June 1, 2011 - From the May, 2011 issue

Milken Global Conference Real Estate Panel: Real Estate in Recovery?

Excerpts from the Milken Global Conference panel on Real Estate follow. Moderator: Lewis Feldman, partner and L.A. chair, Goodwin Procter LLP. Panelists: Joseph Azrack, managing partner, Real Estate, Apollo Global Management; Richard LeFrak, chairman, president and CEO, LeFrak Organization; Peter Lowry, CEO, Westfield LLC; Barry Sternlicht, chairman and CEO, Starwood Capital Group; and Robert Toll, executive chairman, Toll Brothers Inc.

Lewis Feldman

Lewis Feldman (Goodwin Proctor): In clinical psyche terms, the market has been practicing "gestalt with a deadly weapon." That line killed at the American psychological association in '72. But lately it does seem that while real estate continues to decline from its 2007 heights, it's been a little more up than down...The voices in your head say there is money to be made, but are we delusional?...

Let's begin with the economy, and analyze where we are today...

The U.S. emerged from the great recession beginning in the third quarter of 2009. The Federal Reserve continues to hold interest rates low through the purchase of 30-year bonds by the United States Treasury under QE2 and through its exceptionally accommodating monetary policy. Jobs are now only slowly returning, and eight million Americans still watch Dr. Phil instead of going to work. The nation's unemployment rate rests slightly below nine percent, and California's unemployment rate remains at 12 percent. It's not surprising that consumer sentiment and consumer confidence is elusive and remains at levels consistent with the recession of 1991. Without job security, home equity, or credit card capacity, consumer spending and retail consumption are still extremely muted.

The best one can say now is that the consumer is becoming less negative about spending. On the other hand, real estate prices seem to have stopped their precipitous fall. Things have bottomed out a bit, both in commercial and in housing. Commercial real estate valuations and delinquency trends demonstrate that delinquency rates are still rising...

...Vacancy rates are at high levels in the office and retail sectors, but apartments are renting robustly due to a change in psychology. Housing doesn't necessarily equate to wealth in the eyes of generation X through Z anymore; in fact, it seems to have brought a lot of pain that renting could have avoided. Negative returns experienced in 2008 and 2009 in real estate are now giving way to positive numbers. Commercial properties are now selling at 2003 levels, and capitalization rates are much lower than they were in 2009. Industrial is now trading at a 2005 capitalization rate, and retail is now trading back at a 2008 cap rate. Office is trading at a 2008 cap rate, and multifamily is trading back in its prime, at 2006 cap rates.

Let's start with a little group therapy. I have one question for you. With all of this, are we crazy? Are prices and cap rates even rational today?

Barry Sternlicht (Starwood Capital Group): Are we crazy? I've been doing real estate since I got out of business school in '86. The world is so different than it was in '86, with so much money flowing across borders, looking now for yield, and there are a lot of excess piles of cash in unusual places, like $200 billion last week. China Investment Corp. got an incremental $200 billion from the Treasury to invest.

You go to the Middle East, and oil is back to $113 a barrel, and there is a lot of cash rolling around, and what are you going to put it in? What are you going to put it in today when Five-Year Treasuries are at 1.98 percent?

The property markets may rally way ahead of their fundamentals in many markets. Not Silicon Valley and probably not New York. But, in general, it's a yield instrument. And it looks good when high-yield bonds are at 680. Because of that, institutions are playing the same game. You can lever it lightly, and hit your eight bogey for your pension fund accounts. The spreads between capped rates and interest rates at the moment are positive, which is different from ‘06 and ‘07 and early '08.

You have one hidden jewel, which is you probably have some unusual hedge to inflation. It's unusual because it's not de facto that real estate prices go up with inflation. Usually, replacement costs go up, so there is no new supply because rents have to go up to justify new construction.

If we get high rates, because for various reasons we have to sell more debt and we get high interest rates, it's not for sure that all classes of real estate will respond to inflation. Some will, hotels will. Malls will be the best hedge, because they have percentage rent clauses in all of the leases, so nominal inflation makes him wealthier than he already is. But other asset classes-offices in tertiary cities, or strip retail, industrial, land should participate, but if rates go too high because you're trying to slow down inflation, housing will probably not get the chance to cover how you'd expect.

You have to look at real estate among all the asset classes, not isolated. You have to look at the full funds now from around the world, not just domestic. And you have to also throw the dollar into the game. Pretty soon, you'll be able to buy a whole state in the United States with earnings from Brazil.

We look at the world so myopically because we're used to being "The Guy" as an American investor. Foreigners look at us and see the dollar against the Euro, and if you're a Dutch pension plan, you got $1.48 on the Euro and you don't think its going to stay there-come buy a building in New York and take it for 30 percent off. That cap rate seems low, but again, you know the ten years at three and one-quarter, and everybody in the world knows that cap quantitative easing is expiring on June 30.

I've been very surprised at the capital markets. What's happening with the property markets reflects the flow of funds more than the exact fundamentals of a business that's not likely to do great with huge demand in most markets going forward.

Peter Lowry (Westfield LLC): I'd pick up on two things you said, Barry. The most important is that the institutional investor is looking for an eight total return. When you look at the total return that their looking for, with moderate leverage, you can then work out where the cap rates of this asset class has gone.

From the dollar perspective, I first came to the U.S. and lived here in 1980. The Australian dollar was a buck 25. It fell to 49 cents, and today is back to 1.09. Over long periods of time, if you're a long-term investor, you then take out those short-term currency fluctuations. You are seeing large amounts of capital looking to come into the U.S. here. You're seeing it out of Canada, you're seeing it out of Singapore, you're seeing it out of Australia, you're seeing it out of Europe, China, and Korea. When you look at that flow of capital, you look at the treasury returns, and you look at the total return that the investor is looking to get, you can see why these prices and why these capped rates are where they are.


Barry Sternlicht (Starwood Capital Group): You can't buy treasuries, right? By the way the one asset class I should give a gold leaf to is multifamily, because that's a good market. It's going to be really good, everyone knows it, and capped rates are very tight. Richard, do you want to pick up on that?

Richard LeFrak (LeFrak Organization): I have to say that in my career, which is 40-plus years now, I have never seen the multifamily business in as healthy a shape as it is in today...

We have extraordinarily low interest rates. We've had a change in the population interested in multifamily occupancy as home prices have proven to be not as great an investment as they were once thought to be. Occupancy rates are up. We have something called the echo boom, which is a demographic in the 19-33 year-olds, who are natural renters. We've had basically a shut off of supply. All these factors together, plus having the help from Fannie and Freddy and GSCs for financing, has created an environment in which we have low interest rates, fantastic cap rates, very good fundamentals going forward, and no real avalanche of supply coming to change anything. It's true that if you're in New York or in Washington or some of the major markets, rent increases are going up faster and you're doing even better, but it's true almost everywhere. Barry and I bought up portfolio properties in Florida that were failed condos. They are being bought by South Americans to rent them and they are taking three percent returns on these things, but they are filling them up.

The multifamily sector in my opinion, even though cap rates are very, very strong-very low-the fundamentals are so good now that they may actually be worth what people are paying for them now, and that is in prime markets, sub-five, today.

Robert Toll (Toll Brothers Inc): Once upon a time, we did a million to a million and a half new homes, the bulk of which are starter homes. Starter homes were the bulk of the business. The stat just came out for April-we're back up to 300,000 new homes. The differential has to go somewhere-it has to live somewhere-and it's living in apartments.

Barry Sternlicht (Starwood Capital Group): And empty houses, foreclosed homes. They're renting houses.

Robert Toll (Toll Brothers Inc): Yeah, but there is a huge bulk of it that has taken into apartments, rather than going to buy a starter home, because they are scared about the value being there. And it used to be, whatever you got, you got nothing but rent receipts, and a guy like Richard (LeFrak) is standing there renting them on Saturdays saying, I'll tell you what you haven't got is a mortgage that's under water and somebody whose chasing you down the block.

Lewis Feldman (Goodwin Procter LLP): In 2005, homeownership was at the highest level in American history. The decline is bringing us back to 1999, 1998 levels. For many, the "American Dream" became the "American Dream Catcher," which collected only nightmares. It seems that at this point you're right, people are moving, households are not forming, people are bundling up, and apartments seem to be doing much better as a result of household formation actually contracting. People are getting into homes that are going on the market, and then they are doubling up or tripling up. They haven't gone out and started to buy homes. Forty percent of all sales are distressed sales; they are short sales or foreclosed sales.

Barry Sternlicht (Starwood Capital Group): By the way, that's effecting the statistic causing this phenomenon. In other words, when you get 40 percent of the sales being all cash and distressed sales, it looks like home prices are falling faster than they are. Actually break the data out and look at the normal sales and they're pretty flat, and some markets are actually going up. In Miami home prices are about 15 percent. It's been one of the strongest in the nation year over year.

Frankly, we need to stop selling the condos in courts, because we were selling them too fast, and we were paying off our debt to quickly. There won't be any more because you're selling them way below what they cost to build with land for free. But this phenomenon is going to get worse, because what we noticed also in the Coors Portfolio is that end-loan originators, which are the Deutche Banks, and the MetLifes, and the banks, are beginning to get worried about what's happening at Fannie Mae and Freddie Mack, which have announced that they are supposed to shrink. They are worried about how they are going to get rid of these mortgages that they originate. If that becomes a serious problem-you ain't seen nothing yet. Multis will be a really nice place to hang out for a while. Although there is going to be new supply, because we love building in the real estate business. And you can, you can get loans today to build for multifamilies, so people are putting shovels in the ground very quickly.

Joseph Azrak (Apollo Global Management): The market is a little schizophrenic. But to put that in context, and to step back a little bit from the more specific property-type discussion, the way I think of where we are today is the end of the beginning. Up until the second half of last year, there was very little transaction activity. There was very little activity, it is now increasing, and the price value relationship, as Barry mentioned, was driven by what I would call more capital markets, public policy, free money phenomenon-flight to yield. And that's a short-run phenomenon, whether it will be sustainable remains to be seen.

The fundamentals are about to take over in terms of the supply-demand and occupancy in the market. We are on the cusp of probably the second great exchange we've had in commercial real estate. The first one started in the late 1980s with the thrifts going broke and moving out of the business, continuing into the banks in the early 1990s and the RTC recap. Now we have a similar situation, where there is literally $1 trillion of paper coming due-it's already been extended for a couple years, but it's still coming due at the rate of $3-4 hundred billion a year over the next three to five years.

A portion of that is not money good, Bernanke told the regulators not to worry about mark to market, only look at what the income is. It's not hard to cover your income yield when you have a zero or one percent short-term rate and you're floating at maybe 100 or 150 over. But those extensions are now not available because the properties are not being invested in and are running out of cash, so the lenders of all different types are finally having to foreclose and find an equity owner who will actually put capital in and run it like a real business.

We're just at the beginning. This should have happened, were it not for the public policy maybe a year to a year and a half ago, but it didn't. We're now just beginning to what will become $500 billion to a $1 trillion recapitalization of commercial real estate. Fortunately, assuming the employment market continues to improve, the fundamentals should support growth in that operating income. The delinquency number you saw in one of the charts is more of a lagging indicator at the present time than a leading indicator-indicative more of the opportunities that are forthcoming than the problems that exist.

I'm relatively optimistic about the opportunities in the multi asset class in most areas, maybe not the fully-leased apartment projects that are going for very dear prices, but certainly, for properties that need to be recapitalized and are challenged. The only thing positive about that is I've learned over the years that when real estate is on an agenda at a meeting like this, and we end up in the largest room that's available, that's usually not a good sign for what will happen in a year or two.


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