12 Mar 2007  Research & Ideas

The New Real Estate

Real estate continues to defy revert-to-the-mean gravity to deliver handsome returns to investors. Professor Arthur I. Segel looks at the latest developments in the field and also considers several warning clouds that could darken the picture. Key concepts include:

  • Fueled by a world awash with liquidity, real estate is creating returns for investors that outshine many other asset classes.
  • Last year (2006) was notable for record-breaking real estate prices, inventive new capital market instruments, growing interest in sustainable development, and opportunities in emerging markets.
  • There is no telling when this bull market in property will end, but investors should note that REIT dividends are at an historic low, housing markets are taking their lumps in the U.S., Australia, and Great Britain, and sub-prime foreclosures have risen significantly in recent months.

 

How long can the real estate boom last?

No one knows the answer, but this is the most exciting time in real estate during my almost thirty years in the business. The world is awash with liquidity, and real estate is capturing much of it for three reasons.

First, because of the stock market crash of 2001, real estate has become a legitimate asset class and a good diversifier from stocks and bonds. Second, with graying populations in the West and Japan, real estate is particularly appreciated because it is a strong generator of current cash flow needed to pay pensioners. And third, the returns relative to all asset classes have been enormous.

Let's take a moment on this last point, high returns relative to other investments. The public real estate markets as recorded by the Dow Jones Wilshire Real Estate Securities index for the period ending January 31, 2007 (and before the recent market downswing) was 30 percent over the last three years, 26 percent over the last five years and 16 percent over the last ten years. This compares favorably with the S&P at 10 percent, 7 percent, and 8 percent, and even well against Emerging Markets equities at 29 percent, 25 percent, and 8 percent over the same time. (It should be noted that over shorter periods, some emerging markets such as the Hong Kong Stock Exchange and the SENSEX index for the Bombay market last year grew by 84 percent and 48.5 percent respectively.)

Investors are witnessing improving fundamentals (increasing rents and decreasing vacancies) coupled with continuing low interest rates.

During the last year, we saw four big stories in real estate that underscore this continuing-to-boom market: record prices, new capital market instruments, and growing interest in both sustainable development and emerging markets. Here is a survey of what is happening in these four areas:

Record prices

Record prices are being paid for property in the U.S., but also in Europe and Asia. In the U.S. records were broken for the most paid for a single building ($1.8 billion for 666 Fifth Avenue in New York City), the most paid for one project ($5.4 billion for Peter Cooper Village, also in New York City) and now the second largest LBO ever after TXU ($39 billion takeover of commercial property owner Equity Office Properties Trust).

Investors are witnessing improving fundamentals (increasing rents and decreasing vacancies) coupled with continuing low interest rates. This is providing a huge arbitrage play between the public and private markets and a "de-REIT-ing" or privatization of approximately $90 billion last year. These privatizations occurred even though 2006 witnessed a surge of U.S. REIT returns of 35 percent for the market as a whole.

New capital market instruments

The press and Wall Street are focused on the 24 countries which now have REITs and the 28 countries which are expected to have REITs over the next 18 months. But the new, new thing in the world of real estate capital markets is the world of property derivatives. Derivatives help investors deal with the cumbersome, expensive, and timely nature of buying and selling real estate. Through synthetic derivative instruments, investors can rebalance portfolios and transport "alpha" from one portfolio to another to optimize diversification and reduce risk. This is the new world of real estate finance which, as my friend Harvard Business School professor Andre Perold will argue, is just catching up with everyone else.

Sustainable development

Sustainable development hit a "tipping point" last year. Fifty city mayors are insisting that new construction in their cities be "green" and LEED (Leadership in Energy and Environmental Design) certified. While the LEED system of classifying green construction is far from perfect, it goes a long way to improving the inefficient waste of resources we use today. Building codes are finally being rewritten, although the U.S. is still far behind Northern Europe. The real challenges will be in rewriting zoning codes, redensifying communities, and creating area-wide planning especially difficult in tradition-bound New England.

Rumania and Bulgaria probably had some of the best real estate market returns anywhere.

Green real estate development in dense locations in our urban centers could have an enormous impact on our energy use. The average home owner in the U.S. suburbs today, according to Jonathan Rose Companies, uses 240 BTUs (British Thermal Units) per year for heating and transport versus 143 BTUs for the average U.S. city dweller. If the city dweller lived in a green multifamily building and drove an energy-efficient Prius, his average use would drop to 62 BTUs, a savings of 75 percent from the average suburban U.S. household. Cumulatively, this is a huge difference in energy usage and would have a profound effect on our economy, not to mention our national security.

Emerging markets

There is tremendous real estate growth in emerging markets. If the U.S. is replacing under 2 percent of its physical stock, China is building 75 percent. I witnessed this firsthand as I trudged through Beijing developments last summer and saw some of the 142 new facilities being built for the 2008 Olympics.

Another sign of emerging growth: India has at least 150 new real estate funds. Gurgon and Noida outside of Delhi have dozens of new shopping malls where you sometimes see more camel and donkey carts (now there's green energy!) than autos parked outside. India's 300-million-strong middle class is hungering for consumer goods and decent homes. Despite the lack of infrastructure, this year 10 million cars will be sold.

And since Mexico was reclassified as a part of North America, as opposed to Latin America, by CALPERS a few years back, huge amounts of capital are being poured into that country, notably in the housing and retail sectors with office bouncing back strongly. The next big market poised for large scale investment will be Brazil.

Moscow, the largest city in Europe with 15 million people, has 4 million square feet of office space—one-seventh the space per capita of London. But the picture is changing rapidly. After eight years of continued growth, Muscovites want to spend, and huge amounts of development are underway. The early perestroika days when real estate developers could command six years of rent upfront before the building was even built have been reduced to six months. Unlevered going-in returns of 30 percent on costs are now 14 percent or less. And last year, Rumania and Bulgaria probably had some of the best real estate markets returns anywhere.

Where does it end?

Everyone knows that the "darling" of the day is already sowing the seeds for the next downturn. People can debate whether this boom is a mania or a paradigm shift. But there are warning signs. REIT dividends are at an historic low of 3.6 percent or 100 basis points below the risk-free ten year Treasury, and 400 bps below where they were just four years ago. Housing has already taken its lumps in the U.S., Australia, and Great Britain with possibly more on the way. And sub-prime foreclosures have risen significantly in recent months.

The boom may end when interest rates rise from a falling dollar or if there is a surge of commercial overbuilding around the country. A political or terror event could bring things to a halt. Most likely, it will be something unexpected that stalls real estate. It's anyone's guess. But history has taught us one lesson: In the end, even real estate will revert back to a mean and return to earth just like every other asset class.

About the author

Arthur Segel is a professor in the Finance and Entrepreneurial Management units at Harvard Business School.