United States Versus European Real Estate: A New Paradigm
The last decade has brought a series of
major shifts in the global real estate capital markets,
from a heavy reliance on private capital to greater use
of publicly traded vehicles to raise equity and debt. Nowhere
has this trend been more pronounced than in the United States,
where until the early 1990's there was only a miniscule
amount of publicly traded real estate equity and virtually
no publicly traded commercial real estate debt. In this
article, we will explore the impacts of these global capital
trends, with a particular focus on what lessons can be drawn
from the U. S. experience as Europe undergoes dramatic changes
brought on by the European Union and the EMU.
Recent History in the US
Let's take a quick look back at the US experience, as it
has important implications for European real estate in the
new millennium:
In the late 1980's, new tax rules limiting
the use of real estate write-offs killed the real estate
syndication market overnight. Congress also challenged the
wisdom of letting Savings & Loans (S&L) use government
deposit guarantees in raising money to invest in junk bonds
and risky real estate loans-this led to the virtual exit
of the S&L industry from any significant role in commercial
real estate financing. In addition, the Japanese economy
started to soften, creating a need to repatriate capital
invested in US real estate, much of it originally invested
at inflated values. A decade where we added over one third
of all the office space ever built in the US came to a close,
with lots of "see-through" buildings and plenty
of scared developers, investors and lenders.
In the early1990's, the real estate industry,
already reeling from the events described above, was hit
by a recession. During this period, federal regulators completed
the dismantling of most S&L's and turned their attention
to commercial banks-while not as severe as the S&L problems,
the Feds found significant issues in bank real estate portfolios
and enforced tighter real estate lending standards. The
Japanese were hammered and sold a large number of trophy
assets at fire sale prices, which further eroded investor/lender
confidence.
On a positive note, the opportunity fund
concept was born (but in keeping with the gloom of this
period, they were called vulture funds). Also, a long forgotten
acronym was resurrected, REITs (Real Estate Investment Trusts),
and a new one was born, CMBS (Commercial Mortgage Backed
Securities).
By the mid-1990's, the economy had started
to come back. In real estate, the principles of Economics
101 took effect (i.e. supply and demand equilibrium); since
we had not built anything in the US in almost 10 years,
any tick upwards in demand had a dramatic effect on occupancies
and valuations. Wall Street also got in full swing: total
REIT market capitalization went from less than $40 billion
to over $100 billion in two short years; the CMBS market
hit its stride-as investors got comfortable with the concept,
the Street started originating loans specifically for securitization
and the rating agencies developed the capability to put
standard bond ratings on these securities opening up the
market for institutional money; and Opportunity Funds started
raising massive amounts of new equity on the strength of
good early track records and the intuitive appeal of their
being able to pay 40-60% of replacement cost for trophy
assets.
By the late 1990's, technology was driving
an incredible period of economic growth in the United States.
Capital generation and savings rates increased rapidly on
both the strengthening economy and demographic factors.
Stock market values exploded, in a frenzy of "irrational
exuberance" according to Allan Greenspan. Real estate
was a huge beneficiary of these trends-more capital chasing
a finite commodity increased valuation multiples, and tenant
space needs skyrocketed. The capital markets proved true
to predictions that transparency would help prevent, or
at least limit, future real estate cycles. At the first
sign of overbuilding, the IPO and secondary markets for
REITs, as well as the CMBS origination market, virtually
shut down. The reality that real estate was now integrally
linked to the global capital markets was driven home when
the Russian debt and Asian currency debacles spilled over
into the CMBS market.
Looking back, all these trends seem obvious
and predictable; twenty-twenty hindsight is a wonderful
thing. A huge shift in wealth took place in less than five
years, no longer is the Forbes 400 dominated by real estate
tycoons, and the Japanese are still trying to recover from
their enormous losses on US real estate. But visionaries
on Wall Street, and Main Street, were tremendous beneficiaries
of the new opportunities created by access to broader sources
of capital.
2001 and beyond: So what does the new
millennium hold?
The United States
Obviously the stock market has come back to earth--you still
have to support your stock price the old fashioned way,
with real earnings and a rational P/E ratio. The economy
appears poised to take a break, but it probably won't be
a long one. The big risks on the downside include: 1) energy
prices 2) "irrational panic" in the capital markets
(the mirror image of Greenspan's earlier comment) 3) renewed
debt and currency problems in the 3rd world and the former
Soviet Union since they will be hardest hit by a slowdown
and 4) a new President who may want to get "his recession"
out of the way early in his first term.
Offsetting these risks, however, are lots
of positives. Efficiencies are still being generated from
existing technologies just when a new technology wave is
hitting us (hand held devices, wireless data transmission,
B2B on the web, fiber optic connectivity, etc.); the demographics
are still in our favor with the most educated, highest earning
generation in history still years away from retirement and
global technology leadership is engendering a better product
export market while providing a wonderful magnet for high
talent labor imports. A final positive are the high capital
spending rates in various sectors: manufacturing, due to
its running at high utilization rates and the demand for
modern, high-tech facilities; the public sector, which continues
to face aging infrastructure, but now with budget surpluses
providing money to spend; and our old friend commercial
real estate, where office construction has still lagged
behind demand in a number of key markets.
The threshold question is: Will all these
positives allow investors to continue to get 20+% IRRs on
their US real estate investments? Frankly, it is unlikely
that the US markets will be able to sustain the IRRs of
the last half of the '90s, at least on a risk-adjusted basis.
That was a unique time, when the events described earlier
had driven the market value of long-lived trophy assets
way below their replacement cost. An unbelievable drop in
hindsight, but one that was startlingly real at the time.
To achieve high IRRs in the US today will take moving up
the risk curve by developing vs. acquiring, investing in
riskier property types and venturing into new markets. For
many, these risks are not worth taking and they are moving
their new investment money out of the US.
The European Opportunity
While European real estate did not suffer the fate of the
US markets ten years ago, it also was not a priority asset
class for institutional or publicly traded equity. So, just
as values did not decline precipitously, neither have they
risen as dramatically in the last several years as those
in the US. With an economy approaching $9 trillion in GDP
and a population of almost 400 million, Western Europe offers
a market equalling or exceeding the US in size and sophistication.
The missing link in the European real
estate value equation has been a macro trend to drive above
average returns. Now that link appears to have arrived in
structural changes within the European Union (EU), including
its implementation of the European Monetary Unit (EMU).
The ability to cross borders seamlessly (whether for capital,
material or labor) has the potential to yield massive economic
benefits. However, to take advantage of these benefits European
businesses and consumers will need to change many of the
historical ways they have done business.
In the past, cross-border tariffs, exchange
rate risk and border delays were added to the other more
obvious impediments (language, culture and political differences)
to doing business in a pan-European model. Eliminating a
number of these impediments, while not making the European
market totally seamless, starts to level the playing field
versus the United States. At the same time, it will require
a huge change in distribution networks and logistical facilities
that previously were focused on domestic markets. Add to
this
e-retailing and just-in-time inventory trends and you can
see the groundswell for re-building and/or expanding warehouse
and distribution networks all over Europe. Given the difficulty
of finding and obtaining permits for new sites, existing
facilities that are well located will become even more valuable.
On a broader front, real estate has not
been a large publicly traded asset class in Europe, with
many class A properties in private hands-office buildings
are owned by the primary tenants and hotel ownership is
widely dispersed, with little branding. As European and
US companies start competing for capital more directly,
and as European stock markets become more focused on the
retail investor, pressure will build to move high-value,
low yielding assets like real estate off corporate balance
sheets. Moving massive amounts of real estate assets off
the balance sheets of companies all over Europe will take
a number of years and a lot of capital. On the hotel front,
opportunities will exist to acquire properties and affiliate
with either a US, Asian or pan-European brand to enhance
the value of the entire portfolio.
So how do you play? Obviously you can
invest with local companies who have operated in European
markets for decades, many of which are publicly traded.
A potential drawback here is that they may not be able to
change their historical paradigms to fully take advantage
of this new era. Another way is to invest with the small
host of US opportunity funds (e.g. Apollo, Blackstone, Morgan
Stanley and The Whitehall Funds/Goldman) who have set up
shop in Europe. This group has the advantage of ready amounts
of capital, diverse lender relationships and track records
of developing entirely new ways of doing business. A number
of them also have experience in doing deals in Europe over
the last 3-5 years, so they know the intricacies involved.
There is also the new phenomenon of the global real estate
developer and owner/operator. A number of these US companies
have demonstrated an ability to export their American development
expertise to foreign markets (e.g. Hines, Simon and Tishman
Speyer). They possess the advantage of having learned from
the opportunity funds how to raise institutional equity
capital, plus they have broad lender relationships and established
histories with key tenants. Similarly, there are several
US REITs (Prologis and Shurgard) with a significant presence
in Europe, possessing the same advantages as the developers,
along with the major benefit of providing investors with
more liquidity through their publicly traded stocks.
Only time will tell if this is another
once in a lifetime trend that will generate the spectacular
returns we saw at the end of the last millennium in US real
estate. But it is hard to ignore the historical significance
of the EU's maturation and the implementation of the EMU;
these are events that do only happen once in a lifetime
in mature economies like Western Europe. It is also hard
to ignore the number of savvy investors and real estate
companies that have made a big investment in Europe-they
have wonderful track records demonstrating their ability
to get in front of key trends. Playing follow the leader
with this group could be a very good strategy.
Pete Nachtwey is the Partner-in-Charge
of Real Estate Consulting Services for the Tri-State region
of Deloitte & Touche LLP. The consulting team focuses
on four areas: capital markets and transaction strategies,
real estate operations and systems consulting, corporate
services, and specialty valuation services. Additionally,
he is a member of the firm's national real estate steering
committee. Mr. Nachtwey moved to Deloitte & Touche's
New York office in 1996 after working in Washington, DC,
European, and Cleveland offices. His clients include CS
First Boston, Kajima International, The Blackstone Group
and Tishman Speyer, among others. Mr. Nachtwey is an honors
graduate of Syracuse University.
