Commercial Properties, Gorillas, and the Limbic System
A recurring question from Minyans is whether the collapse of the housing market portends a similar fate for commercial real estate.
Commercial real estate is becoming concentrated in the hands of big players; without a resurgence of over-leverage a full blown bubble is not likely.
A recurring question from Minyans is whether the collapse of the housing market portends a similar fate for commercial real estate (CRE). For purposes of this discussion, I am addressing only the "Office Market," which is where the other side of my firm's business is currently involved, and my comments should not be extrapolated to other types of CRE, such as industrial, storage, healthcare properties, etc. With that disclaimer in mind, the answer is a definite "it depends." More precisely, it depends on whether one thinks of CRE in terms of share prices of publicly traded REIT's, or whether one focuses on the state of the underlying real estate market.
Let me reprise from a News and Views back on February 16:
"Over the last ten years, on the development and ownership side of the business, the players have changed dramatically. On the commercial side, real estate used to be dominated by buy-and-hold private investors who viewed their properties as sources of cash flow; the occasional refi or sale would provide a nice bonus. Today, office buildings are more and more the domain of public or private institutions, whose funds are allocated to real estate primarily for short term (3-5 years) speculative purposes; as the institutions comprise more and more of the total players, more and more of the real estate inventory is being flipped. Even those who initially invested for cash flow find themselves in need to enter the "flipping" fray if they want to remain competitive. Such, in my view, is the nature of bubbles, i.e. the railroading of an asset class away from its intended "business purpose" and toward speculation in the asset itself. Nothing wrong with speculation of course...as long as an investor recognizes that the game has changed (from cash flow to speculation) and controls risk accordingly..."
But here is the good news: while CRE is exhibiting many bubble-like symptoms, from my turret it still lacks two things. First, what academics call "emotional amplification," which Prof. Reamer assures me resides in the limbic system and which is necessary for a full blown case of the "bubbles." This is usually manifested in valuations completely removed from all realms of financial reality, i.e. what has happened in housing. Second, and far more important, CRE has not yet been able to attract the leverage needed to facilitate a full blown limbic spasm.
As a simplistic example, the chart below shows the Debt to Real Estate Assets ratio for Vornado (VNO), General Growth Property (GGP), Equity Office Property (EOP), and Washington Real Estate Investment Trust (WRE). Despite all that's been happening, it has remained relatively reasonable and steady since well before the transactions frenzy began circa 1998. The exception is GGP which is currently digesting the buyout of the Rouse Cos.
Furthermore, CRE properties are moving from small investors/speculators into the hands of large investors/speculators with deep pockets and able to withstand a normal (if there is such a thing in real estate) cyclical downturn. In sum, the landscape for CRE does not look susceptible to a structural disaster. Which is not to say, however, that it is not ripe for disappointments, and which brings me to the issue of REIT's shares and the "bad news" portion of today's program.
First, some raw statistics: using the Bloomberg REIT Office Property Index as our reference, from Jan.1, 1993 to Dec. 31, 2005 the Index has appreciated at an average annual compounding rate of 9.47%. This excludes dividends. Breaking down the returns in shorter periods we get the following compounding rates of return:
1/94 – 12/97: 25.5%
1/98 – 12/02: (5.4%)
1/03 – 12/05: 16.4%
1/1/06 – 8/31/06: 43.5% (annualized)
Without the benefit of older data, it is tough to tell whether the 9.5% average since 1993 is "high," "about right" or "low," but intuitively it seems "about right." In my experience, institutional "hurdle rates" for investments in Class A/B buildings used to run in the 11%-15% range, (including dividend/preferred return payouts) for 10-yr investments. If you add to the 9.5% appreciation the Index Avg. Yield of 6.1%, and factor in some higher "hurdle rates" for lower quality properties, the 15% total return seems very much in tune with past reality.
The potential risk to current REIT shareholders is that the Index returns were not consistent year-in and year-out, but rather came in bunches of great years and lousy years. Right now we are well into the fourth year of a really good spell, and unless "this time is different," one should expect that sooner than later, REIT's shares will enter one of their cyclical slumps. The likelihood that we will soon see a statistical reversion to the mean jives well with the economics and limbic "twitches" which, anecdotally, have been prevailing in many deals over the last couple of years, i.e.:
Transactions at cap rates in the low-mid single digits.
Transactions where, as the exec. of a private REIT lectured me "cap rates don't mean anything, what matters is replacement costs."
Transactions where replacement costs don't mean anything because the replacement costs will be higher in two years.
Purchases with annual hurdle rates of 15% for two years: these entailed knowledge of the existence of a greater fool ready to relieve you of the property in exactly 24 months at a price 30% higher.
Transactions where brokers are physically threatened when they inform the losing bidders that they are going to have to find another target for their burning cash.
And my personal favorite: "We don't care what we buy, we gotta get this money out (i.e. invested) by 12/31, or the investor is going to want it back and will give it to someone else."
More quantitatively, the general overpaying for properties can also be seen in the withering returns on assets, capital and equity.
I recognize that perusing an Index return over just 12 years, basic "return" statistics and a bunch of anecdotes is hardly a rigorous analysis of which direction an Index might take in the future. But my sense is that on a macro level, commercial real estate is a rather simple business that does boil down to returns on investment, not overpaying, and the inescapable cycles of this business.
Where it does get complex is on a company by company, deal by deal, basis. That's when you enter the arcane world of complex tax structures, deal syndications, JV's, participation loans, etc. which are at times incomprehensible even to the participants. And this brings me to a couple of closing thoughts on "micro" issues.
In my humble opinion, at an individual company level, office REIT's are investment black boxes. Yes, one can guess rent rolls, operating expenses, and cash flows for a given property, but those are in constant flux and replete with assumptions; and when that exercise must be repeated for dozens of properties, in the end you are far closer to guessing than estimating. So from an investor's standpoint, buying REIT shares is mostly an investment in the management of the REIT, an investment in the smarts/stupidity, honesty/dishonesty, local knowledge, discipline and risk appetite of the decision makers. And for my money that's about the toughest type of stock one can look for.
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