For Colony Capital’s Tom Barrack, one of the rules for success is remembering not what was done right, but what was done wrong.
“The first thing about lessons learned is that nobody ever remembers them,” said Barrack, speaking during a keynote presentation at the IPD US Real Estate Investment Forum in New York this week. Referencing the start of the global financial crisis in 2008, he recalled that the collapse of the banking and money raising systems was accompanied by hard-to-understand capital structures and equally complicated derivatives. Following that period, the industry went back to basics, he said.
“Simplicity is the key to real estate investing,” said Barrack. “Real estate is unbelievably forgiving if it’s properly leveraged and unbelievably detrimental if it’s not.”
However, the tide may be turning once again, as investors push sponsors for higher returns, sponsors push banks for more leverage and more capital flows into the market, he noted. “If you thought in 2008, you were never seeing it again, I’m telling you, we’re back in spades.”
Barrack added: “When you go back and look at 15 years of mistakes, probably none of us had many real estate mistakes. We all have a lot of people mistakes.” Those people mistakes came out of getting caught up in a frenzied investing atmosphere and lacking adequate information to make proper decisions, he said.
The industry also can focus too much on risk premiums, he added. For example, had Colony increased the amount of risk it took on in its projects in 2007, the firm would have quadrupled its underwriting. But dialing up risk during troubled times is “anathema,” he said. “The wrong capital structure can kill a great deal. A great piece of real estate with the wrong sponsor is going to be a gigantic problem.”
Risk premiums when moving up the capital stack are illusive, moreover. “As the markets get better, we all drink the Kool-Aid,” Barrack said. “And as we drink the Kool-Aid, we accept actually lower returns for greater risk, which is an amazing phenomenon. Everybody’s a little bit nervous. Haven’t we been to this movie before?”
The uncertainty in commercial real estate market in the wake of the global financial crisis was one of the factors that led Colony to refocus its real estate business on debt rather than equity investments in 2009. “What we’ve found is the debt business is the highway to understand where we are, because you’re underwriting every day,” said Barrack. Because of the lack of clarity market, it’s better to generate 18 to 20 percent returns on 30 to 40 percent leverage rather than 20 to 30 percent returns on 80 percent leverage, he said.
Barrack didn’t see the industry headed for another bubble, given the lack of “maniacal building” thus far. That said, “where this market ends up, what’s really happening underneath, how long it will be in the upwardly cycle, we don’t know,” he said. “It could change in an instant.”