Capital gains

Although the theme of the fall 2006 PREA conference was “Back to Basics,” delegates found the current state of the real estate industry anything but. By Alison Granito

Tip O'Neill, the former speaker of the US House of Representatives, once famously said, “All politics is local.” And so is the real estate business, according to the conventional wisdom. At the Pension Real Estate Association conference in Washington DC, held in late October, the nexus between real estate and politics was on full display.

Delegates kicked off the conference by schmoozing over cocktails in the shadows of the halls of power, the Library of Congress—one of the capital's many architectural marvels and an impressive piece of real estate in its own right.

But the dome of the Capitol building cast its shadow over more than just the opening soiree. With the midterm US Congressional elections less than two weeks away at that point, delegates wondered aloud what the future would hold for investors when it comes to both politics and monetary policy.

And who better to interpret the markets than a Washington icon of a different sort: Alan Greenspan, the now retired chairman of the US Federal Reserve. On the second night of the conference, delegates were treated to a no-holds barred discussion between Greenspan and Bernard Winograd, chief executive and president of Prudential Investment Management. Unlike your typical conference event, there was not an empty seat in the ballroom and nary a Blackberry in sight.

The man who was often considered more important to the economy than any of the four presidents under which he served not only packed the house, his mere presence set it abuzz. Before the evening's discussion began, outsiders who wandered into the room may have expected the imminent appearance of a major Hollywood star—such was the level of excitement and chatter in the ballroom—rather than the bespectacled, unassuming older gentleman seated on the stage.

The “oracle,” as some call him, did not disappoint, his usual candor in evidence.

“I, frankly, think it is unethical for the government not to tell it like it is,” he said.

He discussed the highly globalized world we now live in and how the markets have changed so much that $1 trillion no longer represents a shocking figure in the global economy. He called the current state of the real estate market highly volatile. And though the present boom has been a fascinating period, he said it wasn't going to last, much like the delegates had heard earlier in the day.

However, given his background, much of Greenspan's focus was on interest rates. What has been driving them in recent years, he said, has its roots in the end of the Cold War. When the Berlin Wall fell, the world saw the “economic ruin” that was behind it.

“There was no eulogy for central planning but it died,” he said. The Third World, particularly China, began to come alive and attract industry, which helped to spur a globalized workforce.

Today, Greenspan said, “something has got to give” as far as the credit risks taken by some developing nations go. He admitted, however, that he has been saying this for years.

On the domestic front, Greenspan's analysis was equally cautionary. Despite the recent downturn in the housing market, which was an engine for growth in recent years, the US economy continues to prosper—a mystery, even to the oracle.

“The markets have held up for reasons we do not yet know,” he said.

The next morning, a group of economists gathered for the formidable job of “interpreting the oracle,” as panel moderator Mark Zandi of Moody's joked.

Like Greenspan, they agreed that the biggest threat to the nation's fiscal security continues to be spending on entitlements. With the amount the US is mandated to spend on programs such as Social Security, Medicare and Medicaid set to skyrocket as the Baby Boom generation retires, something will have to fill the gap—which leaves large tax increases looming if Congress doesn't act on serious reform. Coupled with the rise in defense spending—even when the military operations in Iraq and Afghanistan are discounted— it paints a scary picture for investors and the American public at large.

Said Douglas Holtz-Eakins, who holds the Paul Volcker chair in international economics at the Council on Foreign Relations: “If we don't make changes the taxes are coming.”

In his remarks leading to the conference's opening panel, which took a look at the broader investment market, Philip Riordan, director of real estate at GE Asset Management, paraphrased former GE chief executive officer Jack Welch. “You deal with things the way they are and not the way you want them to be,” he said.

Most delegates seemed ready and willing to heed that advice, acknowledging that the prolonged run of the most recent real estate boom may be at its crest. However, PREA attendees remained optimistic about the future, albeit inclined to proceed with caution.

“It's the top,” said Mary Ludgin, head of the US private real estate group at Heitman, during a panel discussion on the fundamentals of the US real estate market. “The question is,‘How long can it be sustained?’”

One factor giving investors pause was the aggressive amounts of debt financing that have entered the market in recent years. One panelist noted that approximately $2 trillion (€1.6 trillion) in sub-investment grade debt is currently outstanding.

“There has been an explosion in more esoteric debt structures,” said Ron Insana, author and senior analyst on financial news network CNBC, who was moderating the panel. While these instruments have performed well to date, many of them have not been tested under adverse circumstances, he said. The question is what will happen when that test comes?

“We don't know how they'll behave, but we can bet they will behave badly,” he said.

Although the theme of the conference was “Back to Basics,” panelists discussing the broader investment market frequently highlighted opportunities for investors in both distressed debt and emerging markets, highlighting the degree to which once exotic investment strategies have entered the mainstream.

Staking a claim in some emerging markets, particularly finding a way to get a piece of China and India, is practically a must for institutional investors. However, one of the most important factors on the attractiveness of emerging markets, be it in real estate or other asset classes, is the price of oil.

Robert Kessler, chief executive of The Kessler Companies, said that those in the US tend to forget that low oil prices, while beneficial to the domestic market, can often produce political instability in key areas of the world. The solution for investors is to hedge their bets in emerging markets.

“Figure out what you can buy on the opposite side to protect yourself,” he said.

Paraphrasing a famous line from the old television show Hill Street Blues, David Ferrero, director of real estate investment at Harvard Management Company, urged the crowd “to be careful out there, be very, very careful out there.”

Despite that admonition and the competitive state of the industry, one crop of panelists, who focused on the four primary sectors in the US real estate market, found some reasons for optimism.

For example, logistics properties near major ports and rail hubs have been performing especially well and are expected to continue to do so, particularly in Los Angeles, California's Inland Empire, Northern New Jersey, Miami, Chicago and Kansas City.

The office sector continues to look strong in former secondary markets, especially Seattle and Florida, which have joined the ranks of primary markets due to strong growth.

In the multi-family sector, the 78 million “echo-boomers,” the children of the Baby Boom generation, are driving a strong rental market; the panel concurred that there is more to come. And additional opportunities exist as immigration remains strong.

As far as retail goes, most agreed that the sector crested more than a year ago. However, ethnic retail centers were noted as one potential opportunity. Some centers that cater to mainly Hispanic and Asian immigrant populations are showing numbers that one panelist called “off the charts.”

In terms of predictions for the future, the panel saw a number of things on the horizon, including a proliferation of green buildings based on environmentally sustainable principles, the return of a strong rental housing market, a resurgence in urban living and the emergence of mixed-use, high-density “urban nodes” in contrast to traditional shopping malls or lifestyle centers. Look for the traditional retail models based on the department store anchor to disappear within 20 years, the panel said.

But perhaps the most telling trend was the torrid growth of the asset class itself. Despite an increasingly challenging environment, most delegates seemed to concur that money is not going to stop flowing to real estate any time soon.

Invoking Greenspan's dismissal of $1 trillion as a sum that ceases to shock, Harvard's Ferrero joked that it might not be too long before some ambitious fund manager seized on that advice.

“What are the odds on how long it will take before some newly emboldened fund manager tries to raise a trillion-dollar real estate fund?” he asked.