The Kellogg Real Estate Conference was held on November 13, 2013 at the Museum for Contemporary Art in downtown Chicago. Over 250 people attended this year’s conference including current Kellogg students, Kellogg alumni, and many locally based real estate professionals. The day’s events began with an alumni luncheon, followed by an economic keynote address, two panel discussions, and a conference keynote address from Jonathan Gray, Global Head of Real Estate at The Blackstone Group.
Economic Keynote Address
Professor Martin Eichenbaum, Professor of Economics at the Weinberg College of Arts & Sciences and Co-Director of the Center for International Economics and Development at Northwestern University, kicked-off the 2013 Kellogg Real Estate Conference with an enlightening discussion of how the economy has performed in the past 5 years and what lies ahead. Most people are familiar with the Great Recession story by now – a housing bubble burst became amplified as banks’ losses mounted on complex derivatives tied to the mortgage market. Professor Eichenbaum, however, offered valuable insights into what drove the creation of this bubble and what amplified the burst.
Why were banks lending to obviously poor credits (in hindsight)? This is easy, delinquencies were low. Why were delinquencies low? Delinquencies were a direct function of home values, since in a rising home price environment, homeowners were loath to give up their most valuable asset. As such, homeowners did everything they could to stay current on their mortgage payments. As soon as housing prices started to decline, the house became the borrower’s least valuable asset. Mortgage delinquencies skyrocketed as borrowers defaulted since they no longer had as great incentive to stay current on their mortgage.
So what turned the housing bubble burst into the Great Recession? That’s a bit more complicated, but as Professor Eichenbaum explained, it was essentially due to a run on the shadow banks. “Old-fashioned” banks borrowed short (deposits) and lent long (mortgages). The shadow banks did the same thing – borrowed short and lent long – except their short-term borrowings were from each other and their long-term lending was in the form of complex bets on mortgages. As the value of their long-term bets declined due to the burst housing bubble, banks stopped lending to each other citing counterparty credit risk. As a result, banks could no longer fund their own activities, but more importantly, they couldn’t fund corporate Americas’ needs. Broadly, it was this freezing of credit due to a run on the shadow banks that turned a housing crisis into the Great Recession.
But the Great Recession is behind us now, so what lies ahead for the real estate world? Professor Eichenbaum focused on three things: 1) interest rates, 2) inflation and 3) state/municipal finances.
Intuition would tell us that yield based investments, such as real estate, decline when interest rates rise, and we know that interest rates must rise from their current levels. However, rising interest rates follow strong economic output, which tends to have a positive impact on real estate.
A lot of people believe inflation is right around the corner; however, it hasn’t begun to show up. The Federal Reserve and public sentiment do not believe it is an issue. And capital markets don’t see inflation surpassing roughly 2% for the next 10 years (calculated from the spreads between regular and inflation-protected Treasuries). So inflation doesn’t seem to be an issue for the foreseeable future. Then again, if you asked if we were in a housing bubble in 2005-2006, the Federal Reserve would have said no, public sentiment would have said no and the capital markets would have said no. John Paulson would have said yes.
Finally, Professor Eichenbaum discussed state and municipal finances, which he viewed as the greatest threat to real estate investors and developers, depending on the location (ahem…Illinois). Several state pensions are massively underfunded. Furthermore, the ability to continue to kick the can down the road is getting more limited. For instance, Illinois is forecast to be spending 48% of current revenue on pension obligations in 2019. Luckily, these are solvable financial problems, but solving them will require sacrifices from all stakeholders. Real estate professionals need to think carefully about the implications of their state’s and their municipality’s financing situations and what overcoming any hurdles means for the investment environment.
Panel 1: Taking Shape: Development, Revitalization, and Usage
Scott L. Goodman, Founding Principal of Sterling Bay Companies moderated the day’s first panel. The panel included Curt Bailey, President of Related Midwest; Steven Koch, Deputy Mayor of Chicago; Daniel T. McCaffery, Founder and CEO of McCaffery Interests, Inc; Bill Rogers, Internal Director and Broker Leader for Jones Lang LaSalle; and Adrian Smith, Partner for Adrian Smith+ Gordon Gill Architecture.
The panel focused on development in Chicago going forward and discussed how the city has differentiated itself from its suburbs, other US cities, and international cities. When comparing Chicago to its suburbs, Mr. Rogers noted that firms are continually moving downtown to attract top talent.
Mr. Bailey quickly pointed out that in addition to office space, great multi-family buildings are in demand by the same workforce. He added that rental buildings are now “functioning at a higher level” to meet the demands of Chicago’s highly educated population. In addition, the panelists agreed that the availability of affordable housing would continue to be extremely important to the city of Chicago, as the general workforce is the engine that makes the city of run. The panel also discussed competing against the Chicagoland suburbs in terms of long-term homes for families. Mr. Koch, while mentioning safe streets, great schools, and a great economy as the three most important things to the Mayor going forward, said great schools are the number one way to get families to stay downtown longer.
Later, Mr. Goodman asked the panel to discuss Chicago’s positioning nationally and globally. Mr. Koch initially talked about how Chicago had “won the battle” as the dominant Midwest City, and is currently enjoying a thriving economy. Mr. Smith then brought the discussion more national. He believes Chicago, when compared to the major coastal cities, is uniquely positioned to grow due to lower taxes, land costs, and rents. He added that Chicago’s airports and education systems are also huge advantages.
When comparing Chicago to cities abroad, such as Dubai and many Chinese cities, it was clear that higher regulation and labor rates in Chicago (and the US in general) are a headwind for development. However, in regards to regulation, the correct answer going forward was not clear. Mr. McCaffery noted that Chicago is bound up in regulation, which can delay the development process immensely. Mr. Rogers quickly pointed out that, at least partially due to regulation, all commercial buildings opening in downtown Chicago over the last 15 years “have been opening up 90% pre-leased”, calling them “huge successes”. The panel agreed that regulation and zoning are very complex matters. Mr. Koch summed it up perfectly by saying “regulation is an ebb and flow that’s hard to get right”.
The panel concluded by Mr. Goodman asking for the panelists’ opinions on where we are in the real estate development cycle. There was agreement that we are somewhere in the trough. The panelists seemed to think that development projects starting now will be in good shape going forward. Panel 2: Sources and Uses: New Perspectives on Capital
The second panel of the day, which focused on trends in the Capital Markets, was moderated by Michael van Konynenburg of Eastdil Secured, with panelists Wendy Silverstein of Vornado Realty Trust, Charles Purse ’85, of Park Hill Real Estate, and Jonathan Pollack of Deutsche Bank.
The panelists indicated that they are currently watching the Federal Reserve to see if there will be any significant changes in monetary policy; however, they noted that so long as unemployment stays high and inflation remains low, the Fed will likely not change course. Mr. Purse indicated that the market is currently pricing interest rates to remain low for the next 3 years, based on a broad belief that the Fed will hold course. Furthermore, Mr. Pollack noted that the holdings of debt investors have amortized faster than they have been replaced; he related that he has been oversubscribed by five times on a recent CMBS issuance due to limited supply and strong demand. He believes that supply-demand fundamentals will ultimately prevent interest rates from rising precipitously.
It was noted that there is a significant amount of liquidity in the market, as Fannie Mae and Freddie Mac has continued to provide financing to the multifamily sector, including $85BN in new issuances this year. Positive momentum in the lending market has allowed sponsors to finance projects that they had not been able to earlier in the cycle; this has cause an increase in both investment sales volume to $250BN, the most since 2006, while pricing for malls, apartments and strip centers are now above their previous cyclical high. Despite this, Mr. Purse noted that the only way for an investor to close a $1BN loan is through the CMBS market, so a continued revival in this market will be crucial for larger deals to close.
Ms. Silverstein noted that dynamics in the REIT market have changed as well, citing Vornado’s decision to raise a private investment fund in 2010. She noted that due to challenging capital markets in 2009, her firm made the decision to raise money outside of the public realm; this also allowed them to do smaller deals with joint venture operators. Citing a recent $1.2BN deal Vornado closed with 4 co-investors, she indicated that she believes that working with joint venture operators will become a greater part of Vornado’s business on a go-forward basis, especially in space constrained markets such as New York, where deals can be very expensive. Additionally, working in JV structures allows them to take on partners who can operate parts of large projects that are outside of Vornado’s core business, allowing them to spread their risk on large projects.
Mr. Purse noted that there has been an acceleration of money moving into funds run by managers with whom institutional investors have had previous relationships. He noted that the skew has been towards larger managers, with smaller firms finding it difficult to raise money. Furthermore, as the stock market has recovered, institutions have realized that their portfolio allocations are short on real estate investments, so they have been rebalancing and putting more money into commercial real estate. However, he also noted that investors are looking to reduce spreads, so some of them have been going directly to operators rather than through fund managers.
The panel concluded with a discussion on the panelists’ outlook for their respective areas of expertise. Mr. Pollack indicated that he is very bullish on impending loan maturities, as they will generate significant business for the banks over the next few years, but he indicated that bank pricing power will be diluted on difficult to finance assets as spreads compress. Ms. Silverstein added that she believes that core markets, such as New York, will outperform the general market, but cautioned that mayoral change in New York City creates uncertainties in the market. Mr. Purse concluded with his thought that 2014 should be a strong year for the commercial real estate market as lenders continue to improve their balance sheets.
Conference Keynote Address
Jonathan Gray, Global Head of Real Estate at The Blackstone Group, delivered a dynamic keynote address. Since joining Blackstone in 1992, Mr. Gray has helped build the largest real estate platform in the world with more than $69 billion in assets under management. Blackstone’s portfolio includes hotel, office, retail, industrial and residential properties in the U.S., Europe and Asia.
Mr. Gray began by providing his own top-down view of Blackstone’s real estate business. He explained that a cornerstone of the group’s strategy is continuity and consistency within their investment committee. Blackstone strives to have a uniform culture (despite operating globally), and thus employs a standardized review and analysis of investments – regardless of their locale. The company also prioritizes allowing their employees to get experience in different global offices, again with the goal of developing a unified culture despite offices located around the world.
Mr. Gray also gave some insight into why Blackstone continued to invest in real estate throughout the financial crisis and housing market downturn. Certainly, the environment was ugly; there was a significant global slowdown in economic growth, a related rise in unemployment, and an unstable global political climate (for example, the debt ceiling issues in the US and the Eurozone crisis abroad). However, Mr. Gray argued that despite the negative backdrop, his group saw positive fundamentals for real estate and found opportunity despite the general distress. Construction was falling more than growth, meaning occupancy and rent levels were both trending higher. There were fewer opportunistic competitors in the market, in part due to regulatory changes and in part because other players lacked capital. Blackstone identified a range of distressed opportunities including the CMBS loan market, income-producing shopping malls for sale at foreclosure auctions, and single family homes in default that needed construction and management upgrades. Blackstone decided to invest despite the crisis and remains bullish on real estate today.
Factors contributing to this view include continued historic low levels of new construction and supply, as lenders remain conservative. Additionally, Mr. Gray believes that US home prices should track the currently improving economy more than be hindered by future increases in interest rates. He also thinks that fundamentals continue to improve in the emerging markets where Blackstone invests; for example, growing urbanization, a rising middle class, and increasing consumption should continue in many Asian countries. China has recently posted double digit increases in same-store sales. Blackstone is actively involved in malls, office parks, and other big investments in such growing economies.
Mr. Gray also discussed what he thought would be some key trends in real estate going forward. First, he highlighted the growing presence of sovereign wealth funds in the arena. These players are attracted to real estate because of the higher yield on the investment in the current global low yield environment, and the inherent inflation hedge in real estate to protect them in the future. He expects their activity in the sector will grow, especially in gateway cities with appealing tax systems. A second development to watch going forward will be the importance of public markets in commercial real estate. Mr. Gray thinks that public companies will continue to see attractive borrowing costs and have fewer liquidity issues, and thus commercial real estate funding should continue to shift away from the banks that are struggling with increasing regulatory demands, existing loan portfolio maintenance, and ongoing capital constraint issues.
The audience had many questions for Mr. Gray on a range of topics. For example, one attendee wanted to know any tips he had for professional progression; he said never to accept conventional wisdom on anything, to never be afraid to speak up (provided you know your facts), and to follow the simple recipe of working hard and caring deeply about the quality of your work product. Another attendee was curious if he thought the Eurozone would stay intact; he does believe it will, although he thinks it will be in a prolonged period of slow growth with potentially some minor crises (and headline risk) along the way. A third person asked his opinion on the current domestic underfunded pension fund crisis; he doesn’t think the situation will crescendo out of control (in part because of general improvement with the markets), but he does think some tough choices might need to be made down the road by the government.
Mr. Gray’s keynote address was an inspiring way to close the conference; attendees left with a sense that the real estate is just going to grow increasingly more exciting in the next few years. We look forward to seeing how 2014 unfolds.