The real estate sector took a body blow in 2008 and has yet to recover. Although signs indicate a slow return to health, there are more reasons than not to hold off on celebrating. The homebuyer tax credit and moves by the Federal Reserve to boost borrowing are due to expire in the second quarter of this year, and with unemployment levels stalled at or near record highs, the outlook for restocking commercial office buildings with tenants remains bleak. As banks regain their financial strength, they are eager to lend-to qualified buyers. As lending practices return to fundamentals, levels seen during the market's recent heyday won't return any time soon. There is good news, though: the publicly traded Real Estate Investment Trust (REIT) market is up approximately 125% since it bottomed out at this time last year. [Source: NAREIT US Real Estate Index Series]
To help make sense of the issues impacting real estate in 2010 and beyond, Knowledge@Emory spoke with Jim Grissett, an adjunct professor in the real estate program at Emory University's Goizueta Business School. Grissett currently works as an investment advisor focusing on REITs and real estate securities. He was a founding partner of The Parthenon Group, a firm that manages real estate investments in both direct and securitized formats.
Knowledge@Emory: A lot of attention continues to be focused on the residential housing market. Have we hit rock bottom?
Grissett: There are a number of signs, such as the recent Case-Shiller Home Price Indices, that show we are stabilizing and even seeing price increases in a few markets, but it is too early to sound the all-clear signal. The most fundamental indicators I look at are housing affordability ratios, which compare income to house payments, and they are near two-decade highs in affordability. However, this is driven more by home price declines rather than income gains, especially with job losses still occurring.
Also, some of the sales are being spurred by the homebuyer tax credit and the Federal Reserve's purchase of mortgage securities to help keep borrowing rates low. Both of these training wheels are scheduled to come off in the second quarter of 2010, and we will have to see how buyers and sellers react. The other challenge we have is resetting the many variable rate mortgages that were done in 2005-2007 and move beyond their teaser rate between now and 2012.
Finally, it is important to realize there are nuances between and within markets. For instance, the broad Atlanta MSA (Metropolitan Statistical Area) is larger than the State of New Jersey, and there is great variation in the various submarkets within that area. Also, the upper end of the market is under more pressure than the lower and middle tiers, as the jumbo mortgage market (over $417,000 in most cities) that depended on securitization outside the government guaranteed/GSE channels (e.g., Fannie Mae, FHA) is really not back in size.
Knowledge@Emory: The art of 'flipping' rose in popularity and even was the basis of several TV shows. Is flipping as a generator of large profits over with? Or will the practice continue?
Grissett: Flipping in the way that we saw people buying condos in Miami in the morning and selling for a profit in the afternoon is done for the foreseeable future. Those shows should have their own version of the Nickelodeon or ESPN Classics, and new homebuyers should be forced to watch it for at least a day before buying.
However, there is still a significant component of investor buying, especially in distressed markets. But they are a different type of speculator-often converting a property to rental housing while waiting for price appreciation. This is really a healthy development as a means of getting our nation's homeownership rate back to the 65% or so level where it had been for many years-before spiking to near 70% at the bubble peak. Five percent doesn't sound like a big difference, but with 115 million households in the US, that translates to almost six million housing units built for sale rather than rental. This conversion process-from condos to apartments, for instance-is a part of healing the housing market and our financial system.
Knowledge@Emory: As the coffers of banks and lenders fill back up, are you optimistic that they will begin to work with homeowners?
Grissett: Most banks are eager to lend. After all, that's how they make money and they earn much higher margins lending to creditworthy borrowers than they do keeping it in short-term reserves. Many banks actually have more loans outstanding than they did a few years ago-and they will tell you the problem is qualified loan demand, not capital.
What many people don't understand is that almost 40% of lending in our economy in 2007 was occurring in the shadow banking system outside the regulated, FDIC insured banks where most of us have our checking accounts. (Paul McCulley, the well-known bond fund manager of PIMCO, is said to have described this shadow banking system as the whole alphabet soup of levered up non-bank investment conduits, vehicles and structures.] In short, these firms bundled receivables from subprime mortgages, car loans, and credit cards and turned them into securities.
It worked well for a while coming off the last recovery, but then the music stopped and the conventional banking system has not yet been able to take up the slack. To some extent, the TARP and TALF programs were designed to help them do so, but with the politics and real problems at some of our biggest banks, they have not been able to fill in the 40% hole in aggregate.
Knowledge@Emory: Do you foresee banks looking more positively toward commercial real estate?
Grissett: Again, banks like to make loans, but it is hard to lend against a property that has tenants who depend on customers that depend on jobs. So, a lot depends on the economy and jobs. Likewise, banks are caught between conflicting governmental forces: easier monetary policy vs. tighter regulatory policy. As someone said, they have both feet on the gas pedal and both feet on the brake.
Knowledge@Emory: In terms of commercial real estate, it looks like 2010 is going to be an especially painful year: defaults, writedowns, the end of pretend and extend policies. How long do you see this type of environment persisting?
Grissett: The short answer is we will be working through the poorly underwritten loans for the next five years. The good news is that commercial real estate is less than one-third the size of the residential mortgage market-and most of it is rent and income producing, with a real economic value. Again the problem is the subset of properties that were built or refinanced during the 2005-2007 bubble, many at inflated values or with luxury construction costs that really didn't make sense then, much less now. If we can get the economy and jobs back on track, the result will be a few spectacular, high profile blowups in the newspapers-and total losses for some investors-but it won't pose the kind of systemic threat that the residential market could have.
Another interesting question in this regard is if the good parts of the securitization market can come back, which I think can and should. One interesting development is the front page battle for the malls owned by General Growth Properties, many of which were financed this way. Competitor Simon Properties (they both own a number of malls in Atlanta) is bidding to buy out their common stock-almost unheard of in a bankruptcy situation-and may be outbid by another group. While regional malls are unique, it suggests long-term real estate value is being recognized and the writedowns on good properties will not be nearly as bad as feared a year ago.
One last point in this regard: the publicly traded REIT market is up 128% in price since it bottomed almost exactly a year ago while private market indices like the NCREIF [National Council of Real Estate Investment Fiduciaries] are continuing down in aggregate and will likely do so for another couple of years. In the debacle of the early 1990s, the publicly traded REIT market likewise bottomed years ahead of the private market, but this suggests that the worst is priced into current expectations. The forward-looking securities markets tend to go down earlier than the appraisal based private index-and turn up quicker when the seeds of recovery are visible.
Knowledge@Emory: One of your areas of expertise is in the industrial/warehouse sector. With retail in the doldrums, what will it take before industrial rebounds?
Grissett: Again, it comes down to jobs, but industrial is one of the tamer sectors. It has a relatively short construction cycle and is built more for real tenant demand, not glitz. Thus, it didn't get as overdone, and it also benefits from growing world trade and the fact that corporations always work to be more efficient on the logistics front. I have been overweight in industrial in my REIT portfolio.
Knowledge@Emory: Layoffs are rampant in residential and commercial real estate companies. Is there a sector that is hiring? If so, what types of talent do firms need now or in the future?
Grissett: Certain areas in real estate are overloaded with work demands and need professionals with appraisal, legal, and accounting skills, as well as special servicers-the people that are directly involved with the resolution of problem properties. A number of distressed equity funds have real money and are looking for financial analysts. Good leasing people with the personality and skills to get tenants signed up are always in demand.
Knowledge@Emory: What is the takeaway from the current state of real estate in general? Is it a return to fundamentals? Ten years from now, when we look back at this time in history, how might we describe it?
Grissett: This is the fourth real estate cycle I have experienced to one degree or another since the 1970s. After the early 1990s, I thought the improved information flows would help us avoid another mistake of this magnitude. But in reality, the solutions to that cycle (securitization) became the seeds to this cycle. The two things I know are that we will find another way to do this again in 15-20 years, but that it won't be the students in my class who are making those bad decisions.
Knowledge@Emory: Anything on the horizon our readers should know about? Any other research you're doing?
Grissett: The bad news is we haven't really fixed some of the structural issues in our broader financial system that got us here. The good news, at least thus far, is that markets and fear are doing a pretty good job of keeping things in check for the moment. I am collaborating with a student on a project that examines how some of the new securities formats and changes in securities regulations may have exacerbated REIT market volatility during the peak stress periods in November 2008-April 2009. Our data looks very interesting, and I look forward to updating you when we get done.