Friday Letter Trophy vs. tragedy

Two years after the crisis, there are mounting fears that excess debt availability could trigger another credit bubble. Will it end in tragedy this time around as well? 

In trying to explain real estate’s boom and bust cycles, one veteran investor once joked that the problem wasn’t actually with the asset class, but with people’s [in]capacity to remember. “Real estate has 10-year cycles,” he said, “but real estate professionals have five-year memories.”

Little more than two years after the collapse of the world’s financial system, it appears there is more than an ounce of truth in the adage.

Over the past few months, there has been much talk about the rush of equity into core real estate in the US. Now, however, there are growing fears that the country could be heading towards another real estate credit bubble, as lenders continue to plough into the asset class in search of yield in today’s low interest environment.

This week, Starwood Capital Group’s Barry Sternlicht and Colony Capital’s Richard Saltzman both warned against the ever-larger amounts of liquidity eyeing real estate, saying the industry faced repeating the mistakes of 2007 and 2008 all over again.

“I think it’s a very difficult situation that we are in right now to the extent that, if the [US] government keeps rates artificially low long enough, there’s the potential for another credit bubble similar to the one we went through just a few years ago,” said the Colony president. It was, he suggested, an “accident waiting to happen.”

For Sternlicht, the rush to deploy capital was resulting in some “undisciplined” lending, as institutions pushed loan-to-value ratios higher “without the [underlying] cash flow. If you look at what is happening to real estate, it is exactly what happened in 2007 and 2008 when cap rates were plunging and LTVs were going up without cash flows,” the Starwood chairman and chief executive officer also said this week.

To hear complaints about the dangers of excess liquidity in the real estate credit markets may seem strange considering the sheer lack of debt available just 12 months ago. However, mortgage origination volumes have risen rapidly over the past year – not through traditional bank lending, which remains down by roughly 25 percent compared to 2009, but from insurance companies, conduit, agency lenders and investment funds all looking to extend credit to borrowers.

The problem lies, though, in the fact that much of this credit is targeting core, stablised real estate assets in a handful of prime locations rather than the multitudes of Class B and Class C properties in secondary and tertiary markets.

This concentration of capital towards core has led some industry professionals to decry the “trophy versus tragedy” mentality gripping vast swaths of the lending and institutional investment community.

Saltzman and Sternlicht are just two people hoping it doesn’t turn to tragedy for the entire real estate industry as well.