy assets the ability to raise more money would have been seriously constrained. Also, in this period, public syndication of real estate was underway making purchasing more competitive. If the pool of money had belonged to an experienced individual investor it is very doubtful that the prices paid for many of the assets would never have been paid. Along with their counterparts (the syndicators) IOS was under pressure to invest and a “herd mentality” may have taken over.
The Japanese investments in U S real estate during the 1980’s also demonstrated a competitive investment mentality. The investors sought only prime assets at the start but later dipped into quality secondary assets. Borrowing rates in Japan were lower than rates of return from U S real estate so it looked easy to borrow money in Japan and invest in the U S. The catch was that the Yen to Dollar exchange rate was very favorable at the time of asset purchase but, when it became necessary to liquidate that relationship had been completely reversed. So, not only were U S real estate prices declining but the cost of converting sales dollars back into yen was steeply rising casing a loss of money not only on the sale but also on the exchange rates. The common denominator of IOS (& other syndicators) and the Japanese investors may well have been the role of the money managers making investment decisions rather than the end investor making the decisions.
In the period 2001-2008 the loose lending practices in the single family market ultimately led to the collapse of the entire domestic real estate market. The common denominator was the fact that nobody in the transaction chain had any money at risk. The real estate broker collected the sale commission; the mortgage arranger collected a commission; the lending institution collected a fee for originating the loan; the Wall Street investment banks saw a payday through the sale of loan product through mortgage backed securities; and the rating agencies had a substantial fee interest in rating the mortgage backed securities. The only people at risk were those who purchased the securities. The originating lenders had come up with a foolproof method of transferring all of the risk of the transaction to the investor. Nice work if you can get it.
The dominant real estate market makers (Institutions, Investment Banks, Banks, REIT’s, Fund Managers and related entities) all share a common element. They are all using mostly OPM (Other Peoples Money) in the implementation of their investment strategies. They are all competing in the same markets and share the concern of being labeled “underperformers”. Leading up to 2008 prominent investment bankers, financial institutions, pension funds and others like themselves made some unbelievably ill timed, poorly analyzed, very costly investment decisions.
Included in the list of losers were the likes of State of California employee pension funds that lost $500 million in land investments, Morgan Stanley and other investment banks who lost billions in flawed real estate deals. What happened then demonstrated that people investing other people’s money did not, necessarily make the same kind of wise decisions as they might have made if they had been investing their own money.
In the 1990’s, easy money led to a commercial real estate collapse. Savings and Loan Banks took in billions of dollars using “brokered deposits”. Investors desirous of diversifying to obtain optimum FDIC/FLIC insurance covering their wealth were easy clients for account brokers to land. They earned a fee for leading a client to a financial institution. The banks (mainly S & L’s) became over weighted with cash deposits that had to be invested in order to pay interest to the depositors. Conveniently, the banks earned fees on the loans originated with the gathered funds. The weight of money to lend forced a serious compromise of lending criteria and standards as the loans became riskier and riskier as the loan frenzy progressed until it collapsed. To say that the involved lenders made some terrible, high risk loans as well as falling prey to fraudsters gaming the system would be a great understatement. Again, a common denominator of lending other peoples money was at the root of the problem.
Real estate is very different from the other most favored investment vehicle of listed stocks. Stocks traded on major exchanges are generally very liquid. That is to say that they can be quickly sold on the exchange at a very low transaction cost. So, if an investor wakes up fearing that an investment was a mistake it takes only a moment to get out. Further, a defensive strategy of using “stop loss” orders can be employed to limit loss exposure. Neither quick sale nor “stop loss” are available to real estate owners (as differentiated from investors in real estate securities). It can take 6 months or more from listing to sale closure on a major property. And, the real estate transaction costs can run 2% to 6% of the total sale price depending on a number of factors. When product and service companies operate under adverse circumstances they can substantially reduce their operating costs to offset the adversities. When real estate runs into trouble by virtue of vacancies some costs can be cut but the major costs keep on going. A 100% vacant building still must pay debt service charges, property taxes and insurance as well maintaining equipment to avoid premature breakdown. Then when new tenants are signed a large leasing commission is paid to the leasing broker and the owner usually must pay for substantial tenant improvements. Tenant turnover is expensive. All of this and more contributes to the reason behind a “liquidity premium” The fact that real estate is difficult to sell compared to securities is the reason behind the notion of a “liquidity” premium attached to real estate (for example, if stocks pay a dividend of, say 4% how much higher would the return on real estate need to be to offset the lack of liquidity? The answer is not the same for all properties. However, the greatest risk of all is the interest rate risk and most current investors don’t remember the days of 10% and higher mortgage rates. The real estate rates of return are at current lows resulting in money being cheap. But, if there is a progressive increase in money rates such could well trigger a recession.
The bottom line is that seeing major foreign money move into domestic real estate finance at what may be a cycle top creates an environment where another real estate recession could be triggered. What the trigger will be is impossible to predict just as it was impossible to predict the action of the Fed in 1979 in a surprise raising the discount rate that resulted in mortgage lending rates going to the stratosphere and causing a major real estate recession.