A recent column on the front page of The Wall Street Journal titled “Real Estate Takes On An Unaccustomed Role”, written by Dean Starkman, provides much food for thought.
I love the first line of the article: “Commercial real estate has a reputation for being the drunk driver of economic highways, the sector whose periodic crackups wreak havoc on other industries.”
What a line! What an analogy! You can bet that my attention was sufficiently focused on what that article had to say, which by the way was very complimentary of the metamorphosis that the commercial real estate industry has undergone since the roller coaster of the eighties and early nineties. In fact, the point of the article is that commercial RE is now positioned as a brace of support in a weakening economy, rather than making things worse.
I will quote some further excerpts from Starkman’s article, and then explore some of the possible ramifications for those of us involved in the commercial real estate sector:
Why are things different this time? The ’80’s real estate story was written more by the government than is perhaps widely understood. The 1981 Economic Recovery Act drastically cut depreciation schedules, providing huge write-offs on even small real estate investments. The next year’s Garn-St. Germaine Act opened the thrift coffers to risky investments such as commercial real estate.
…By the time the 1986 tax bill revoked the incentives and regulators finally and zealously clamped down on thrifts, the country had yawning vacancy rates ready to greet the big employment slowdown that came three years later.
…The 1990s brought changes. Thrifts and Japanese investors are now gone. Commercial banks have reduced their appetite for construction lending and apply much more stringent underwriting standards. And publicly traded real estate investment trusts [REITs] now own more than 15% of all US income-producing property, while commercial mortgage backed securities [e.g. conduit loans] provide about 19% of the real estate industry’s debt. The two industries, insignificant or non-existent a decade ago, have spawned a small army of analysts watching the industry’s every move. (“Real Estate Takes On An Unaccustomed Role.” The Wall Street Journal, 2 April, 2001, Sec. A: page 1).
What does this mean for us, the average commercial real estate investor, as we look into a somewhat murky crystal ball? I’ve heard a number of questions from investors lately about where we may be headed in this suddenly uncertain economy. My own opinion is that real estate investors are somewhat insulated from the wilder swings in property values and performance of the past, precisely for the reasons outlined in the article.
The particular magic of commercial real estate derives from the perceptions of risk inherent in the game. It is an accepted financial axiom that when one takes higher degrees of risk, then the potential and real returns must increase as well. High Risk = High Return, Low Risk = Low Return. But assessing the degree of actual risk vs. perceived risk is a very subjective exercise. Risk, it seems, is often in the mind of the beholder rather than based in any concrete evidence, skewing the perception of actual risk, and hence the value of the investment. This skewed circumstance can also work in reverse. The recent NASDAQ experience is a glaring example of risk perception gone awry. In that case people ignored the signs of real risk, allowing the perception of momentum to mask the danger.
Commercial real estate is now in the opposite situation. The stabilization and lowered uncertainty provided by the large players in the industry has lowered the actual risk, but the old perception persists. Those that understand the fundamentals of income-producing real estate know that this gap between the generally held perceptions of risk in commercial RE as compared with the real risk involved has substantially widened in the last ten years, creating an opportunity to capture higher, perception-based, risk-adjusted returns without the concomitant actual risk. The end result is that we are now in a climate in which we have the opportunity to gain a risk premium from activities that have in fact become very stable.
When a deal makes good economic sense, (i.e. real positive cash flow not dependent on tax losses) then all involved can and will benefit. A properly diversified portfolio can be assembled that is just about recession proof if the basic fundamentals of deal structure and leverage are properly applied, and once assembled it will compound and pyramid wealth at rate unmatched by almost any other investment.
Does this mean there is no risk? Absolutely not. There is always risk in any investment activity that goes beyond government bonds. But as the massive run-up in the REIT’s portfolios and the increased involvement of the securities markets through conduit loans attest, properly managed real estate investments yield very profitable returns.
Always follow the money folks… and remember that while money doesn’t care who owns it, it despises uncertainty and will always flow to where it is best appreciated (used). There is a reason for these guys (the REITs and Wall Street bankers) pouring such a gargantuan amount of funds into commercial real estate. That money is present in the product by design, not by accident. The reason is obvious… commercial real estate has one of the biggest bangs for the buck across the whole spectrum of investments.
I often rant against the bureaucracy that has been created by the sub-industries of the REITs and the conduit lenders due to the increasingly Byzantine criteria for underwriting and analysis. But even in the midst of my frustration, I have to appreciate the resulting stability that now characterizes our industry, and admire the concentration of wealth produced. In many ways it has made it possible for me to be doing what I am doing today. Most certain is that this skewed circumstance of real vs. perceived risk in commercial real estate has created a window of opportunity from which we can all profit.