From Site Selection magazine, September 2000
M A N A G E M E N T S T R A T E G Y |
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An El Niño Period Ahead b y M A R K A R E N D
but trained observers of real
estate cycles and their
susceptibility to economic
trends see inclement
conditions on the way.
First, the good news.
"We don't have one delinquent mortgage loan in our portfolio, and that's never happened before," noted Ward, adding that the entire life insurance industry is enjoying record-low loan delinquency rates. "A large corporate real estate fund we manage for a pension-fund client has averaged almost a 14 percent return over the past five years. If inflation has been about 2 or 3 percent, then the real return has been 11 percent. Historically, that's double what you would expect returns to be."
Even in a downturn, the real estate lending industry is well positioned to ride it out relative to other economic players, observed Ward. But there is a fly in the ointment.
The result is a dramatic reduction in the volume of real estate lending activity, which has Ward and others looking closely at the situation. "We are seeing very few actual transactions close," Ward related. "Our financing side, whether it's the direct lending or conduit business, is off significantly. I would guess that transactions are pretty important to what all of you do," he added. "I'd like to think that the Federal Reserve's so-called soft landing will come to pass. But my biggest fear is that although there is not much overbuilding, if we were to lose 3 million jobs a year and go into a recession, then the real estate business will be as much fun as it was the last few years."
If the current scenario doesn't worsen, and particularly if a recession is averted, then the capital markets will rebound, Ward predicts. More to the point, when spreads narrow and the markets are reinvigorated, then transaction volume will recover.
In the meantime, there is cause for concern, said Thomas McCahill, vice president, real estate investment management, at The MONY Group, Littleton, Colo. "Economic forecasts all seem to be very sound and positive," he allowed. But it's hard to ignore the marked increase in business costs. "We see double-digit increases in occupancy costs, labor costs impacting the industry's ability to attract and retain talent, higher housing and transportation costs and the impact of rising interest rates on the economy. And we come to the conclusion that inflation is with us, though we may not realize it's with us. There is cause for concern with the underlying rate of inflation."
McCahill's reading of the tealeaves is less than optimistic. "As foreign economies start to rebound, particularly in Asia, we'll continue to see an impact on prices overall. What [Fed Chairman] Alan Greenspan is doing in terms of raising interest rates will continue to impact our industry. Personally, I am not convinced interest rates will fall next year as precipitously as some think."
"The economy has been exceedingly strong, and that cannot be sustained," observed Raymond Torto, CB Richard Ellis/Torto Wheaton Research, Boston, Mass. The rising interest rate environment will continue as the Federal Reserve works to stave off inflation.
With respect to the real estate market, Torto also sees cause for concern. He argued in his remarks that what happens on the demand side of the economy did not have a dramatic effect on the real estate market during the two major recessions of the last two decades. "It was the supply side that was the real culprit in the recession of 1990," he asserted. "Go back to 1982 -- a far worse recession -- and vacancy rates were 5 percent. It didn't effect real estate."
Supply again is on the upswing, and Torto maintains that the economy will endure another recession, one resembling the one of 1982. Nevertheless, he added, "Inflation will not rise above 3 percent, Greenspan will make sure of that. But real estate, from an investor's point of view, will continue to be a terrific inflation hedge."
A third speaker made the point that new capital sources and financial intermediaries are giving traditional players a run for their money. Walter D'Alessio, president and CEO of Legg Mason Real Estate Services, says his firm was a major player in the CMBS (collateralized mortgage-backed securities) market a few years ago.
"Life insurance companies have figured out how to compete," says D'Alessio. "They are more flexible in deal structure, in lock-in rates, and they did a lot of things with Class A real estate that the conduits couldn't do, and they competed very well."
Smaller players in the life insurance business are changing the way they do business in the real estate arena, which D'Alessio urged attendees to pay attention to. Provident Mutual Life Insurance of Philadelphia outsourced its entire real estate portfolio to Legg Mason recently to reduce costs associated with managing it inhouse. "The life companies are figuring out ways of being more efficient," D'Alessio pointed out. "They have been a great player in the real estate industry, they will continue to be that in my view. If anything, some of them are getting stronger."
A number of insurance companies are demutualizing, or becoming public companies, which also drives their strategies for competing in he marketplace. "The MONY Group demutualized two years ago, and life is definitely different as a stock company," noted McCahill. "Most of the major life insurance companies are doing the same thing, and that will have a significant impact on how they conduct themselves on the real estate side."
The main result is a downsizing of their equity portfolios, which has lead to rising demand for debt. A second result is the emergence of life companies as conduit lenders. "The infrastructure is there," McCahill explained. "The capabilities of warehousing mortgages in an uncertain environment and in a rising interest rate environment allows them to warehouse loans." They then can securitize those loans and generate earnings, which investors expect to see.
"Most life companies, ourselves included, are looking at ways to leverage our infrastructure, and the conduit business is one area in which to do that," McCahill noted. "The advisory business is another."
Just as important as new competitors is the impact of technology on the business, D'Alessio reminded the forum's participants. Staying informed about the opportunities technology brings to the table is critical to staying competitive as an industry.
"It is particularly important to stay on top of technology trends in one respect," he related. "As you look at our ability to attract new people to this industry, it is difficult to compete with e-commerce. We have to find ways to make this an attractive industry for younger people coming out of school." Nevertheless, the next generation of employees will bring a keen appreciation of the role of technology relative to the employees who precede them. "We have to grow new talent and find ways of doing what we do much better, and if we don't get there on our own, our clients will see that we do."
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Skies may look fair today, 
"When I started in the industry in 1971, real estate wasn't part of the U.S. capital markets, which it is now," said Ward. "The bad news is that the capital markets are in total disarray at the moment. That's impacting us in such a way that in what should be the best time for real estate investing, it's not happening. People generally are risk averse at the moment, thanks to volatility in the stock market and other factors." These include a rising interest rate environment and spreads on Treasury bonds, LIBOR and mortgage rates widening. Funds with which to invest in real estate are harder to come by. "The fact is we're not being driven by what's happening in the real estate market any more," Ward noted.
Life Companies Come on Strong
