As Alphonse Carr, the famous French philosopher, noted over a century ago, "plus ca change, plus c'est la meme chose". This is translated in English to "the more things change, the more they are the same." Many seasoned lenders, appraisers and investors are frightened by the recent headlines, such as "Let The Good Times Roll -- Field of Dreams," etc. On the other hand, many of the MBAs who are currently designing real estate financial instruments, suggest the "old timers" just don't understand the 1990s and they will not likely navigate the real estate starships of the 21st Century. Doesn't this sound familiar?
With the return of capital to the marketplace, the forecasted overall real estate recovery has become a reality. Ironically, office and hotels, which were yesterday's stepchildren, are today's darlings. Prices have rebounded exponentially. Investors are betting on substantial rent increases as they have recognized the fact that many lenders and investors in the early 1990s overreacted in the disposition of their assets, with these assets selling at bargain basement prices. The industrial sector has also been a favorite among investors. Values have increased commensurate with increasing occupancies and rental spikes. Apartments continue to show strength, however, investors are somewhat cautious, as rents in the stabilized markets have reached levels where new construction is a factor. Nevertheless, investors are still attracted to the apartment sector fundamentals.
Finally, retail is experiencing mixed reviews. Malls in 100% locations are still in favor, with prices escalating. Buyers complain of little product from which to choose when attempting to place their investment dollars. Secondary mall locations are trading at yields from 8% to 10% and older, third tier malls, will likely be the victim of wrecking crews for redevelopment. Factory outlets and power centers showed signs of strength in 1995. However, the additional supply in the discounter category killer class is taking its toll. Bankruptcies in the retail sector, as a result of lagging sales and profitability, have reaped havoc. With the exception of malls in excellent locations, lenders and investors are examining this sector of the market with a jaundiced eye.
Increased overall supply, as well as competition within each segment, has investors taking a "wait and see" attitude. Wal-Mart, the retailing "sweetheart" of the 1980s, was recently downgraded by one of the rating agencies to a "hold" from a decade of "buy" recommendations. The feeding frenzy seems to be over, with the consumer dollar being spread among too many competitors. The ultimate result will likely be continued weakness in this sector, which will be tantamount to flattening values as a result of the excess supply. Year-end figures for retailers such as Wal-Mart, K-Mart, J.C. Penney, Marshall Fields and Bloomingdale's fortify this hypothesis. Wal-Mart's same-store sales increased only about 1% over a year ago and Penney's sales declined more than 4%. The numbers also suggest that, in an economy where jobs and pay raises are uncertain, shoppers are in no mood to spend more than necessary. Only Kohl's and GAP posted gains well in excess of inflation, registering 5.3% and 6%, respectively. The GAP's recent success is attributable to the addition of the "Old Navy" store, which like the original GAP, focuses on a modest pricing format. Other apparel chains with notable sale decreases were Talbot's, with a 7% decrease, and Ann Taylor with a 13.8% decrease.
The recent expansion of discounters and big-box category killers seems to have been a result of excess capital supply, rather than an examination of the fundamentals of increased demand. In short, the retailing course is charted for more stormy weather. Investors and lenders should proceed cautiously.
Yes, real estate values have rebounded from the late 1980s and early 1990s. Yet the question remains whether the rebound is attributable to lower interest rates and readily available debt and equity capital or a change in the fundamental relationship of supply to demand. Thus, one must examine today's capital markets as well as the demand components to understand this relationship. Today's capital markets are largely discussed utilizing a four quadrant matrix, yet the best understanding of the marketplace was perhaps illustrated by Jacque Gordon of LaSalle Advisors, Ltd., in the Institute for Real Estate Appraisers Universe publication as follows:
The impact of these various markets and the reduction in interest rates have had a profound effect on real estate values in the past 36 months. A brief discussion of each market is, therefore, appropriate.
Private Direct Equity
While this form of real estate investment provides the ultimate control, disadvantages include lack of liquidity and concentration in a property type and market. Should the economics of the property's locale change, the return to the equity investor will likely follow the local economic trend. These investments are usually made by advisors in separate accounts, or joint ventures or insurance companies. Investors vacated this market in the early 1990s, but have returned with a vengeance. Through third quarter 1995, AEW, Morgan Stanley and J.P. Morgan had invested in this sector $708, $450 and $286 million, respectively.
Private Indirect Equity
Capital in this segment of the market is being raised by Wall Street and traditional advisors. The funds are usually structured with open-end or closed-end funds. Large private investors (i.e., institutional size) are also in the category.
Public Equity Market
This market basically was revitalized with the resurgence of the REIT investment. Presently, over 170 securities are available to investors with market capitalizations experiencing rapid growth over the past three years. Continued mergers are expected in 1996, as analysts appear to be following only REITS in excess of $500 million in capital. This vehicle provides investors with the ability to make sector bets, diversify their investments and maintain a reasonable amount of liquidity.
Private Placement Equity Markets
With the IPO market sluggish in 1995, many investors approached institutional money partners directly. This sector provides more control to the investor, however, this control is at the expense of liquidity. Nevertheless, investors that wanted to make sector bets and have faith in management have chosen to diversify utilizing this vehicle.
Loans
Life insurance companies, banks, savings and loans and pension funds dominate this sector. The market is about $650 billion with insurance companies accounting for about $200 billion, pension funds accounting for $50 billion, and savings and loans and banks accounting for the balance. Through third quarter 1995, the three leading loan originators were Principal Financial, CIGNA and Northwestern Mutual, which closed transactions totaling $899, $630 and $487 million, respectively.
CMBS Public Markets
The existing Commercial Mortgage Backed Securities market leveled off to about $50 billion. This financial instrument was designed for the RTC, but has transplanted its roots to the private sector. The investment grade bonds trade based on their independent credit rating. The credit ratings are evaluated with credit analyses prepared by independent real estate advisors.
CMBS Private Markets
This sector is generally referred to as the "B" piece of a CMBS transaction. The subordinated tranche is high yielding and its success is closely tied to real estate and initial underwriting. The market has evolved to approximately a $10 billion market.
Given the understanding of how each market interacts with the real estate business, it is also helpful to examine the originations within each market. The Roulac group tracks this information from various sources with second quarter results noted below:
RTC and FDIC Liquidation of Assets
December 29, 1995 marked the last business day for the Resolution Trust Corporation. During its life, the RTC dissolved 747 institutions with $220.6 billion in deposits. Through September 1995, the RTC had disposed of 97% of the assets which had been under their control. Book values sold and collected were approximately $452 billion. RTC assets under management peaked at $186 billion in May, 1990 with only $13 billion remaining at the end of September, 1995. Recovery from sales and collections have averaged 87% of the original book value. The RTC reports it has disposed of 99% of its securities, 98% of the home mortgages and 96% of the real estate owned (REO).
The demise of the RTC will likely return a balance to the real estate community that has not existed since its inception. By virtue of the fact that properties were sold based on Derived Investment Values (DIV's), which equated to approximately 40% to 50% of market value, investors received windfall profits which allowed them to discount rents and fill empty buildings with relocating tenants looking for bargains.
Final Note
The first half of the decade has witnessed financial institution consolidation as a result of portfolio losses. Those institutions with little or no value failed, and the Resolution Trust Corporation (RTC) was created to clean up the mess. As the RTC sold portfolios with their new Derived Investment Value (DIV), competing real estate experienced higher vacancies, declining rents and plummeting market values. Capital sources existing in the marketplace deployed their assets to other financial arenas. Those lenders and pension fund advisors that stayed with real estate returned to conservative underwriting standards with reserves for tenant improvements, real estate commissions and capital items above the NOI line. Financial engineering created the new Commercial Mortgage Backed Securities market (CMBS). Wall Street recognized the opportunities available and immediately created vulture (or opportunity) funds and other financial instruments in the real estate community.
REITs gained popularity primarily by offering a real estate alternative with liquidity and daily valuations not subject to question. Developers were offered a safe haven in the REIT sector by converting their holdings to the public market, which offered lower costs of funds and provided an excellent estate planning tool. Proposed tax law changes, which are presently in Congressional committees, may further benefit the REIT sector in 1996.
Investors, lenders, trade organizations and the press continue to report improving real estate performance. However, returns as a result of refinancing are, in many cases, the fuel behind the reported returns. The existing real estate recovery is not a result of more jobs and, thus, is suspect for the long-term. Those MSAs where sectors have recovered are again experiencing new construction. The emerging debt equity matrix suggests diversified real estate investing will continue through the last half of the 1990s. With more capital (i.e., supply) than demand, spreads will continue to decrease. Lessons taught in the mid-1980s will, again, be forgotten by the MBAs of the 1990s. Opportunities in the real estate market will be available to only those investors and lenders astute enough to understand the fundamentals of supply and demand, absent the flow of capital and other outside incentives.
The lessons learned from the developers of the 1980s who relied on tax benefits to make their deals work should not be forgotten. While history will not guide us into the 21st Century with a map for investing to return the highest yields, it does provide us some lessons on what "not to do". Real estate fundamentals have really not changed. All external benefits, like federal tax law benefits or local tax increment financing benefits, should be considered "icing on the cake", rather than the impetus to underwrite a transaction. History does tell us that real estate values are affected by a number of external forces, including supply and demand, capital flow and federal and local governmental influences. Thus, investments should be made considering which external influences are likely to change over the term of ownership, including the ability to exit the marketplace. Investments driven by externil forces add substantial risk to the real estate community and should be underwritten accordingly. Yes, "the more things change, the more they are the same."