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Keepers of the Castle
Real Estate Executives on Leadership and Management
By William J. Ferguson
Urban Land InstituteCopyright © 2009 Urban Land Institute
All rights reserved.
AMERICA'S LARGEST INDUSTRY
The real estate industry's magnitude and impact on the global ecomony is truly staggering. According to an analysis by the Economist, the assets of the world's developed economies are composed of
* Residential property: $48 trillion;
* Commercial property: $14 trillion;
* Equities: $20 trillion;
* Government bonds: $20 trillion; and
* Corporate bonds: $13 trillion.
Of a total of $115 trillion, real estate (residential and commercial property) accounts for $62 trillion, or 54 percent of the assets of developed economies.
In the United States, the real estate industry serves as a barometer of economic health. It is the engine providing space for expanding businesses and a growing population, expected to increase by 100 million over the next 30 years. When property markets short-circuit, shock waves follow. In fact, an unsustainable housing boom and mortgage lending spree led the country into deep recession during 2008 and 2009, deflating property values and the industry's near-term prospects. In the run-up to the recent economic bust, real estate generated nearly one-third, or $2.9 trillion, of the nation's gross domestic product (GDP) and provided jobs for more than 10 million Americans, equivalent to all the workers in New York state.
Real estate is the source of more than 70 percent of local tax revenues, which pay for schools, roads, police, and other essential services. America's commercial real estate is worth approximately $5.5 trillion and includes 4 billion square feet of office space, 13 billion square feet of industrial property, almost 6 billion square feet of shopping center space, 4.5 million hotel rooms, and 33 million square feet of rental apartment space. Some 47,000 shopping centers account for $1.98 trillion in sales and generate $84.3 billion in state sales taxes. Spending by U.S. and international travelers averages $1.4 billion a day, and one of every eight Americans is directly or indirectly employed in the lodging and tourism industries. Residential real estate is an even bigger market: the value of single-family (owner-occupied) housing totals $15.2 trillion, while homeowner equity totals $8 trillion, representing approximately 32 percent of household wealth. Clearly, real estate is one of the most important asset classes in the U.S. and global economies.
The CEOs and other business leaders interviewed for this book operate in a broad universe of real estate–related businesses divided into six primary sectors:
* Commercial mortgage finance
* Commercial real estate ownership/brokerage
* Residential mortgage finance
* Lodging/hospitality and gaming
* Housing for seniors.
Economic, demographic and structural changes buffet these industry sectors, creating uncertainty, opportunity, and risk. Today's real estate leaders not only face the exigencies of overcoming recessionary fallout, they also will struggle to cope with transformed public markets, deleveraging priorities, and managing increasingly complicated global businesses. In charting strategy and new directions, they will become more mindful than ever before of the pitfalls to the status quo. Economic turbulence may raise special challenges for reducing balance sheet debt and reenergizing tenant demand. But real estate veterans have become inured to industry cyclicality, which rarely keeps markets in desired supply/demand equilibrium for long.
Commercial Mortgage Finance
From the end of World War II until well into the 1980s, the nation's commercial real estate was financed primarily by banks, insurance companies, and savings and loan operations in private market transactions. Real estate was mostly a buy-and-hold, long-term investment, cloaked in conference room negotiations. It was very much the province of local entrepreneurs backed by their favored lenders. Developers typically built and held properties in their own accounts, collecting a steady flow of tenant rents while gradually building up their equity stakes as they paid down debt. Likewise, many large companies owned their own headquarters. Even the big retail chains developed suburban shopping centers to showcase their flagship department stores as they moved out of the city cores.
Banks and the savings and loans dominated construction lending and the small to medium-size whole loan market. The major life insurers, meanwhile, were primary lenders in the institutional markets for downtown office buildings, regional malls, warehouse complexes, and hotels. A complicated transaction involved putting a secondary mortgage behind a first loan position, which was secured by property equity. As skylines sprouted and metropolitan areas expanded toward the horizon, commercial real estate was largely a very private, get-rich-slow business without a "buy, sell quick" mentality or highly structured financing. Although insurers and pension funds began investing in equity real estate during the 1970s, the once simple world of mortgage lending began changing in the late 1980s as commercial real estate markets engaged in an overdevelopment binge and Wall Street investment banks became more actively involved in brokering and structuring transactions. The advent of residential mortgage securities led to attempts to create collateralized commercial mortgage bonds. When commercial markets collapsed in oversupply during the economic downturn in 1990 and 1991 and the savings and loan crisis ensued, commercial real estate finance was on the cusp of a radical makeover.
The federal government established the Resolution Trust Corporation (RTC) to clean up the massive mess of failed loans from savings and loans, while banks and insurers were forced into wholesale workouts of underperforming investments with a slew of bankrupt and nearly insolvent borrowers. Regulators constrained new lending by the reeling bankers and penalized struggling insurers with larger reserve requirements. While these traditional lenders took to the sidelines, licking their expensive wounds, the RTC began securitizing pools of nonperforming loans. Wall Street houses, meanwhile, opportunistically established conduits to fill holes in the lending market left by the demise of the savings and loans and provided desperately needed capital liquidity. The formation of CMBS markets was well underway, precipitating nothing short of revolutionary change.
Insurers became more niche lenders. Banks still originated the largest share of new loans. But both banks and insurers began using the securities markets to pool portfolios into bond issues and remove loans from balance sheets, spreading their risk and enabling the redeployment of capital. By 2006, about three-quarters of bank and insurer originations were securitized. Although their fast-growing origination volume still lagged that of the commercial banks, conduit lenders and loan securitizers vaulted into the most influential position in the finance markets.
The New World Order. Conduit lenders and loan securitizers vaulted into the most influential position in the finance markets, although their fast-growing origination volume still lagged that of commercial banks. CMBS effectively morphed into the primary regulator of real estate markets and opened the property sector to huge global sources of fixed income capital. Investors from all over the world bought mortgage-backed bonds marketed by Wall Street firms, based on credit agency ratings. Buyers of B-piece and unrated tranches — the high-risk, higher-return segments — were touted as self regulators, kicking out loans from offerings that did not meet their requirements. Banks and insurers readily took advantage of burgeoning CMBS markets and securitized pools of their loan originations to reduce balance sheet risk and enable stepped-up lending activity.
In hindsight, securitization channeled vast capital flows into real estate markets and created unprecedented market liquidity, but it also led to unsustainable risk tolerances by lenders and other investors. Mortgage bankers — both residential and commercial — focused more on increasing loan volumes and related fee revenues than on diligent underwriting. Transaction activity escalated, speculation increased, and property values spiked. Buyers of properties took advantage of low interest rates, adjustable rate loans, and schemes that required little or no equity down. In turn, financial institutions offloaded bulging loan portfolios from their books into increasingly complicated bond offerings, which were highly leveraged. Ratings agencies gave their imprimaturs to these offerings without much scrutiny of the underlying real estate, relying on the diversification of collateral — by geography, property sector, maturity, and type of financing. Residential loans were lumped with commercial loans, subprime residential mortgages were tranched alongside shopping center and office loans. Even careful bond buyers would have trouble identifying exactly what portfolios comprised. Mostly they relied on the ratings and the reputations of Wall Street underwriters for security.
Meltdown. The spiral in lax lending, higher property prices, and more securitization offerings ended in a precipitous meltdown: U.S. homebuying slackened over sticker shock, and borrowers with subprime residential loans began defaulting as mortgage payments reset upward and property values began to decline. Risk premiums returned with a vengeance, not only to mortgage securities markets but also throughout the credit system, gridlocking lenders and forcing writedowns in investor portfolios. The ensuing credit crisis may take years to play out. For now, discipline has returned to the credit markets — conservative loan to equity value ratios, low debt-service coverages, and recourse financing. The CMBS industry hopes for a second chance, and borrowers who overleveraged and overpaid for properties risk major losses. The real estate industry faces yet another cyclical downturn.
Commercial Real Estate Ownership/Services
Until the early 1970s, most large commercial real estate properties were owned by corporations for their headquarters and operations centers or by local entrepreneurs — typically developers and often family groups such as the Rudins and Fisher Brothers in New York, Trammell Crow in Dallas, Oliver Carr in Washington, or Walter Shorenstein in San Francisco. Major local owners usually formed strong relationships with national life insurance companies or money center banks to finance their projects and holdings.
America's cities had started a heady expansion as the baby boomers entered the work force in droves. Suburbs had mushroomed and Sunbelt cities like Atlanta and Dallas had expanded in the wake of interstate development, new airports, and readily available air conditioning. Gleaming glass and steel skyscrapers, multilevel enclosed shopping malls, and campus-style office parks had sprung up throughout burgeoning metropolitan areas from coast to coast.
While development took off nationally, the federal government mandated that pension funds diversify their assets beyond stocks and bonds when Congress passed the Employee Retirement Income Security Act (ERISA) in 1972. The large life insurance companies, meanwhile, figured out that they could make more money by partnering as equity owners with their developer borrowers. As lenders, they realized no upside, while risking a downside if an investment soured in foreclosure. Why not get a piece of the developer action? Institutional money from plan sponsors and insurers began to flow into real estate from pooled equity investment funds, managed by insurers and some banks, as well as from insurance company general accounts.
Syndicators, meanwhile, emerged to entice affluent individuals into real estate partnerships that could take advantage of favorable tax laws for passive investors. Foreign institutions led by the Japanese also acquired portfolios of trophy office buildings in primary cities. By the mid-1980s, commercial real estate ownership was increasingly dominated by institutional owners and various syndicators. Developers welcomed the flood of capital — often their partnerships gave them sizeable equity stakes and attractive project fees for little or no financial investment. Cranes sprouted everywhere and many markets suddenly and disastrously became overbuilt. When Congress passed the 1986 Tax Reform Act, many syndications cratered — their tax write-offs evaporated, and investments in low-occupancy markets were under water.
Although national space brokers issued market vacancy reports on a quarterly basis, a dearth of real-time information on tenant movements, rental rates, defaults, and foreclosures lulled the industry into complacency despite softening markets. Bank and insurance regulators had limited data from which to raise alarms, and stock analysts and rating agencies had no reason to cover real estate, a mostly private and institutional investment enterprise. Building continued into the teeth of the early 1990s recession, where oversupply met a severe dropoff in tenant demand. Commercial real estate ownership entered its darkest hour since the Great Depression.
The Recapitalization of the Asset Class. The ensuing capital gridlock and a wave of owner bankruptcies, defaults, foreclosures, and workouts ushered in a new era that has transformed real estate from an arcane, privately owned asset class into a more transparent, global business. Ownership, which had evolved from entrepreneurial developers to institutions, became dominated by the public markets. Just as investment bankers devised CMBS conduits to help resurrect the real estate debt markets, Wall Street opportunistically moved to resuscitate large property owners and their companies by raising money through REITs, stock vehicles that own income-producing real estate, distributing 95 percent of their taxable net income as annual dividends to shareholders.
REIT structures had been around since 1960 but had never gained traction among stock pickers or private owners. Running public companies meant dealing with officious stockholders, managing boards, and complying with costly federal regulations. Why would an "anything goes" real estate entrepreneur go public and give up so much control when institutional money had been so readily available?
Forsaken by banks and insurance partners, owners struggled, despite largely intact businesses. In order to survive, they were only too willing to give up some control of their development and management companies by turning them into public entities. Wall Street sold investors on the REIT concept — a classic buy-low opportunity with significant dividend opportunities as property cash flows improved with the economic recovery. Starting from only $10 billion in equity market share in 1992, REITs came to comprise almost $300 billion by 2005, far surpassing the equity stakes of both pensions and insurers. Many smaller REIT companies have merged or been acquired by larger companies, creating dominant owners in various property categories — office, apartment, shopping centers, regional malls, warehouses, mobile homes, and self-storage facilities.
The New Breed of Players. Individuals — whether developers or new forms of non-tax-oriented partnership syndications — continue to own the largest share of the nation's total commercial properties. A changing array of foreign investors — wealthy individuals, institutions, and more recently sovereign wealth funds — also play a significant role, especially in the ownership of larger properties. Germans, Australians, Irish, Canadians, Middle Easterners, Japanese, and more recently Chinese investors all view the United States as a safe asset haven. But the emergence of public real estate markets has had the most telling impact, not only allowing average investors to own property shares but also establishing a network of industry analysts who track trends and marshal data on supply and demand. Although REIT information and CMBS oversight proved insufficient to avoid the subprime meltdown and overbuilding in housing and condominium markets, the commercial real estate supply side appeared more disciplined. Unlike the early 1990s, the recent commercial correction is mostly demand driven, as tenants retrench in the recession and overleveraged investors cannot meet debt service based on-earlier optimistic cash flow projections. Markets cannot get overbuilt easily without analysts sending up red flags and vulnerable stocks taking hits, sending signals to all investors, owners, and lenders.
REITs, meanwhile, led the way in helping globalize equity real estate investment. The larger companies have the potential to grow into multinationals with cross-border assets. Once world economies regain their traction, American developers will likely resume exporting their skills and expertise to expanding overseas markets. Multinational tenants — large international financial institutions, consumer companies, retailers, and manufacturers — should continue to work with global leasing and management firms to select space on different continents. REIT markets have been established in Europe and Pacific Rim countries (Japan, Australia, Singapore), opening international flows into property stocks. Prime tenants — large international banks, financial institutions, retailers, and manufacturers — work with global leasing and management firms to select space on different continents.
Excerpted from Keepers of the Castle by William J. Ferguson. Copyright © 2009 Urban Land Institute. Excerpted by permission of Urban Land Institute.
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