30 Aug 2004  Research & Ideas

Real Estate: The Most Imperfect Asset

Real estate is the largest asset class in the world—and also the most imperfect, says Harvard Business School professor Arthur Segel. He discusses trends toward institutionalization, environmentalism, and globalization.

 

As a driver of both the overall economy and of individual wealth, real estate is pretty hard to beat. As Harvard Business School professor Arthur Segel says, real estate is the largest asset class in the world—the value of housing in the United States alone is $16 trillion. And real estate is the greatest source of wealth for most families.

In this interview Segel discusses the importance and fascination of real estate, and three important trends remaking the industry: institutionalization, environmentalism, and globalization.

Sarah Jane Johnston: Why is the study of real estate important?

Arthur Segel: Historically, perhaps more great fortunes have been made and lost in this asset class than any other.

At Harvard Business School the real estate course is a synthesis of all the analytic, management, and leadership tools students have learned during their first year. I tell my students my course is about risk mitigation. I hope they will be able to answer the following question after a term in my course: How does one use all the tools learned at HBS to successfully structure deals and companies around the risks in this business?

Q: What makes real estate so interesting?

A: In Finance II, students learn about the Rule of One Price, or why two people do not always pay the same. Students learn what professor Peter Tufano calls the "Matrix of Imperfections" in the capital markets, such as transaction costs, asymmetric information, property rights, taxes, etc., which cause different individuals to pay different prices. Real estate is the most imperfect of all asset classes. A simple example that illustrates imperfections in the real estate market is the high level of transaction costs involved with the purchase or sale of a typical home. There are brokerage, legal, recording, and banker fees.

Q: What do you see as the most important trends in the real estate business today?

A: I see three trends: institutionalization, environmentalism, and globalization.

Over the last decade or so, the real estate business has become increasingly institutionalized, securitized, and professionalized. There are over $5.5 trillion of securitized home mortgages, $500 billion of commercial mortgage-backed securities (CMBS) and $200 billion of real estate investment trusts (REITs), much of which did not exist prior to the early 1990s. Most would argue that securitization has brought greater transparency and more discipline and efficiency to an undisciplined, inefficient market. Unfortunately, there's no doubt that more and better information means it will be harder to be the alpha, as Professor Andre Perold calls it, in the market. You have to dig deeper and work harder. It also means the day-to-day business may be less fun. Further, as in all evolving industries, the risks are not apparently clear in this new world of securitization.

The second main trend has been in the environmental arena from greenfields, grayfields, and brownfields to green construction. Debates on urban sprawl and so-called new urbanism are the rage among developers and academics. Grayfield debates concern what to do with all of those old shopping malls and parking lots in infill locations. (One friend told me the problem with shopping centers in the United States is not that they are overbuilt as much as they are under-demolished.) Regarding green construction, we don't have to look very far from here in Boston to witness a wonderful example, the new Genzyme Building down the Charles River in Kendall Square. It is the most "green" building built in the United States east of the Mississippi. Green construction and green operations are the wave of the future and the United Sates is far behind Europe in this regard.

Finally, American real estate investors have traditionally been pretty parochial compared to their foreign counterparts because the U.S. market is so big and diverse. Today, however, American investors are buying distressed mortgages in Japan, industrial buildings in Mexico, and developing shopping centers in Eastern Europe. Globalization has hit the real estate industry big time. A serious impediment for investors, however, is corruption, which in economic terms is a certain kind of transaction cost or tax or another one of those market imperfections.

Q: How are these trends reflected in your teaching?

A: All of my research and cases over the last several years have been in these areas. During the last two years, I have been especially trying to augment the curriculum with international cases. For example, I wrote a case about a hotel in Barcelona, a shopping center development in Hungary, and the recapitalization of Canary Wharf in London. Currently, most of my focus is on Latin America, but I hope to develop cases in Asia and Africa over the next several years.

For example, I just finished a case on a recent construction of an office tower in Rio de Janeiro with a particular focus on financing issues. The building is being financed in a single building REIT with a series of traunches [bond holder classes] priced differently as the building gets built and (hopefully) leased. I have another case I am working on with HBS professor Dan Bergstresser on a real estate mortgage bank in Argentina that restructured itself during the country's recent collapse—the greatest default of sovereign debt in the history of the world. How is it possible that a month before the collapse, rating agencies such as Moody's and Fitch still ranked the country and the bank investment grade credit? What can we learn? Why did real estate perform so differently than expected? Why are real estate mortgage markets so puny beyond the West and Japan?

The real estate business has become increasingly institutionalized, securitized, and professionalized.

I am fascinated with the works of the Peruvian economist Hernando de Soto and why capital markets do not work in much of the non-West. Why does it take seventeen years on average to buy a home in Peru, or seven years to open a bakery in Egypt? He attributes much of this to the fact that most of the world lacks a tradition of property rights (which is consistent with the imperfections matrix mentioned above), as well as courts and title insurance to enforce those rights. To this end I am working with HBS professor Michael Chu on a microfinance case involving the largest concrete manufacturer in Mexico, CEMEX, and its self-construct housing program for families whose incomes average $3,780 per year. CEMEX has over 80,000 families enrolled in the program that enables them to build their own homes in a quarter of the time and a third of the cost. They hope to expand the program ten-fold over five years and hope to launch similar programs in other countries including Egypt, the Philippines, and Venezuela.

I think by systematically investigating these capital market imperfections in the real estate business and finding best practices, we can begin to unlock the wealth precluded from much of the world. Harvard Business School and the University, writ large, with its tremendous reputation and international stature, offer a unique platform to make a serious contribution in this regard.

About the author

Sarah Jane Johnston is a content developer for HBS Working Knowledge.