When I first went to Wall Street in the early 1960s, many senior corporate executives still carried with them an aversion to debt, an aversion they had developed during the economic depression of more than 30 years previous. Indeed, it took the publication of a book by Harvard Business School professor Gordon Donaldson, Corporate Debt Capacity (Harvard Business School Press, Boston 1967 to reawaken corporate America to the positive characteristics of financial leverage. By the end of the 1980s, Donaldson's message had been broadly received.
This tendency to remember long-term lessons is part of what makes "long-wave" societal and economic behavioral patterns. Such patterns have been identified by economists and social scientists from Serge Kondratieff and Friedrich Hegel and Karl Marx to, in our day, historian Arthur Schlesinger, Jr., and M.I.T. economist Jay Forrester who traces fundamental economic forces through history over 50- to 60-year cycles. In the 1930s, economist Joseph Schumpeter theorized about the "creative destruction" of capitalism, an idea that Michael Jensen, currently a Harvard Business School professor, applies to his analysis of the positive regenerative effects of leveraged buyouts and corporate restructuring.
My point in mentioning long-wave theories is to introduce the view that the period from 1990 to 1994 has ushered in a long-wave structural change in real estate financial markets. As a result of the destructive forces prevailing in this period, individuals involved with real estate financial institutions in the United States and Japan, in particular, have made radical changes in their business behavior that will last for the balance of their careers, far beyond the millennium. Their attitudes toward financial leverage, aggressive financial projections, megaprojects, developer profits, and related issues are resulting in the creative destruction and restructuring of real estate financial markets.
This will happen despite much peripheral noise in the marketplace from the financial press and others anxious to restart the real estate bandwagon. Articles encouraging real estate investment have appeared in the Wall Street Journal, Barron's, and Fortune. Many new real estate offerings for pension funds are in the market. Barton Biggs, Morgan Stanley's investment guru, has suggested institutions might allocate up to 15% of their assets to real estate. Thus, even though banks and insurance companies hold billions of dollars of unresolved real estate assets, new and evolving investment funds are again beginning to push returns on newly acquired property to levels that current cash flows cannot support. This "noise" misreads the current conditions of real estate finance in commercial banks and insurance companies and on Wall Street. Commercial banks or insurance companies account for about half of all commercial real estate loans and investments. Until their real estate holdings conform to the demands of market arbiters and until new forms of real estate financing have been created, they will be essentially out of the market.
For banks, the key constraint on funding is not government regulation but access to the capital markets. Banks need to obtain funding at a cost that provides a competitive spread on their transactions. The more profitable the spread, the better the compensation, the better the ability to recruit high-powered managers, and the lower the cost of equity capital.
For debt capital, the higher the credit rating a bank gets from traditional bond rating agencies such as Moods and Standard and Poors, the lower the cost of debt. And the rating agencies do not like real estate. Thus, the less real estate (and the less bad real estate the cheaper the enterprise's funding cost.
Wall Street security analysts likewise have an aversion to real estate, which serves to augment its negative impact on stock prices and cost of capital. …