Just when you thought that things just couldn't get any better-the lowest vacancies in 20 years on almost every property type, stable rental rates, rising property prices, mortages available at loan-to-values unseen since the '80s, booming stock market-?
In case you have been so busy celebrating for the last three months that you forgot to read the paper, let's just say that a few things have changed. The S&P approached Christmas with almost daily volatility. Loan point spreads doubled. And the dread words "credit crunch" were heard again. But for many real estate practitioners, pointing in vain to the best fundamentals in a decade, the question is "Why?"
As Stan Ross, vice chairman and managing partner of E&Y Kenneth Leventhal Real Estate, noted in October at the ULI conference, "For once, it is not real estate's fault, but we will still get blamed."
It's The Capital, Stupid
The good news is-the capital markets worked. All the discipline that real estate analysts have been predicting the public markets would provide really happened-and with a vengeance. Prices and rates that might have taken 18 months to adjust in the old private market went from boom to crisis in 45 days.
The bad news is-the public market worked.
As concerns about overbuilding and overpricing grew, the markets acted-rapidly and roughly. REITs were the first to feel the pain, as share prices fell across the board. "REITs have not had a year this bad since 1990," says William K Morrill, chairman and CEO of ABKB LaSalle Securities. Morrill notes that a recent ABKB study found that the NCREIF Index of pension fund investments had outperformed the NAREIT Index only five times in the last 20 years. In September 1998, however, the pension funds were as much as 30 percent in the lead.
Morrill attributes the REIT decline to a variety of reasons, including $8 to $10 billion of new equity issues in the first quarter of 1998, the negative publicity from federal regulation of paired-share REITs, stock overhang from mergers, and the withdrawal of "non-real estate REIT buyers" when growth momentum slowed. The result was a 20-percent decline in REIT share prices from early year highs.
Finally, global economic concerns over Asia, Russia, and Latin America dealt the final blow. As the S&P fell by 20 percent, the capital markets reeled, and real estate reeled with them.
"This drop just proves that capital knows no boundaries. What happens in Indonesia affects industries worldwide," says Jon Fosheim, principal, Green Street Advisors.
Concerns about overbuilding and loosening of lending requirements in recent months also contributed to the markets swift reversal. The pace of building permits in early 1998-if projected forward on a straight line basis-would have clearly created oversupply. "The market reacted not to overbuilding but to the prospect of overbuilding; it reacted to the presence of cranes," says Dale Anne Reiss, managing partner, E&Y Kenneth Leventhal Real Estate Group.
"The market anticipated weakening fundamentals, although they have not shown up yet," says John Kriz, managing director of real estate finance, Moodys, before a recent ULI audience.
The new REIT market and the CMBS market have not been tested in down cycles, notes Jonathan Litt, senior real estate analyst, Paine Webber, Inc. In part, he believes that the severity of the recent downturn reflected Street uncertain as to how these vehicles would respond to adversity.
If REITs were the harbingers of a shift in capital, the crashing halt in commercial mortgage backed securities was nothing less than a "virtual meltdown of the credit markets to all but the best properties," says Richard B. Saltzman, managing director, Merrill Lynch & Company. Turmoil in the bond market has spilled over into mortgage lending. The razor-thin profit margins of the conduit lenders evaporated as spreads widened. …