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Inflection points

PERE presents four times and places that marked changes of direction and turns of fortune for real estate investors. Three of these are looked back on with fond nostalgia by those fortunate enough to have been present and active. One remains a painful memory. By Dave Keating, Robin Marriott and Eva Poon

‘Were you there?’

UK, 1996 California, 2002
The United Kingdom property market was going to In the wake of the dot-com collapse and the September
“hell in a handbasket” during the early 1990s. But 11 attacks, Americans turned their attention and
then a decision to abandon Europe's Exchange Rate capital to home ownership. As is usually the case,
Mechanism built the foundation of a boom in Brit- California was like the rest of America, only more so.
ish real estate values.
Germany, 2001 Japan, 2003
Enthusiasm following the reunifcation of Conservative Japanese corporate attitudes and practices
Deutschland reached a high point at the turn of the with regard to real estate held steady through
century, and foreign investors lined up to buy property the protracted property declines of the 1990s. Then
across the country. But what followed was the a reformist prime minister was a catalyst for change.
spectre of emptying office buildings and diminished equity values. “Overnight the phones started ringing.”

Rebuilding Britain UK, 1996
Traditionally, US firms have been criticized in Britain for bad timing. A few investment banks such as Goldman Sachs, for example, came over in 1990 in search of better opportunities and promptly walked into a real estate crash. However, in 1996 American private equity firms and investment banks began to enjoy themselves by taking advantage of the spread between the cost of debt and cap rates.

Back story: Britain in the 1980s had gone through a property boom. Red Ferraris, red braces, pin striped suits and free flowing champagne epitomised London at the time. Amid the euphoria, British banking institutions had been keen to lend to speculative developers. Real estate lending rose from £3.5 billion in 1982 to £39.7 billion by 1991, according to the Bank of England.

Though bank lending had spiralled, Britain in 1990 was actually in a state of flux, and recession. Conservative Prime Minister Margaret Thatcher, dubbed the Iron Lady, had been ousted by John Major amid widespread discontent. Before her replacement, there had been riots in London's Trafalgar Square following a protest against a new local tax, called the Poll Tax. But worse for business, interest rates stood at 14 percent, compared to the 5, 6 and 7 percent rates that Britain enjoyed over the subsequent 17 years.

Given that interest rates were high and buildings were lying empty, it was little surprise that property companies were going bust. The symbol of the crash was Paul Reichmann's Olympia & York, the development company behind Canary Wharf, which went into administration in 1992 with debts of $20 million. There were 62,767 business failures in total that year in the UK.

Total property had been on a terrible run, going suddenly from 15.4 percent in 1989 to minus 8.4 percent in 1990, minus 3.1 percent in 1991 and minus 1.6 percent in 1992, according to Investment Property Databank (IPD).

Roger Orf, who was at Goldman Sachs at the time and set up Whitehall Funds in Europe, said: “The world was going to hell in a handbasket. At the time everyone felt as if the world was crashing around them.”

But then, a new era dawned heralding a change in fortunes for investors. It was the advent of US “capital allocation” players investing in the UK, and performing well.

In late 1992, the decision to enter Europe's Exchange Rate Mechanism (ERM) was reversed after two tortuous years of membership. The idea that Britain's economy would do well if sterling was tied to Germany's currency had proved a disaster. In order to keep the pound within pre-agreed ranges, the Government had raised interest rates to 15 percent in a last ditch attempt to stay in the ERM. But this strategy was no longer viable. On September 16, 1992, the Chancellor of the Exchequer, Norman Lamont, took Britain out of the ERM on a day that became known as Black Wednesday.

Though in the short term London's financial markets entered a period of chaos, the decision proved to be a long term catalyst for sustained economic stability. Most importantly, interest rates came down overnight from 15 percent to 6 percent.

In a series of later movements, interest rates hovered between 5.5 percent and 6.25 percent over the next few years and were never to go above 7.5 percent for the rest of the 1990s.

Unemployment figures were suddenly being reversed as Britain's fortunes changed. According to official UK government data, unemployment stood at 10.25 percent in 1993 but dropped to 8 percent by 1996 and fell each year for the next three years.

Speculative development in London's financial district was no longer out of control. In 1991 there was nearly 6 million square feet of new development, according to Richard Ellis, but this had been reduced to less than 1 million square feet by 1996.

Inflection point: In 1996, conditions were right for foreign private equity firms to find a spread between the cost of debt and cap rates. Orf recalls it was possible to buy property at nine percent cap rates when the cost of debt was six percent.

Those that entered the UK property market did so at a time when rents were beginning to climb. For example, rents in London's West End had fallen from over £60 a square foot to way below £40 a square foot during the property doldrums. However, they climbed from just over £40 to £80 a square foot between 1996 and 2000, according to PMA.

One of the successful deals in 1996 was the purchase of a portfolio of properties by a consortium including Orf's platform Pelham Partners backed by Apollo Real Estate.

Insurance companies such as Norwich Union were selling off property, and US investors were happy to step in. Pelham, Apollo and its partners paid £27 million for 13 properties including a West End office in Great Titchfield Street, W1. The London property was flipped a few months after the acquisition. Overall, the portfolio deal achieved two times money and an internal rate of return above 25 percent.

Subsequent performance: All property returns that were negative in 1992 had turned positive. Returns from all British property in 1996 were 10 percent, according to IPD data, then 16.8 percent in 1997, 11.8 percent in 1998 and 14.5 percent in 1999.

It is often said that everyone did well in UK real estate from the middle of the 1990s until the tech-wreck of 2000 and 2001. Nevertheless, the capital allocation investors would continue to prosper, turning their attention to other European markets.

Next on the investment map was France in the aftermath of the French banking crisis. Just like the UK, France began to offer positive spreads to real estate investors.

Italy was next on the road trip. The country was one of the great beneficiaries of the euro, debt was ridiculously cheap, and it began to open up to foreign investors willing to fill the void in quality real estate. Private equity firms pursuing development as well as active asset management opportunities did as well as the capital allocation investors. But the capital allocators did not enjoy the same fortunes in their next stopover: Germany.

When the wall came tumbling down Germany, 2001
Germany in 2001 was meant to be the next country set for economic recovery in Europe. Instead it was a country marked by trade union disputes, massive job layoffs and large buildings laying ghostly empty. Consequently, the capital allocation players pursuing a buy and hold strategy on this occasion were ultimately disappointed.

Back story: Ever since the Berlin Wall came down in 1989, there was fierce optimism that Germany would become a place to invest in real estate, and from 1997 onwards it seemed that it might just develop into one.

The underlying thesis was that Germany was entering a period of sustained economic growth.

According to the German Society of Property Researchers (GIF), commercial premises all over the country were attracting tenants in bullish mood. In 1997, vacancy levels stood at 5 million square feet in the main markets of Berlin, Cologne, Dusseldorf, Frankfurt, Hamburg, Leipzig, Munich and Stuttgart. The vacancy rate fell to below four million square feet by 2000.

The reason for this real estate optimism was that Germany was making money. GDP growth of two percent in 1999 went to over three percent in 2000, according to the Federal Statistics Office.

As a consequence, some foreign investors put the country on their strategic maps. In 2000 Blackstone announced a plan to open an office in Germany. The same year, LaSalle Investment Management raised €850 million to invest in “growth markets” of Europe, including Germany. But perhaps the poster boy for foreign capital into Germany was Goldman Sachs' Whitehall Funds. By early 2001, it had reportedly acquired €230 million of real estate in Germany. One of its deals was the purchase of Top Tegel business park near the Berlin airport.

Inflection point: The trouble was, 2001 turned out be the beginning of more trouble, not a bold new beginning.

Structural difficulties in Germany and the economic problems precipitated in the US – including the tech wreck – scuppered the possibility of continued growth. As if the economy needed a further kick-in–the-teeth, the terror attacks of September 11, 2001 shunted economies further off the rails. Germany, being the largest economy in Europe, suffered the worst.

Foreign investors who bought into the German buy-and-hold dream in 2001 had arrived too early. At best they had to wait much longer than anticipated to make the returns promised investors. At worst, they lost their investors' equity.

Growth in GDP collapsed. According to Germany's Federal Statistics Office, the GDP expansion of 3 percent in 2000 fell to less than 1.5 percent in 2001.

By February 2002, just a year after Whitehall Fund's investments, the horrible truth was official: Germany was in a recession. Government economic data revealed two consecutive falls in GDP. It had shrunk 0.3 percent in the last quarter of 2001 following a 0.2 percent fall between July and September.

Unemployment began to climb. According to Germany's Labor Office, in September 2001 it rose to 3.8 million, its highest level in 15 months. Adding to the depression, Siemens, a symbol of Germany's engineering base, announced losses of €1 billion in the final quarter of the year having earlier revealed plans to slash 17,000 jobs in the country. Having consistently fallen between 1997 and 2000, unemployment was now rising above 10 percent again.

Doughty Hanson's head of real estate, John Howard, recalls the knock-on effects on property vacancies. At the time, the London-based firm had taken on a redevelopment in Munich. “Vacancy rates went from two percent to 12 percent,” he remembers.

Vacancy rates were not just rising in Munich, though. Buildings were emptying across the whole country as the recession bit deeper. According to GIF, vacancy levels rose above four million square feet in 2001, then above six million square feet by 2003, and above eight million square feet in 2004.

Subsequent performance: Foreign investors who bought into the German buy-and-hold dream in 2001 had arrived too early. At best they had to wait much longer than anticipated to make the returns promised investors. At worst, they lost their investors' equity.

A major source of schadenfreude amid the wreckage was Whitehall Funds' Top Tegel business park, measuring 807,000 square feet. Whitehall acquired Top Tegel in 2001 in the mistaken belief that the main tenant, Deutsche Telekom, would renew a lease. Whitehall Funds ended up handing the keys to the lender, Eurohypo.

Global property services firms were knocked sideways as a result of the malaise in Germany. Jones Lang LaSalle, for example, suffered a 50 percent drop in operating income because of Germany. DTZ's profits collapsed 58 percent.

Between 2001 and 2006, annualized total returns from all direct property in Germany stood at 1.9 percent, a dismal performance. According to the DIX German Property Index and IPD, it would have been far better to invest in other asset classes. Total annualized returns from equities would have delivered five percent. Property shares would have delivered 11.2 percent, while bonds would have delivered 4.8 percent. The worst performer out of all sectors between 2001 and 2006 was offices, which delivered pitiful annualized total returns of 1.1 percent.

Not that everyone performed badly. Lone Star was taking advantage of non performing loan portfolios, for example.

Doughty Hanson's Howard, who was working with Marc Mogull at the time, managed to find tenants for the redevelopment in downtown Munich through a mixture of incentives, luck and determination and eventually made 5.7 times money on the investment. Doughty Hanson was deploying active management techniques across Germany where it had opened an office, and managed to turn $1 into $4 between 2001 and 2003 from its investments.

Though there were clearly success stories for some who were part of the Germany 2001 vintage, the experiences of the capital allocators looking to buy and hold was on the whole, bad. The vintage could be described in a word: schrecklich.

Surf's up, dude California, 2002
From a state of flux to a golden age, the housing market in California underwent a reversal of fortune. The aftermath of the dot-com bust and the Federal Reserve's heavy hand on interest rates set the stage for a housing boom in California. Interest in residential properties soared as money moved from technology into real estate.

Back story: In the early 1990s, house prices in California took a serious plunge. Sales were bottoming out amidst rumors of a coming recession. Through the mid- to late-1990s there were signs the market was recovering with improved buyer confidence translating into increased home sales and higher prices.

In 1998, a market dislocation in the form of the Russian debt crisis interjected a pause in an otherwise steadily improving marketplace. In 1999, 2000 and 2001, there was a continuation of upward trends driven in part by technology and market confidence. In March 2000, the dot-com bubble reached its furthest limit. Afterwards, it seemed as if there was no floor for the value of profitless tech and telecom stocks, with grave implications for California's economy.

The subsequent crash, arguably, pushed many people to funnel their money into what were perceived to be safer investments, such as real estate.

In 2001, the September 11 terrorist attacks interjected another pause in the market. The attack had an immediate impact, most specifically on properties with short-term investment profiles such as hotels and other rental properties, which saw a big drop-off. A period of discontinuity lasted for some period after September 11, but slowly gave way to continual improvements which led to greater success in the years following 2001.

Inflection point: The year 2002 saw the tide come in. Home sales in California increased 13.5 percent from 2001, according to the California Association of Realtors. Median home prices also rose throughout the year to $315,870—a 20.4 percent increase over the 2001 median and the largest since 1977 when the median house price jumped 28.1 percent.

By sector, condos and townhomes also saw an 18.4 percent increase in median price from $204,100 in 2001 to $241,630 in 2002. Sales volume also grew by 20 percent.

Taking California's Bay Area as a microcosm of the Golden State, at mid-year Bay Area home sales showed considerable increases over 2001, with prices moving to record highs.

A total of 11,238 new and resale houses and condos were sold in May 2002, up 42.9 from the previous year, according to real estate information provider DataQuick Information Systems, a subsidiary of MacDonald, Dettwiler and Associates.

The median house price in May 2002 stood at $413,000, a 9.0 percent increase from the same period in 2001.

But the fun didn't stop there. By year end in 2002, home prices in the Bay Area were higher in all areas except San Mateo and San Francisco, with the number of homes sold increasing to a lesser extent from the mid-year sales volume.

The urge to buy was high: number of buyers outnumbered sellers and demand and low inventory was pervasive across the Golden State.

The Federal Reserve's interest rate cuts in 2001 and 2002 further fueled the housing market. In 2001 alone, the Fed cut interest rates 11 times in an effort to keep the US economy from falling into a recession. Rates fell from 6.5 percent at the start of the year to 1.75 percent at its closing—the lowest level in 40 years.

Four of the rate cuts were made following the September 11 attacks, once immediately afterward, then again in October, November and December. In November 2002, the Federal Reserve again cut the federal funds rate to 1.25 percent, a new 40-year low.

According to the California Association of Realtors' Housing Affordability Index, the HAI index was 34 percent in November 2001, up 3 points from November 2000 despite an 11.2 percent increase in the median price, mainly because the fixed mortgage rate fell nearly 1¼ percent over that time.

Persistent low interest rates pushed up home sales as buyers took advantage of subsequent low mortgage rates.

“At the start of the year, few expected 2002 to be a banner year, given the state economy's continued weakness and lack of new jobs,” Robert Kleinhenz, deputy chief economist at the California Association of Realtors, said in a 2003 “Market Trends” report. “But few analysts anticipated that interest rates would drop throughout the year to lows that have not been seen since the Nixon Administration and earlier. Low mortgage rates, strong demographics, and, to some extent, the poor performance of investment alternatives to real estate all contributed to an outstanding year.”

“When I landed in Japan in 1999, foreign capital was very nervous about the Japanese economy and the real estate market. But since then there's been a transformation from being an insular, domestic, institutional market to being one that's fully opened up.”

Subsequent performance: Buyers who allocated an outsized amount of capital to California residential properties in 2002 were rewarded with outsized returns in the following years.

Record-low interest rates kept home values high. In 2002, annual home prices appreciated more than 10 percent in California. According to OFHEO's House Price Index fourth quarter reports, home prices appreciated 11.5 percent in 2002. In 2003, home prices appreciated 13.8 percent and again, in 2004, the appreciation rate had reached 23.4 percent.

In general, property values soared in the years following 2002, with occasional market fluctuations. At the end of the first quarter this year, house prices had appreciated 98.8 percent from values in 2002.

The year 2002 also witnessed a record number of million-dollar home sales in California, another indicator of strong property values, and a trend that only grew with time. A total of 13,828 homes were sold for a million dollars or more in 2002, up 45.5 percent from 9,501 in 2001, according to DataQuick.

The mix of low interest rates and high prices led to a record-setting year in the Golden State's housing market. Strong demand versus supply pushed up median house prices with property values increasing into 2003 and 2004.

From 2004 to 2005, California again broke records with house price increases in excess of 25 percent per year.

“Once stocks fell, real estate became the primary outlet for the speculative frenzy that the stock market had unleashed,” Yale economist Robert Shiller said in a Barron's Magazine article in June 2005. “Where else could plungers apply their newly acquired trading talents? The materialistic display of the big house also has become a salve to bruised egos of disappointed stock investors. These days, the only thing that comes close to real estate as a national obsession is poker.”

Rising in the East, finally Japan, 2003
For centuries, Japan had been known to the West as one of the most closed societies on earth. But since the days of American Commodore Matthew Perry, Japan has interacted with foreigners, with mixed results for both sides. Foreign investors have found Japan's economy a tough nut to crack. So when economic reforms and a real estate asset sell-off commenced at the most recent turn of the century, opportunistic investors leapt at the chance to go after a distressed play, acquiring property assets at low prices in a formerly impenetrable market.

Back story: A lot changed in Japan in the course of the last decade of the 20th century, to put it mildly. In 1990, the economic success of Japan was marvelled at, as well as feared, by the West. Four decades of phenomenal growth had sent Japanese corporations looking for opportunities to invest their wealth overseas, and much of that came in the form of US real estate. Both at home and abroad, Japan was looking like a real estate king.

However when the Japanese economy crashed in the early nineties and the bubble in the country's real estate values began to deflate, Japan's fortunes reversed dramatically. In the 1980's, Japanese attitudes toward property as the best possible collateral for almost any type of loan, together with the popularity of real estate acquisitions by Japanese corporations, had in the end created a situation where corporations were saddled with bad property assets and banks were drowning in nonperforming real estate loans. Even worse, the continued valuation of real estate by the government based on just the land rather than on its cash flow meant the situation was not correcting itself.

When the Asian financial crisis that began in 1997 reached Japan, it was enough of a shock to the system that the government stepped in to take drastic action. The valuation system for property was changed from land value to cash flow. Prime Minister Koizumi instituted drastic economic reforms and the government stepped in to help companies work through their bad property debt. Though there was still a great amount of unease in the market, by the early part of this decade some investors were willing to bet that these changes would deliver a turnaround for the Japanese property market.

Inflection point: “When I landed in Japan in 1999, foreign capital was very nervous about the Japanese economy and the real estate market,” recalls Simon Treacy, who at the time had been appointed as the country manager for Japan at Macquarie Global Property Advisors. “But since then there's been a transformation from being an insular, domestic, institutional market to being one that's fully opened up.”

After setting up Macquarie's Japanese operations, the firm started investing in 2001, targeting the property assets and non-performing real estate loans that were now being sold by Japanese corporations and banks. Treacy credits the valuation methodology change as one of the main factors leading to the Japanese corporations finally selling off their real estate assets.

“It was extremely significant, all of a sudden people were talking about cap rates, rather than values,” he says. “Lenders started lending on the basis of cash flow rather than property, and that helped drive the market.”

Investors getting in to Japan at the turn on the century were coming in for a distressed play at a low point in Japanese property. According to the Japanese Real Estate Institute, in September of 2003 land price indexes in Japan's six largest cities had been falling by about four percent every year since 1991. But around this time the reforms and adjustments started to take effect and things quickly changed.

“The height of the concerns about the financial system collapsing was in 2003,” says Treacy. “Then all of a sudden, with the Koizumi reforms, business turned in the third quarter of 2003. Overnight the phones started ringing, people started to feel more confident to take decisions to expand business premises and buy assets. The economy hasn't looked back since that point,”

Subsequent performance: Some of the opportunity funds that got into the distressed game during this time included Lone Star Funds, Aetos Capital, Deutsche Bank and Goldman Sachs. Morgan Stanley in particular has been in Japan through all the distressed opportunity. It began by investing in non-performing loans in the late 1990's, and then moved on to buying distressed assets in 2002 and 2003. The firm's investments have varied widely across different sectors and deal types, including a $150-million air-cargo industrial park near the Tokyo airport and a 36-story hotel purchased for $109.5 million.

The property price decline trend, which had seen property value steadily fall since 1991, suddenly reversed at the beginning of 2004 and has been steadily climbing since. The rise has mostly been felt in commercial property in the central districts of Japan's largest cities. In Tokyo, the property price index in the first quarter of 2007 increased by 11 percent from the previous year, according to the Japanese Real Estate Institute. “Anyone who bought between 1997 to 2005, if they sold their properties today, they could be getting 30 percent plus returns,” says Treacy. “They'd be living like rock stars today. Since then there's been a tenfold increase in the number of foreign players coming to the market, and there's an equal number of small boutique local companies being formed. Many of these firms started as just two man operations in 2000, and today they're swimming in a sea of market cap over a billion dollars.”

By 2007 it's clear that the distressed play is over. With prices rising, the Japanese real estate market is well into its recovery and exit liquidity has improved greatly. Now investors are beginning to diversify and look toward other sectors and second tier cities. But for firms that were able to get in right as the market reached its low point, the strategy seems to have paid off.