By now, if someone doesn’t know that real estate has declined in value, by a substantial amount, from its highs in 2007, they have just awoken from a three year sleep. There is no doubt that there was a real estate “bubble” and that the “bubble” has burst. That is not the question. Rather, the question is one of why did the “bubble” occur in the first place and why did it burst when there are so many supposedly brilliant, highly paid, bankers and investment advisors out there who should have seen it coming?

There is a vast difference between single family residential property and commercial or investment real estate yet, the root of the collapse would appear to emanate from a single cause. The market was being driven by “other people’s money”.

In the case of single family housing, the home buyer was chasing the illusion that values would continue to increase forever. This illusion was fed by irrational competition between lenders eager to push money (mortgage investor’s money and not their own) out the door and earn a fee for doing it. The mortgage brokers, eager to earn a fee, helped the lenders by supplying new and re-financings at a rapid clip. In some cases they helped unqualified borrowers to “qualify” through providing false financial information. But, none of their own money was at risk. The lenders relaxed their “due diligence” processes because they were going to package the loans and sell them to investors through investment banks as mortgage backed securities. Thus, in theory, they would have none of their own money invested in the mortgage. The investment banks, also eager to earn fees, sold mortgage backed securities to their investors and, theoretically, would have passed the risk on to those investors. To facilitate the sale of mortgage backed securities, the investment banks hired rating agencies to rate the securities. The rating agencies, eager to earn fees for this service, overlooked the risky practices taking place but, then, they had none of their own money invested in the product. The home borrower, in many instances, had very little of their own money invested in the home either by virtue of very low down payment requirements or by virtue of successive re-financings, as prices increased, to a point that more than 100% of what they initially invested had been taken back out. Thus, the foreclosed homeowner had no material investment in the property and it was the owner of the mortgage who suffered the financial hit. The market also evidenced a substantial amount of speculative activity from people who purchased many properties with the goal of a quick, profitable re-sale. Had it not been for the easy availability of credit, minimal financial qualifications and the lack of any real risk assumed by the home buyer/owner, would there have been a wild escalation in prices (bubble) leading to a collapse?

Supposedly experienced financial people should have seen the handwriting on the wall at least two years before the collapse occurred, as all of the signs were there. Low or no down payments, abundant availability of funds to loan, very relaxed borrower qualifications, ease of selling mortgage backed securities and a surge of speculative home buying taken in the aggregate were a prescription for disaster. But the fact that the bankers didn’t see the handwriting on the wall shows that, possibly, they were blinded by the substantial fees they were earning and that they succumbed to the competitive pressure of not wanting to “miss out” on a very profitable business opportunity. The fact that investment banks (led by people earning multi-million dollar bonuses) ended up with mortgage backed securities in their own portfolios only shows how they began to believe their own propaganda. Firms like Bear Stearns and Lehman are no longer with us because of the collapse of the mortgage backed securities market. Goldman, a brilliant survivor obviously saw it all coming and made billions shorting the mortgage market (while at the same time continuing to sell mortgage backed securities to investors).

The bottom line seems to be that the pressure of “other peoples money” drove the residential real estate market since the investors who purchased mortgage backed securities, theoretically at least, ended up with all of the risk while all others in the process earned fees but were left with no risk (unless they retained the mortgage securities in their portfolios). There was a time, earlier in the market history, where home buyers needed a relatively substantial down payment and were subjected to very demanding financial standards to assure that the buyer had the ability to service the loan. It is doubtful that the collapse would have occurred if more rigorous standards had been applied but, more importantly, things might have been different if the institution that originated the loan had been required to “age” the loan before selling it in a package of mortgage backed securities.

In the commercial/investment market easy financing was also available with the ability to highly leverage properties through the sale of commercial mortgage backed securities. However, that was only a fraction of the cause of problems in the commercial markets. Major players in the commercial markets are institutions (pension funds), investment funds marketed by investment banks and real estate investment trusts. In each of these vehicles the investment decisions appear to be made by people who are not the end investor.

Pension funds hire investment advisors who are paid substantial fees for vetting investments and guiding their clients into “suitable” investments. The advisor has only one risk – loss of the confidence of their client with a loss of the client. But, the advisors work under an unseen pressure, one that is not anticipated or factored in by the client. If the advisor does not produce “suitable” investments or turns down investments that are ultimately announced by a peer pension fund, the advisor may find that the client moves to another advisor. So, there is a pressure to produce results. And that pressure can, and most probably does color recommendations. This is especially true when there is fierce competition for real estate investments with little or few qualified offerings. The risks to the pension funds are great as seen by the Calpers (California Public Employees) purchase of two major apartment complexes in New York with an estimated loss of $500 million and CALSTERS (California State Teachers) estimated loss of $970 Million in a land development investment in California. Probably, no problems would have occurred if the properties had been acquired at the beginning of the real estate cycle but they were bought at the height of the cycle. Investment advisors should be able to recognize when cycles are nearing their highs but, competitive pressures may serve a blinders.

Investment funds put together by investment banks have the same root problem. They put together a large fund based on the investors’ expectation that they will be able to successfully invest and leverage those funds. Failure to put the money to work creates investor unrest leading to an unseen pressure to show some progress. That pressure often leads to “stretching” the analysis to make the numbers work. A major investor once remarked “even when I lie to myself with the numbers, the deal doesn’t work”. The difference there was the investor was investing his own money where in the case of funds, the purchaser is investing “other people’s money” and that decision does not seem to carry the same risk pressure. Once in a while an investment bank will acquire a property using a high degree of leverage anticipating the easy ability to easily raise the money later. Again, the decision is not made with the expectation that the investment bank will hold the property in its own portfolio other than very temporarily. When it works out as planned, no problem. However a major investment bank lost a substantial cash investment when investors did not buy the fund and ultimately lost the projects to the lender.

Again, it appears here that “other people’s money” drove the investment decisions. Institutions fall prey to the same competitive pressures as lenders. The pressure is the fear that someone else will end up with the deal to their embarrassment.

Real Estate Investment Trusts (REITs) are public corporations investing in real estate and are most often traded on a major stock exchange. Growth in the value of REIT shares comes about by any one of several routes or a combination thereof. Increasing cash available for distribution through increasing rents or decreasing expenses is the most obvious. This route is management driven. Expanding the portfolio by use of leverage and acquisition of properties where the acquisition would be accretive to earnings is another means of share value growth. Finally, a competitive reduction in the rate of return on properties (the capitalization rate) raises portfolio value. The latter is something over which REIT management has no control since it is completely market dominated.

The first avenue to value growth is strictly in the province of property management or operating management skills, but, comes into play by financial managers and the REIT board when making a purchase decision as part of a forward looking financial analysis. However, the ability to raise rents is strictly a function of the market. It is interesting that almost no analysts provide any commentary on the quality of property operations yet that is a very important aspect of growth.

Growth by acquisition comes about through the raising of new capital or leveraging the existing portfolio. Many of the current REIT problems are the result of over-leveraged portfolios in the face of declining rents. Here, again, the acquisition decisions are too often competitively driven with the decision made easy by the fact that it is the investors’ money being put at risk. The decision makers usually do not invest their own money in the acquisition. Competition between REITs places the same unseen pressures on the decision makers as in other vehicles using other people’s money.

There seems to be an inescapable conclusion that the decision makers risking other people’s money do not tend to view risks in the same light as an investor risking their own money. The investor investing his or her own money faces no competitive pressure or embarrassment for failing to make an offered investment and is only concerned with the probability of success of that single investment.

There is also another seemingly inescapable conclusion that the investment models utilized by investment managers (REIT, Investment Banks and Pension Fund Advisors) were most probably flawed by a failure to build in a sufficient downside risk factor. Many analysts utilize discounted cash flow models (DCFs) to determine investment suitability. The models usually forecast only future increases in rents and an increase in value at the time of sale. The models usually did not capture the potential competitive impact of new projects coming on stream and did not consider the possibility of negative economic factors causing vacancies and reducing rents over time. The models made it possible to easily manipulate the results to justify a favorable recommendation.

With all of this one might conclude that over optimism and naive beliefs, by money managers that things go up forever became “blinders” to risk. That attitude seemed to be fueled by continued rising prices and rents and an easy supply of money.

What happened in the recent past relative to commercial properties is reminiscent of the syndication explosion of several years ago. In that era, before public securitization of real estate via REITs, syndicators purchased a property and then sold it in the form of limited partnership shares at an aggregate price substantially above the acquisition cost. This type of market activity gave rise to a theory that the value of real estate was not its value to a single purchaser but rather was its value after being sold off in limited partnership interests. There is no question that tax benefits were a strong inducement to limited partnership investors. However, the pace of syndication activity and the ease of attracting limited partnership investors gave a strong push to the activity in the market and the market fed on itself. If it had not been for the ease of bringing in limited partners, the activity in the market would have been substantially less and prices would not have climbed so quickly.

One thing is certain; whatever has happened in the past will be repeated in the future, although probably in a different form. Those who earn their livings “creating” investment opportunities are very resilient and can be counted on to be able to “invent” a new theory demonstrating that a new type of investment vehicle or investment is bound to be successful even where reason and logic might dictate otherwise. Caveat Emptor!

December 16, 2009 – Recent discussions by some analysts regarding the pending financial regulation legislation have attempted to deflect blame from the banks and Wall Street by focusing on the role of Freddie and Fanny. While it is true that these quasi governmental corporations helped create the problem, the fact remains that without the ability to securitize the mortgage the problem would not have occured. They may have been facilitators but the greed of m mortgage brokers, loan originators, Wall Street, the rating agencies and, last but not least, the homeowners, the problems would not have taken on the magnitude they did.

Much has been said about the “poor homeowner” being forclosed out of their homes. What remains unsaid is that many home buyers knew they were providing false financial information to lenders in an attempt to get their loans because they were anxious to participate in the never ending real estate boom. In many cases they had little or no equity in their homes long before the collapse of the market. So, they are really not all big losers in a forclosure action. Little is said about the homeowners who had built up substantial equity in their homes over the years and then began to use that equity, thorugh succssive re-financings, to spend themselves into prosperity. By the time the forclosure notice arrived many of these people had little or no cash investment remaining in their homes. Finally, what remains unsaid is the part speculation played in the collapse. People caught up in the boom psychology began buying homes on speculation intending to sell them quickly at a profit. That worked for a while but it too came to an end. The only peoplefor whom tears should be shed are the hard working, “straight arrow” people who had built up a good equity in their homes, carrying a manageable mortgage, and then found themselves unemployed and unable to service their loans. These are the people who deserve a “bail out”.

January 26, 2010

The “bubble” mentality and force of “other peoples money” is very well demonstrated by the news that Tishman Speyer are giving Stuyversant Town to the lenders. Tishman, with other investors, acquired the property in 2006, at a market high, of $5.48 Billion. According to news releases Tishman invested $112 million of its own money in the deal. CalPers, through investment advisors reportedly invested $500 million and the Government of Singapore was reportedly in there too. The news release estimated the current value of the project at $1.8 Billion. In addition to the cash investors, the big losers are the primary and mezzanine debt holders. Reportedly, a cornerstone of the deal was the belief that the applicable rent controls could be modified.

One must assume that some pretty smart real estate, investment and finance people did a substantial amount of due diligence before entering into the transaction. So – what went wrong? Reading between the lines, the price of $5.48 Billion was probably not supported by the rents in place at the time of acquisition and to make the numbers work required relief from the rent control laws. One would also assume that the rent control issue was well vetted by a team of lawyers. It obviously was not a “slam dunk”. Those kinds of things never are. This leads to the conclusion that the euphoria of the day blinded all participants to the risks inherent in the deal and most of all, since the bulk of money was coming from investors and lenders, Tishman had a very high reward-risk potential if it all worked out. In 2006 who would have believed that the dynamic commercial real estate market would ever cease increasing rents and values. But, when it is “other peoples money” being risked the people behind the transaction rarely build the proper element of risk into the investment model and the lenders willingly buy into the story line. CalPers were put into the deal by an investment advisor but the investment advisor did not take the risk. Enough said.


Anyone interested in reading, in great detail, about the causes of the “bubble burst” must read Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon
Gretchen Morgenson (Author), Joshua Rosner (Author).
This is an excellent, very well written book, detailing all background of the collapse.

This entry was posted in Property Ownership, Real Estate Appraisal, Real Estate Investment, The Real Estate Economy and tagged . Bookmark the permalink.

Leave a Reply

Your email address will not be published. Required fields are marked *