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A Disconnect in Real Estate Pricing? Real estate fundamentals have weakened, even as property pricing has soared. Is this a disconnect in rational pricing? Upon close examination it becomes clear that the pricing movement is completely in line with theoretical expectations. Today’s cap rates are driven by low long-term risk-free rates, and improved by long-term NOI prospects and increased connectivity with global capital markets.
The CMBS Market There are a number of tools to assess CMBS value. The first relates to the language of credit performance itself. Property markets overall remain reasonably disciplined; however, there are two yellow flags. Property price firmness may be overdone, and the authors would underweight the apartment sector. They are also cautious about larger trophy transactions, which have been such a major part of 2003 large loans. The second tool is Credit Drift, a proprietary technique that J.P. Morgan Securities Inc. has been using since 1998. Credit Drift deals broadly with discipline, but it also deals with loan-level real estate issues. The third tool grows out of a study of loan underwriting performance. The authors examine the ten largest underwriters, representing roughly $116 billion out of $156 billion of pre-2002 issuance. While large loans come out favorably with implied lower default frequency, the authors think it is important that investors insist on shadow-rating for most large loans. Historically, structuring in large loan deals provided pooled credit enhancement to protect investment-grade bonds. With the proliferation of A/B notes and rake-like structures, that is much less true today.
Reining in Opportunity Fund Fees A cornerstone of the private equity fund philosophy is that general partners (GPs) compensation should reflect performance, and the interests of GPs and limited partners (LPs) should be aligned via the compensation arrangement. This paper examines real estate opportunity fund fee structures and the disconnect between compensation and investment performance that has resulted as markets have changed and returns have declined. The paper proposes fees that represent a continuum along the risk and return spectrum such that GPs are paid for performance relative to the returns they deliver.
Real Estate Returns in Public and Private Markets The relationship between appraisal-based returns on the NCREIF Property Index and transactions-based returns on NAREIT’s Equity REIT Index is reexamined using new data from the modern REIT era. The lead-lag relationship first identified in Gyourko & Keim (1992) whereby current equity REIT returns predict future NCREIF returns is shown to still exist. Further analysis shows that it is the infrequent nature of the appraisal process that is behind this result. Moreover, one should not expect this relationship between private- and public-market returns to change unless appraisals became much more frequent. Finally, we examine the changing correlations of equity REIT returns with broader market indexes and conclude that the lower correlations with the S&P500 index and a small stock index reflect improved investor awareness of the true risk profile of a diversified portfolio of commercial real estate.
Diverging Values and Fundamentals: A Phase or A Transformation? The author examines the capital market forces, supply/demand dynamics and demographic changes that have contributed to the apparent disparity between pricing and fundamentals. Theoretically, capital should become more expensive and scarcer as the risk associated with an investment increases. But, recently, just the opposite seems to have occurred in the real estate market. Despite the weaker property market conditions, liquidity abounds, and asset pricing is rich. Although many factors ultimately will determine how long this disconnect persists, capital market forces, property market dynamics and demographic changes provide some explanation for why the disconnect developed and what features, if any, will endure. While the gap between asset pricing and market fundamentals should narrow as the economy and stock market recover, longer-term forces, such as the lower return expectations for all asset classes, more rational and efficient capital allocation and powerful demographic trends, should continue to be positive influences on the pricing for real estate investments. The author concludes that while some features of the current environment are more cyclical than secular, others will be part of the new normalcy in the market, since they are a reflection of long-term fundamental forces.
Housing’s Changing Role in the Business Cycle Residential real estate has been the cornerstone of the recent economic recovery. One third of the economy’s growth since the start of the decade can be attributed to housing and mortgage market activity. During this period, home equity increased by $4 billion, thus counterbalancing for losses experienced in the recent bear market. Without the strong housing and mortgage markets, the overall economy would have experienced a decline and might still be near recession. Housing and mortgage markets have rarely dampened an economic downturn in the past. Indeed, in every other downturn in the nation’s history, housing markets have exacerbated the economy’s basic problems. The new counter-cyclical behavior of the housing and mortgage markets is due to a number of factors, most important among them mortgage rates at or near 50-year lows. Mortgage rates cannot fall indefinitely and will likely rise with continued improvement in the economy, and housing and mortgage markets will therefore cool going forward. While these markets will cool, they will not collapse due to the integration of the U.S. mortgage market with global capital markets through the secondary market. The availability of fixed-rate mortgages has also increased as a result of the secondary market, thereby helping homeowners weather future increases in interest rates.
Global Trends and Performance Effects in Corporate Real Estate The authors explore trends and performance effects in corporate real estate ownership. Based on a sample of 4,636 companies from 18 industries and nine countries, the authors document that corporate ownership is driven by industrial rather than national differences, with corporate real estate ratios ranging between 0.13 for business services and 0.63 for the mining sector. Overall, real estate ownership appears to be decreasing over time, which may be due to the gaining popularity of lease alternatives. There is a significantly negative relationship between real estate ownership and a firm’s systematic risk. With respect to stock returns, results show that returns are generally lowest among firms with the highest real estate ownership levels in each industry, but the opposite is true for firms active in the hotel, retail, transportation and mining business.
Global Financial Centers After 9/11 Does the post-9/11 transformation of Lower Manhattan presage a fundamental change regarding the advantages of spatial agglomeration in contemporary economies? Despite 9/11, global financial markets appear to continue to depend on concentrated financial centers. New York City and London rank highest according to stock market capitalization and the quantity of specialized corporate services. Tokyo, Frankfurt and Paris rank highest in corporate headquarters and large commercial banks, but New York City ranks far above the rest when it comes to assets of the world’s top 25 securities firms. The corporate services sector in each of these cities varies considerably, with New York and London the largest exporters of legal and accounting services, either directly or through affiliates in other cities. On the other hand, Tokyo and Paris account for 33 percent and 12 percent of assets, respectively, of the top 50 largest commercial banks; London and Frankfurt each account for 10 percent; and New York City accounts for 9 percent. The reasons that financial concentration and agglomeration remain key features of the global financial system, and the network of global financial centers remains crucial for the global operations of markets and firms, are social connectivity, the role of financial centers in cross-border mergers, and the presence of de-nationalized elites.
Cities and Globalization Economic and cultural globalization are unprecedented phenomena, and have led to so-called global cities, which respond to global rather than national or regional forces. Yet cities have always played a trans-national role. From the twelfth to the sixteenth century, city-states in northern Europe and northern Italy were centers of innovation. City bankers pioneered long-distance trade and bills of exchange, accounting, and gold money. In other words, they invented capitalism. With the arrival of nation-states, the largest cities, which the author calls prime cities, had several roles. They were the engines that kick-started and powered the national economies. Goods flowed from the prime city across the nation-state, and beyond. In addition, prime cities were frequently the seats of political power, no longer merely the power of the city itself but the power of the entire nation. When globalization re-emerged as a force at the end of the twentieth century, the prime cities were particularly well-placed to become the command points of the new world economy. Cities were always richer than their surrounding hinterland, but in many parts of the world today, global cities differ not only economically but also culturally, socially, and even politically.
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