By Steven Pearlstein
December 6, 2006
SourceIt's been more than a year since we've heard from those who denied there was a housing bubble.
Since then, the industry boosters, along with the "soft-landing" crowd over at the Federal Reserve, have coalesced around the idea that maybe the market got a bit frothy after all, but now the correction is almost complete, the unsold inventory's been worked off and the worst is behind us.
But just when you're feeling hopeful again, you get reports like yesterday's Wall Street Journal piece reporting that delinquency rates are suddenly soaring on all those loosey-goosey subprime mortgages. They are starting to cause real heartburn for pension funds and other investors who bought securities backed by those mortgages on the theory that they were no more risky than a Treasury bond.
"We are a bit surprised by how fast this has unraveled," Thomas Zimmerman, head of asset-backed securities research at UBS, told the Journal, removing his head from the sand. Trust me, Tom, you ain't seen nothin' yet. After the subprime loans come the 100 percent, interest-only loans, followed by the meltdown in the overbuilt multi-family housing sector.
But enough hand-wringing over the residential real-estate market. Not much anyone can do about that now. The new story is the bubble in the commercial real estate market -- offices, hotels and retail establishments -- which has generated spectacular returns for investors over the past few years.
Prices have risen to ridiculous levels, relative to the risk involved and the amount of income generated by these properties. But even those prices don't seem to scare away pension funds, university endowments and Arab investors, who continue to pour hundreds of billions of dollars into real estate investment trusts, private-equity real estate funds and hedge funds that specialize in real estate finance.
Exhibit A is the purchase of Equity Office Properties, the country's biggest owner of office buildings, by the real-estate arm of the Blackstone Group, a private equity firm. What you need to know about this $36 billion deal is that 80 percent of the purchase price will be financed with debt, and that the "cap rate" -- the rate of return from next year's rental income -- is an estimated 5.5 percent.
What, exactly, does that mean?
First of all, it means that the lessons of the past five real estate crashes have, once again, been forgotten, and real estate has once again become a highly leveraged investment class. So, when the inevitable downturn finally happens and the price falls by more than 20 percent, there's a pretty good chance the value of the collateral will fall below the value of the loans, which in financial circles is considered a no-no. To make things even worse, it's a good probability that these are interest-only loans, which means that even in good times, the borrower is not paying down principal.
These numbers also mean that once you take into account things like the need to invest each year in maintaining the properties, investors will earn a premium of less than 1 percentage point for the risks associated with real-estate investing -- little things like tenants who don't pay rent or vacant property that can't be rented -- as compared with risk-free Treasury bonds. As risk premiums go, that's as low as anyone can remember.
But not to worry, says just about everyone in the real-estate business. The prices for real estate aren't too high because there's a new paradigm in which the old rules no longer apply!
After all, in a post-inflation world with a glut of global capital, its only natural that risk premiums and rates of return are now permanently lower.
Major institutional investors -- pension funds and university endowments -- that used to stick to bonds and blue-chip stocks have concluded that the only way they can meet their investment targets is by allocating 15 percent of their portfolio to real estate.
And don't forget the whole panoply of new financing mechanisms -- collateralized debt instruments, mortgage-backed securities and the like -- that have made it easier and cheaper to finance real-estate deals.
And if all that is not enough to convince you that commercial real estate is quite cheap right now, industry boosters claim that many leases coming up for renewal were negotiated in the lean years of 2001 to 2004, when rents were low. Now that the market has recovered and rents are significantly higher, that almost guarantees that rental income will increase by 5 percent in each of the next five years. That will boost annual rates of return and, with them, the value of the properties.
It's possible they are right, of course. People like me have been warning about a bubble in commercial real estate for more than a year, during which lots of money was made by people who didn't believe it. Now there's so much momentum behind the market that it is almost inevitable the party will continue for at least another six months, driving prices even higher and cap rates lower.
But at some point this commercial real estate bubble will burst. The cause may be a sharp decline in the dollar that scares away foreign investors. Or an unexpected spike in interest rates. Or a recession. Or a surge in new construction that causes supply to outstrip demand. Or a pushback from tenants who decide they simply can't afford to pay $70 for a square foot for prime downtown office space.
I can't tell you exactly how it will unfold, or when. But when it does, probably sometime in the next two years, everyone will look back and wonder why anyone could have doubted there was a bubble, why credit-rating agencies didn't warn of the risks, and why bank and securities regulators didn't step in.
By then, the fund managers who made and financed the deals will have gotten rich from all the fees they collected. It wasn't their fault, they'll explain: They merely took money from people who had already decided to invest in real estate and put that money to work.
And the Journal will run a front page story quoting some Wall Street executive on his surprise at how fast it all came unraveled.
Steven Pearlstein can be reached at
pearlsteins@washpost.com.