Real Estate: Pumped Up And Cruising For A Bruising?
Are the good old days in commercial real estate getting a little too good? For the past three years, the market has wowed property investors and buried the nightmarish memories of the early 1990s, when foreclosures and bankruptcies reigned.
But now there are worrying signs that the industry has reached a peak--or soon will. Like the seasons and the stock market, real estate has cycles, particularly in the capital-intensive commercial arena: offices, hotels, retail outlets, and industrial space. As many pros see it, the market is overheated and due for a correction, albeit nothing like the early-'90s catastrophe. "There's too much damn capital out there," says Lewis M. Goodkin, president of Goodkin Consulting, "and too much optimism."
The industry is cruising on a high-octane mix of a hot economy, modest interest rates, and low office vacancy rates in many major cities. Downtown Manhattan has 12% office vacancies, about half the 1991 rate, as Wall Street activity has exploded. Midtown Manhattan has a tight 8.1% vacancy rate, making good space hard to find. Since very little construction took place during the last bad period, the recent surge in demand has produced a squeeze that has sent rent prices skyward.
BIDDING WARS. Remember how it wasn't supposed to be this way? Futurists once said telecommuting would render the need for additional office space irrelevant. Well, the current boom shows that, for now, face-to-face office environments are still a desired commodity. And the cash is out there to buy it. Real estate investment trusts (REITs) and other big players are flooding into the market with capital aplenty.
The question: Is it too much? A spell of interest-rate hikes and an economic slowdown could mean trouble as tenants shrink their space needs and rents plummet, leaving generous buyers with half-empty buildings and holes in their balance sheets. Even now, a good number of recent deals are looking pricey (table). Take the Embarcadero Center, a landmark office address in San Francisco's financial district and among the highest-priced assets on the West Coast. Owners Prudential Insurance Co. and David Rockefeller are auctioning the five-building complex off with at least three ardent REITs bidding at prices insiders say exceed $300 per square foot. That's up 50% from what local observers say the complex would have fetched two years ago. It may be the classiest trophy around. Yet paying such a high price would seriously erode yields from rent, warns Gerald W. Haddock, chief executive of Crescent Real Estate Equities Co., which dropped out of the bidding.
Another sign that the good times are waning comes from the performance lately of REITs, whose market value has almost quadrupled since 1994. REITs, publicly traded companies that own and manage pools of properties, are this decade's answer to small investors' desire to be landlords. Until recently roaring along--at a 19% pace in 1997 and 36% in 1996 (table, page 82)--the REITs' total rate of return, which encompasses stock appreciation and dividends, took a disheartening dive in 1998's first quarter, posting a -0.54% showing. Says Frederick S. Carr, a principal of the Penobscot Group research firm: "They're paying too dearly for properties, and the market is beginning to find that out."
The intrinsic problem for REITs is somewhat like that of a shark: They have to move forward or founder. By law, they must pay 95% of their taxable earnings in dividends to shareholders. As a result, they must keep tapping Wall Street for funds and continue buying property to sustain growth. REITs are racing big private investors and pension funds for acquisitions. That could lead to mistakes. Carr and others hope returns will improve somewhat by next year at a more sustainable return in the low teens, as rent hikes drive cash-flow growth. Still, real estate investing is clearly no longer the slam-dunk it has been and requires careful navigating.
BURNED. Despite all the nervousness, however, hardly anyone thinks we're in for a reprise of the last gut-wrenching cycle. Rather, the industry may be headed for a soft landing. Or perhaps a mild slump in two to three years. Property investing nowadays is nothing like that in the orgiastic 1980s, when heedless overbuilding led inevitably to the reckoning of the early '1990s. A decade ago, a project's economics often were an after-thought. Real estate tax shelters, since abolished, funded construction no one wanted to lease, leading to helpful paper losses. Cowboy savings and loan operators threw money at dubious deals out of ill-considered optimism and sometimes to aid cronies.
Burned so badly not very long ago, investors in the current boom aren't as giddy as they were in the '80s. "Almost every new office building announced triggers hand-wringing over `are we doing it again?"' says M. Leanne Lachman, managing director at Schroder Real Estate Associates, institutional asset managers. Construction figures illustrate the relative caution that is today's watchword. Look at offices, the largest commercial sector. According to The McGraw-Hill Companies' F.W. Dodge Div., new space weighed in at 184 million square feet in 1997, double the 1992 performance, but nothing like the 350 million peak in 1985. While Dodge projects a healthy 11% increase for 1998, that's nothing like the torrid 32% growth last year. This time, far fewer buildings are going up "on spec"--without tenants already signed up.
Overall, the rise of public markets for property investing keeps the party from getting too out of hand. With wads of cash available from investors, these companies put mostly equity into building purchases, as opposed to the debt-loving 1980s bunch that had trouble meeting interest payments once the economy dipped. The increasing role of REITs and their ilk spreads the risk, which means less of an impact if a big project fails. And although the prices some are paying may be questionable, REITs and other publicly owned groups at least have more real estate expertise than many of the last decade's dealmakers.
Securities laws, further, require publicly traded real estate vehicles to report detailed information on properties they are buying. "There is real research," says Thomas Barrack, CEO of real estate fund Colony Capital. "There are real businesses with real executives and real programs."
At this stage, there are no obvious disasters happening. But everyone has opinions about apparent excess, whether so-and-so overpaid for this property or that. The purchase of the Ritz Carlton Laguna Niguel hotel by Security Capital for $500,000 a room has raised eyebrows. Ditto for the TrizecHahn real estate company's $804 million payout for Chicago's Sears Tower last December. The spate of massive casino-hotel projects under way in Las Vegas gives rise to doubts that they'll attract enough gamblers to support them. Only a true economic downturn will determine how wise or foolish these investments are.
As always in real estate, local peculiarities drive supply and demand. In San Francisco, tough zoning laws make building a new edifice tough. Result: The city's office vacancy rate is a mere 4.1%, making possession of office space a sure cash cow. That accounts for the frenzied bidding for the Embarcadero Center. On the other hand, the consolidation following Charlotte (N.C.)'s NationsBank merger with San Francisco's BankAmerica may result in a big-time loss of BofA jobs and empty office space.
If the economy sags in the next few years, the office market would be particularly vulnerable. That's because many 10-year leases, signed in the waning days of the last boom, will come due. With layoffs lowering demand for space, tenants would enjoy the upper hand. Even if the economy keeps chugging along, a mass of leases expiring all at once is bad news for any landlord. "We'll see a crunch around 2000," warns Michael L. Evans, national research director of the Ernst & Young Kenneth Leventhal consultancy.
There's no predicting macroeconomics that determine the commercial market's fate, along with that of its sister, the residential market, where new home sales in 1997 were at a 19-year high. Although the current boom could roll on for a few more years, it's significant that a lot of savants think an end is in sight. Says Jack Rodman, an E&Y Leventhal partner: "I'm telling my clients to sell U.S. real estate and invest in Asia." In short, no terror but plenty of nervousness.