HAVE A CUP OF COFFEE AT STARBUCKS TODAY

The letter below from Howard Schultz appeared in many newspapers and while it has little to do with real estate it has a lot to do with the health of this country and is most appropriate for a 4th of July post.

 

Mr. Schultz, a very responsible business leader, has absolutely identified what is wrong with America today. It is a glaring leadership deficit where the elected appear to be much more interested in re-election than they are in solving problem. The political partisanship, ideological bickering and brinksmanship should be an embarrassment to all of them but it isn’t.  Winning political points and playing “gotcha” appears more important than solving the nation’s problems by rolling up the sleeves and working together.

 

Every thinking American should join in this discussion whether today or later, and let our elected politicians knows that if they can’t get their acts together and act responsibly to solve America’s problems with civility and cooperation, the voters will find new people to represent them.

To spark the conversation in your neighborhood Starbucks, please join us this 4th of July for a free tall hot brewed coffee.

An Open Letter: How Can America Win This Election?

Friday, June 29, 2012

Posted by Howard S., Starbucks chairman, president and chief executive officer

On Independence Day, our country celebrates the promise of America.

It’s a day to remember that the principles that bind us together vastly outweigh what keeps us apart. The freedom to dream and the opportunity to create a better life – not just for ourselves, but for each other – has always defined our great nation.

I am a product of that American Dream. As a kid who grew up in public housing, went on to get an education at a state university and build a business, I am grateful for what this country has made possible for me. In turn, at Starbucks, we have always tried our best to honor our responsibility to the communities we serve.

And on this Fourth of July, our communities need all of us.

Across the country, millions of Americans are out of work. Many more are working tirelessly yet still unable to adequately care for their families. Our veterans are not being welcomed home with the level of support they deserve. Meanwhile, in our nation’s capital, our elected leaders are continuing to put ideology over real solutions. I love America, but we all know there is something wrong. The deficits this country must reconcile are much more than financial, and our inability to solve our own problems is sapping our national spirit. We are better than this. America’s history has showed that we have accomplished extraordinary things when we act collectively, with courage, creativity, and generosity of spirit—especially during trying times.

As we celebrate all that is great about our country, let’s come together and amplify our voices.

Let’s tell our government leaders to put partisanship aside and to speak truthfully about the challenges we face. Let’s ask our business leaders to create more job opportunities for the American economy. And as citizens, let’s all get more involved. Please, don’t be a bystander. Understand that we have a shared responsibility in solving our nation’s problems. We can’t wait for Washington.

At Starbucks, we are trying to live up to our responsibility by increasing our local community service and helping to finance small-business job creation with Create Jobs for USA. Our company is far from perfect, and we know we can do more for America. But we need your help. We need your voice.

Join the national conversation with #INDIVISIBLE. Starting today, I invite you to share your view of America, and how we can all put citizenship over partisanship. On Instagram, post a photo of the America we all need to see. On Twitter, provide a link to an innovative idea. Blog about who’s making a difference in your community; or on YouTube, share how you made your American Dream come true. No matter where you post, if you use the tag #indivisible, Starbucks will do its part to collect and amplify your voices.

To spark the conversation in our stores, your local Starbucks will proudly serve everyone a free tall hot brewed coffee on the Fourth of July.

Together, we can set a new tone in America. We hope you agree that doing so is a powerful way to celebrate our nation’s birthday.

In 2012, America needs to win the election more than either party does. It is time now to join together as Americans. It is time, whatever our differences, for us to strive and succeed as one nation – indivisible.

 

Posted in Condominiums, Eminent Domain, Property Developemnt, Property Ownership, Real Estate Economy, Real Estate Appraisal, Real Estate Investment, Real Estate Lending, REITs, The Real Estate Economy | Tagged | Leave a comment

CHANGES IN THE REAL ESTATE INVESTMENT ENVIRONMENT

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.

Posted in Property Ownership, Real Estate Economy, Real Estate Appraisal, Real Estate Investment | 2 Comments

MORGAN STANLEY REAL ESTATE FUND PROBLEMS

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.

Posted in Real Estate Economy, Real Estate Investment, The Real Estate Economy | 1 Comment

Goldman Sachs Takes A Loss

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.

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Retail Store Euphoria

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.

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APARTMENT RENTERS PLIGHT

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.

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IS THE REAL ESTATE MARKET RECOVERING?

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.

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HAVE OFFICE BUILDNGS RECOVERED?

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

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REITs GO GLOBAL

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.

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REITs REVISITED

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.

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