by Andrew Stewart
“Managing expectations” ranks among the most useful, if underused, concepts in business and in life. It is the attempt to ensure that a person’s projected reality does not exceed what one can reasonably expect to occur. In the case of real estate investing, owners of equity and debt should have an understanding of expected benefits – and risks. Today, the community marketing these investments to the buying public is doing a credible job of potential benefit education; its effort in potential risk education, however, is another story altogether. The real estate community will suffer less dislocation and stress in the long run if expectations are well managed.
To start, let’s examine the basic premise upon which real estate investors found their favorable view of real estate. A common phrase such as “they aren’t making any more of it” or the concept of rent inflation over time forms the bedrock of most investors’ thought processes. To take this to its logical conclusion, David Ricardo (1772-1823), a pioneer who helped give economics its modern structure, can help. He looked at the factors determining prices, rents, wages and profits with a sense of system that has served economists ever since. Ricardo regarded population as a dependent variable – it “regulates itself by the funds which are to employ it, and therefore always increases or diminishes with the increase or diminution of capital.” Increased wealth and productivity bring more people but not more land. As a result, those who own land are able to command an increased return for an increasingly scarce commodity. “Every rise in profits” on the other hand, “is favourable to the accumulation of capital, and to the further increase of population, and therefore would, in all probability lead to an increase in rent”. Sounds like some good reasons to invest in real estate in the enormous U.S. economy — two-and-a-half times as big as the next largest economy in the world and almost as large as that of the other members of the Group of Eight combined, not to mention the G8’s most stable political environment.
Alas, but there are other factors that impact value: the availability and cost of capital, the cost to operate real estate, legislative incentives or disincentives, and users’ ability to pay (for rent or purchase) from funds generated through income or reserves. Then, of course, the microeconomic factors of supply and demand in each submarket also directly affect value.
Nearly 50 years ago, the recently deceased economist John Kenneth Galbraith coined the phrase “Conventional Wisdom” as the continuum of ideas that are esteemed at any point in time for their acceptability. Conventional wisdom becomes a sort of comfort zone where everyone who abides by it takes solace in knowing that his or her contemporaries take the same view. This does not mean that the conventional wisdom is always correct. Galbraith goes on to say that the “correct” conventional wisdom of today may not be true tomorrow. A changing environment can deal a fatal blow to the conventional wisdom when those ideas fail to respond to some contingency that threatens to render them obsolete. Real estate conventional wisdom is also subject to change; some of the following widely-held assumptions may have obsolescence creeping in.
Rent and Operating Expense Inflation
Rents for many types of real estate are currently increasing. Demand for hotel rooms and office space in many supply-constrained markets lead the way, as does multifamily, where the rent-to-own ratio remains lopsided in the renters’ favor. There are many other markets, however, where job losses and/or excess supply will constrain rent growth for the foreseeable future.
Other than labor costs, there often exists little correlation between rent and expense inflation. Rising rents usually signal a local economy strong enough to put upward pressure on wages. By contrast, real estate taxes, utilities and insurance may rise independent of rents; just ask anyone in the Southeast and Texas now attempting to procure property and casualty insurance. Conventional wisdom in the crude market has changed radically since 1998 when crude oil prices dipped (in inflation-adjusted May 2006 dollars) to less than $12 per barrel and it was believed excess supply would last for a long time. Likewise, real estate’s current conventional wisdom – of rent inflation outpacing expense inflation – is flawed, as markets unable to command rent increases are likely (at least in the short term) to see net income, and subsequently value, fall.
Is AAA Really AAA?
Investors pay top dollar and accept lower yields for properties in the best locations that have the highest rents. Assumptions are lowered for vacancy rates, turnover frequency andyield requirements, and increased for rent inflation. Some of us may question the conventional wisdom here, since vacancy, turnover, and yield requirements can increase at the same time that rent is falling. Look at San Francisco office values in 2000 and then 3 years later, an “investment grade” market that took quite a tumble. Are the immense premiums paid for top-tier real estate actually worth it?
AAA CMBS issued in 1997 had subordination levels in the 30% range; in the 3rd quarter of 2002, Moody’s stressed debt service coverage ratios hovered in the 1.20 range. By contrast, current AAA’s have subordination levels of 15% and Moody’s stressed debt service coverage ratios of 0.98. Combined with the widespread use of interest-only periods and the higher leverage (AAA’s now have lower subordination levels on much higher valuations), it is clear that the risk profile of these bonds has increased even though they are still marketed as “AAA.”
Some in the bond buying community acknowledge these changes. Yet market behavior demonstrates that AAA’s are, if anything, considered safer today than 10 years ago. Lower spreads have been achieved within the context of a maturing marketplace touting solid repayment history, better information flow, larger and more diverse pool sizes, and fewer exotic properties types such as healthcare, golf courses and marinas. The emergence of cross -sector relative value investors who move from sector to sector in search of incremental spread and the securitization of bifurcated A-notes further illustrate this perception. In reality, the risks of balloon repayment and potential cash flow interruption are greater than before.
According to Moody’s and Standard and Poor’s, a AAA security is defined as one whose capacity to meet its financial obligation is extremely strong. Maybe “extremely strong” could be replaced with “pretty good”.
Can Home Buyers Continue to Pay Up?
Many believe that the long-term outlook for housing remains excellent, and it probably is. In the short term, however, homebuyers must overcome several obstacles. As noted earlier, taxes, insurance, and utilities have all risen recently. This, combined with teaser rates offered on many home mortgages, stirs trouble on the horizon. Over $1 trillion of adjustable rate mortgages – 12% of total U.S. outstanding mortgage debt – will roll to market rates in 2007; adding in amortization will cause some initial payments to triple or quadruple. For example, a $200,000 home loan with an initial teaser payment of $400 per month would have a 2007 monthly payment (assuming a 5.25% 1-year Treasury) of $1502 – a 275.5% increase. These pressures will eventually force numerous distressed owners to sell their property, which will likely result in a tangible loss in home values.
Availability of Capital
Most people take for granted the notion that capital will always be available for real estate. Those who entered the industry after 1995 have never seen a time (except for short-lived periods in late 1998 and post-9/11) without liquidity for real estate. If some of the aforementioned (net income deflation, losses in commercial mortgages and reduced values) actually happens, liquidity would leave the market. Values in this scenario would plummet.
As long as investors in real estate understand the risks associated with it, their expectations can be properly managed. The massive increases in value that have occurred over the past 15 years cannot continue unabated. The stability resulting from properly managed expectations can allow the health that the market currently enjoys to continue. There is nothing wrong with an investor occasionally losing money in real estate, as this alone will not create a massive dislocation and subsequent heartache for the economy. Unfortunately, those who believe in possibly obsolete conventional wisdom may not be managing their own expectations of potential losses. Therein lies the problem.
Behavioral economist Michael McBride of University of California at Irvine studies happiness and its causes. “People ask me all the time, ‘What do you learn about happiness? What’s the secret to happiness?’” McBride said. His standard answer, only half kidding: “Low expectations”.
Sources: Moody’s Investor Survey; JP Morgan CMBS Report; New York Times; The Affluent Society, John Kenneth Galbraith; Los Angeles Times.