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2010 Spring Members’ Meeting Summary

More than 400 members and their guests attended the 2010 Zell/Lurie Spring Members’ Meeting, Tuesday and Wednesday, April 27-28 at the Rittenhouse Hotel in Philadelphia.

Lawrence Summers, the Director of the White House National Economic Council, was the dinner speaker and also special guest at a private Colloquium and cocktail hour for Research Sponsors. At dinner, three exceptional members and noted real estate professionals who had passed away recently were remembered: Claude Ballard, Max Farash and Bob Larson. Assistant professor of real estate Fernando Ferreira then announced the scholarships and awards for this year’s students and faculty.

Robert Lieber, Vice Chair of the Zell Lurie Center and New York City’s Deputy Mayor for Economic Development, opened Wednesday’s session by speaking briefly about Dr. Summers’s presentation. “He set the stage to talk about what’s going on in real estate markets here and around the world. In the last 37 days, there’s been a complete change in people’s view of real estate… Once again there is confidence, enthusiasm, and balance of what the opportunities really are.”

The Center’s director, Professor Joseph Gyourko, welcomed the audience and thanked long-time Center Research Sponsor, David Marshall, owner of the Rittenhouse Hotel, before introducing the first panel.

A Conversation with Sam Zell opened the day with Peter Linneman, Albert Sussman Professor of Real Estate, Finance, and Business and Public Policy at Wharton, sharing the stage with legendary real estate tycoon Sam Zell, engaging in sometimes lively dialogue. They first fondly reflected upon four influential men in the industry who passed away in the past year: Claude Ballard, Max Farash, Bob Larson, and Mel Simon.

Linneman’s opening question got right to the point: “Where do you think we’re at in the economy as it relates to real estate in the United States?” Zell’s reply also got right down to the main issue: “If everybody in real estate business focused on the core issue—supply and demand—all the other factors, ideas, and concepts would go away.” Zell noted that since July 2007, apartments have been the only real new building going on in the country. At the same time, the U.S. is in a demand recession. All the past down cycles (in 1974, 1981, 1990) were oversupply problems. This time it’s a lack of demand, due to the large job loss of 8.2 million jobs in 18 months. There are those who say those jobs can’t be added back, and Zell said if they are right, the country’s inflation will continue to rise, with the suburbs most drastically impacted, especially as easily exported jobs are sent overseas. “We’ll see core city center real estate doing well, though,” he added. “I see a slow recovery, but I don’t know how long [it will take].”

Zell went on to say that the environment isn’t as ripe for “grave-dancing opportunities” as it was in the late 1980s and early 1990s, and those who are waiting for those chances may have a long wait. Another factor that makes this time different is the overlying philosophy of “cut our losses and move on.” “Really, the real value of the asset between the time of trouble starting and time of resolution is starting to get better… equity is coming back, and trends have turned from negative to positive.”

Zell used the hotel/hospitality sector as an example. “A year ago, the hotel business looked like an elevator shaft. One after another got into trouble, but they reorganized, they didn’t foreclose. In the past year it’s started to come back up, occupancy is better.” “It’s like the stock market. A year ago there was no perceived ‘tomorrow.’ Now there clearly is a ‘tomorrow.'”

Linneman wanted to know if Zell, as “one of the Pied Pipers of modern REITs,” felt that these instruments had withstood the recent “stress test” as he imagined they would. Zell answered that liquidity equals value, and the net effect has been that people were able to sell low and gain what is more valuable now—cash and liquidity. “The structure and access to capital worked exactly as we had hoped it would work when we set it up.”

The two men talked briefly about the current Administration, investor and contractor regulations, and the goals in Washington today. Linneman asked, “Have the days of dynamism ended in the U.S.?” To which Zell replied, “If the policies of this Administration continue in their current form, it’s hard to imagine we’ll return to the historic dynamism of this country. The world has changed a lot, and we’re not as far ahead in it as we used to be. And yet, the perception is still that of the American Dream, and people are still coming here.”

They went on to discuss pros and cons of investing in various emerging markets, including Western Europe (“It’s like Disneyland,” said Zell) Russia (trading growth for the lack of the rule of law) India (intriguing but bureaucratic system that inhibits efficiency) China (a command economy that makes doing business difficult) Japan (closed society with a decreasing population) and Brazil (an extraordinary and positive experience).

The men closed the conversation with several questions from the audience dealing with financial difficulties currently being experienced by certain European countries, most notably Greece, and the risks these pose to the dollar. And then Zell unveiled his current mantra: “Come clean by ’13” predicting that in a year the situation will be “more stable, with clearer visibility, but still at least two years away from anything you and I would call normal.”

The first panel, “What should we expect from the economy going forward?” was moderated by Susan Wachter, the Richard B. Worley Professor of Financial Management at The Wharton School, and Professor of Real Estate, Finance and City and Regional Planning. Two of the panelists, Peter Linneman and Joe Gyourko, reprised their optimist/pessimist roles from a similar panel in October, joined by the third panelist, Richard J. Herring, Professor of International Banking and Finance. Linneman, billed as the optimist of the group, believes jobs recovery will begin this summer, and predicts three million jobs a year will be added over the next three years. “Population growth is still occurring and everyone needs jobs and goods. Six million of the 8.2 million jobs lost in the last 18 months were largely lost due to panic. When a panic subsides, you need to get on with normal life, which is corporations making money… and bringing people on board.”

Gyourko was less pessimistic than he had been in the fall, and feels now that recovery is real. He believes job recovery will occur at about half the rate predicted by Linneman, with real robustness returning in about 18 months.

Herring reminded the group that several large government programs—such as cash for clunkers and the incentives for first-time homebuyers—were responsible for the “green shoots” visible in October. “But the government is running out of ammunition, and there is danger in the financial system, where there is a lot of complacency, and lots of institutions are adopting bigger aggregate risk.” He went on to compare the location of the banking system at this time to the red zone on a forest-fire warning sign, suggesting the models showing positive results may have been manipulated to look better than they are.

Wachter asked the men to comment on whether equity markets are ahead of themselves. Linneman said that by definition, they are supposed to be, but they may be too far ahead, depending on the market sector. He’s optimistic that the surge in apartment rentals will happen as soon as jobs begin to become more plentiful. Herring commented that he feels the banking system is showing a revival because the Fed has driven the short end of the yield curve to nearly zero. “That’s a wealth transfer from risk takers to the banks.”

He said there is a real concern about a double-dip recession; a variety of circumstances could disrupt the recovery, and inflation could actually help them out of their problems. “But they have more than doubled their balance sheets, and $1.3 trillion is in mortgage-backed securities, which will hamper them… Fannie and Freddie have become a dumping ground.”

Gyourko believes rates will be 100 basis points higher next year, and sees inflation staying “fairly modest over the next year.” “But it could be higher,” said Linneman. “I can see 5 to 8 percent happening with the Fed fire-fighting after the fact, putting things almost back to where they were in 1979.”

The panelists all agreed that a failure in the Greek markets could put U.S. banks at risk; even though the U.S. doesn’t have direct exposure to Greece, world markets are tightly integrated at this point.

Wachter asked the panelists if they saw any clear geographic opportunities. Gyourko believes multifamily housing will lead the recovery, agreeing with Linneman, although not to the same degree. “As soon as those under 25 get jobs, they’ll move out. So for medium term, I like multifamily. Everything else is a long slog.”

Linneman addressed the geographical question by reiterating that higher growth will occur where people want to live, mainly in the southwest and Florida, and will begin as soon as there is more liquidity in those markets.

The keynote address took the form of another “conversation,” between Joe Gyourko and William Ackman, CEO and founder of Pershing Square Capital Management, on the topic, “Corporate Governance, Investment Strategies and Real Estate.”

In his introduction, Gyourko told the audience that Ackman has the “strongest links to real estate” through his father, Lawrence Ackman, and grandfather. He asked about Ackman’s thoughts on corporate governance. “When I first started out, I didn’t think much about corporate governance,” Ackman answered. “Look at the big failures; I blame the boards of directors. What’s happened to capitalism? A real separation has developed between the people taking the risk and the directors,” allowing for an increase in problems.

Ackman continued that he feels that the best way to alleviate many of these problems would be to insist on competing slates for board seats. As things stand today, usually shareholders can either vote for the candidate the board puts up or withhold their votes. “This will put boards on notice, and it could be embarrassing. It’s not something directors are used to, and will improve the quality of director candidates.” He added that Sweden is an excellent example of a country that does this.

“But how does this solve the problem of risk-taking with others’ money?” Gyourko asked.

“Well, going on boards is not retirement. It’s actually a real job,” answered Ackman. “You want meaningful owners on the board who care and who are not management. Those who have skin in the game, and lose money if it fails, and are not on lots of other boards, so they can devote time that’s needed.”

Ackman went on to detail his company’s experience with the giant retailer, Target, and the potential risks they were taking through the amount they had invested in their credit card portfolio. Target built its credit card business at a time all other retailers had transferred their receivables to banks, effectively creating a portion of their business that acted as a bank. His ideas included establishing a new REIT, contributing land under every store, leasing it back to the company that would pay a yield that would increase with time, creating a secure cash flow stream. “We believed that the REIT would trade at a value equal to the market capital of all of Target. We all thought it was a good idea.” Unfortunately, the final presentation was made within weeks of the failure of AIG, Lehman, Fannie and Freddie, and the atmosphere and perception was one of distrust and fear, so the deal ultimately fell through.

Gyourko wanted to know how Ackman approaches investing in general. With a background in real estate, Ackman said he looks for businesses that offer a high degree of predictability. “I like recurring, regenerative things, like buildings… I want high-quality businesses with moats around them, as Warren Buffett would say. My investments are varied, and I try to avoid the uncertainty of the income stream. I read the paper, and things pop up,” he ended simply.

The men ended their conversation with a discussion of a possible merger of Fannie and Freddie to make them more efficient and free of taxpayer support. “I am 100 percent convinced this will happen. It’s just a matter of time,” Ackman said.

The third panel, “Capital and Deal Flow—Yesterday, Today, and Tomorrow,” was moderated by Todd Sinai, Associate Professor of Real Estate and Business & Public Policy. Panelists were Roy Hilton March, CEO, Eastdil Secured; Andrew J. Jonas, managing director, Goldman Sachs; Charles R. Spetka, CEO, CW Financial Services; and Mark L. Myers, Group Head/ Executive Vice President, Special Situations, Wells Fargo.

Sinai led off by acknowledging that there is “more buzz and excitement than there was a year ago.” Then he asked the panel, “What deals are getting done and how do they compare to six months ago?”

March offered his view that the first quarter of 2010 is up, at $36 billion total transactions over $25 million, which is still at pre-2001 volume levels. “The rate of increase over the last 30 to 45 days has increased significantly, with $8 million book in equity sales as of March 15 just in equity sales.” There are good and bad sides to the situation, or as he put it, “trophy or trauma,” where people who just want to get cash invested have driven yields down significantly, but on the negative side. “It’s all about basis,” he said. “We’re pricing on a levered basis across the board, in every product type.”

The panelists agreed that they did not think pricing would be at this rate two years ago, and that it’s surprising because of its sudden nature. March said, “It feels as if there is a scarcity premium on these transactions at this point to get the money out and get it to work.” Todd questioned who is selling, to which March replied, “…funds trying to rebalance their portfolios; special servicers; insurance companies lightening their load; bigger funds wanting some wins—across the board, it’s relative to who’s out there selling them, and it’s modest in each.”

Sinai then asked Mark Myers if he was selling. Myers said he is, but the debt market is at about $3 trillion or $4 trillion, with many banks calling up real estate loans, many of them stressed, bridge and others, with an overall default rate of about 10 percent. “Banks today are sitting on $185 billion in problem assets,” he added. Myers continued to explain that the special situations unit formed when Wells Fargo and Wachovia merged was intended to be liquidated over time. The portfolio of its customer balance is about $40 billion. “This comes from all walks of life, from small balance loans to large project loans, and remnants of CNBS business. This distressed number will continue to grow,” Myers predicted.

He continued to explain how this unit is dealing with that large number: “Hoping and praying is a bad strategy. We’re being proactive and taking an asset-by-asset approach.” They may sell the loan back to the borrower; sell it back into the open market; restructure the loan; sell with a participation; or foreclose if that makes the most sense. Myers explained the challenges in dealing with this huge number of distressed properties as they relate to all banks and the FDIC and the number of banks they’ve taken back in 18 months—150.

Charles R. Spetka explained that CW Financial Services is vertically integrated as a lender, servicer, and special servicing business, and its portfolio of loans is more than $20 billion in less than two years. “We’ve seen the market coming our way … there’s equity available to fun deals, but how can you leverage returns? We need to ensure we’re not buying into high-risk profiles, and in the last 60 days, we’ve been moving more assets and seen the market get aggressive.” Spetka added that his company is dealing with structured, complex deals that require a lot of strategizing. “Every deal is like a little chess game requiring lots of time to think about it. It’s very intellectually interesting as we try to unwind all this stuff we created as an industry.”

Discussion continued about the pipeline of properties on the market, with Myers saying that a challenge to lenders is getting the asset back. “Borrowers are now emboldened to fight to preserve their options.”

Andrew Jonas said the number of loans people can get now have increased from just a few several months ago. “Now you’ve got lots of banks and insurance companies. That’s all changed dramatically. We see 70 percent financing now for a five-year deal in the low five’s, making it attractive. Prices will go up as more people put properties on the market.”

“Everything is financeable to price,” added March. “That wasn’t the case a year ago. Land and hospitality are hard to finance, but even those are being financed.”

“Other than prices being down 50 percent, it feels like we were before, except nothing is selling,” said Sinai. “Where are the equity markets?”

Jonas replied that they’re being driven by overall capital markets for equity debt. One point he made was that REITs were “disciplined—giving investors confidence. And investors have rewarded them by pushing up stock prices.” Although they’re still below the peak, he confirmed overall things are better than several months ago. “Today it feels easier to raise public capital,” he added. “Going forward, the public market will have the advantage until we get back to 2005 or 2006 levels, although we may not get back there.”

In reply to Sinai’s request for a prediction of the future of capital markets, the panel was in agreement that the market has come back faster than expected, although they cautioned that what happens in overseas markets affects those in this country. “All the markets are so interconnected there is substantial risk,” said Jonas. “If things get worse around the world, that will have a significant impact on our markets.”

The final panel, “Investment and Structuring Challenges Facing Real Estate,” moderated by Robert Lieber, Deputy Mayor for Economic Development for the City of New York, featured panelists Dean S. Adler, CEO, Lubert-Adler Management; Inc.; Keith F. Barket, Senior Managing Director, Angelo Gordon; and Spencer Haber, CEO, H/2 Capital Partners.

Lieber opened the session by asking panelists to comment on how their views of the markets have changed in the past year and about the challenges that continue to face the markets on a daily basis.

“A year ago, there was a liquidity crisis that led to a fundamental crisis, which was true across most financial markets,” said Haber.

“We were coming out of a cycle started in October 2008, one of total panic and fear where we wondered how bad it could get, and then it all froze up,” added Keith Barket. As government programs took effect, some stability was felt, although the overall process takes time to take hold. “It’s not surprising that it takes so long for people to start selling their assets,” Barket added. “No one wants to sell for half what they were worth. We think selling has started, and we can see that economy isn’t going to fall off the cliff, and lending and recapitalization that needs to occur is just starting.”

Dean Adler agreed with Barket’s assessment that the deleveraging process has just begun. “As a private investor, you need to be specific and focused. Pick off a few things over the next six months and have patience. As more product gets on the market, rates will come up, giving real estate people the chance to get back in the market at the right pricing.”

Haber spoke about his experiences working with the FDIC, but believes the FDIC model is not the most efficient way to do business. “We’re doing deals direct and finding interesting stuff directly with borrowers. We just need to be patient.”

“But are we going to run out of capital as goods come in?” asked Lieber.

“We’re grossly overstating this crazed marketplace right now,” Adler replied. “Prices are crazy.”

Discussion continued about financing: it’s there, but it’s still based on reset values. The marketplace continues to be small, which skews the valuation. Panelists agreed that what’s being seen now is only the beginning, and it’s difficult to know whether capital will flow or dry up. “No one in the real estate business has ever been very good at timing the market,” said Barket.

Haber made the point that his company continues to look at risk and return the same way—they try to find loans with a 7 percent or 8 percent return, but they also have a place for “ugly loans”—those with a 12 percent or 20 percent return. “There are interesting deals out there, but you have to work hard to find them.”

Additional products are becoming available, but higher returns are found mainly with “messier transactions,” according to Barket. But returns “take care of themselves when we can genuinely solve for the risk side of the transaction,” added Adler.

The panel concluded with the men agreeing that over the long-term, real estate remains attractive in terms of yield and low risk. Barket summed it up: “I’ve seen deals you can make and capital will come. There’s plenty of liquidity out there in the world.”

Bob Lieber closed the meeting, reminding members that the 2010 Fall Members’ Meeting will be at The Inn at Penn, on Penn’s campus, on Tuesday, October 19, 2010.

Posted May 2010

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