Commercial Real Estate

Washington Post business columnist Steven Pearlstein was online Wednesday, Dec. 6 at 11 a.m. ET to discuss the commercial real estate bubble, what the Fed may do to prick it and what will happen when it bursts.

Read today's column: An Economic Pillar on the Verge of Collapse.

The transcript follows.

About Pearlstein: Steven Pearlstein writes about business and the economy for The Washington Post. His journalism career includes editing roles at The Post and Inc. magazine. He was founding publisher and editor of The Boston Observer, a monthly journal of liberal opinion. He got his start in journalism reporting for two New Hampshire newspapers -- the Concord Monitor and the Foster's Daily Democrat. Pearlstein has also worked as a television news reporter and a congressional staffer.

His column archive is online here.

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Laurel: One element that is usually present in a "bubble" is that investors who would not purchase an asset at the current high price for their own use, will do so because rising prices lead them to they can sell the asset for more later. "Flipping" in real estate lingo.

The scenarios in your column don't seem to involve that element as much as they resemble "chasing the yield." Maybe this is an unimportant semantic distinction, but I don't think yield-chasing crashes nearly as hard as a true bubble.

Steven Pearlstein: Well, I think the distinction between chasing yield and chasing short-term appreciation is a very important one. I don't think today's investors are chasing short-term appreciation. I think they are willing to accept low yield relative to risk, however because they are convinced that the cash flow/yield will soon improve with rent increases, and that they still have lots of upside potential on the value of the property in the five year time frame. Their models tell them they can achieve 8 or 9 percent return, annually, which is what pension funds are looking for. What is not in their models is the possibility that the value of the asset will decline, or the economy will soften quickly and ruin the rising-rent story.

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Edgewater, Fla.: Though retired now, I had been a real estate appraiser and broker since 1972. In my opinion the perfect storm for real estate is upon us. I have never seen so many factors come together at one time to inflate prices. It will take some time to unravel but with each event more and more people will recognise that there was a bubble and it is collapsing.

Steven Pearlstein: And no doubt you see that happening most in Florida, Las Vegas, Phoenix.

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Woodbridge, Va.: Yet another excellent column. However, I wonder if there are deeper underlying problems that drives all the various financial bubbles. First, the unrealistic promises made to workers in the 60s, 70s and 80s force pension fund to dig ever deeper into the financial bag of tricks in order to meet current and anticipated obligations that simply cannot be funded with more rational rates of return. Second, the real rate of economic growth in much of the developed world has begun to slow, which means there simply are not as many opportunities offering a reasonable risk adjusted rate of return, so capital is forced into ever more risky ventures (including bidding up equity prices to PE ratios unimaginable 20 years ago).

Steven Pearlstein: You've identified two very important, fundamental trends driving all sorts of markets these days, including real estate markets. I couldn't agree more. I'd add one more, however, which is still a bit unformed in my mind: the change in financial intermediation from banks to markets. It used to be that when banks provided the finance for, say, real estate, they new the properties, the markets and would mostly try to make prudent judgments before making a loan. Now, because the credit is coming through impersonal credit markets with risk sliced and diced and repackaged every which way, the onus is really on the bondholder and the rating agencies to know about properties and markets. And they really can't. so when a real estate arm of a private equity firm decides to make an investment, it is not really saying this is a good investment: it is saying this is the best investment in real estate that I can find now that you've given me this money to put to work. And the bank the underwrites the financing isn't really keeping that on its own books, so it has no incentive to say, "This is crazy." In fact, because of the huge fees, it has every incentive to rationalize the issuance of the mortgage-backed bonds. So there is a lot of buck passing here, with nobody really looking out for the real interests of the investor/creditor.

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Burke, Va.: Good morning. What have the federal banking regulators said about commercial real estate lending? Could it be that one of the lessons of the S and L crisis -- poorly (or not even) underwritten commercial real estate loans have the real potential to fail banks, especially smaller banks -- has been forgotten? Thanks for the chats.

Steven Pearlstein: Yes, one of the lessons has been forgotten. The bank regulators have sent out warnings to banks saying to watch out for overconcentration in their loan portfolios of commercial real estate loans, particularly loans in any one market. But this is not enough, in my opinion. They've got to get into it more, jamming them on particular loans, requiring that they put more convenants back into the loans, requiring payment of principal as well as interest, and overseeing the underwriting of loans that are syndicated or packaged. The philosophy now is to rely on the bank's risk management models, rather than reviewing particular loans or even loan policies. And yet those models don't really have any experience with the kind of problems we are facing. There's not enough experience yet with the real estate cycle, with today's financing mechanisms, to know how its going to turn out. And let me say that the worst offender here is the Federal Reserve, which has jurisdiction not only over the banks but the whole holding company, where the action is on this.

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Danvers, Mass.: A brilliant point made by the NYT this morning adds to your prescience on real estate. That in places like Naples auction house prices are tracking some 20 percent to 30 percent below recent previous same house sales. I note that unlike ordinary broker operated markets, the auction market is necessarily a meeting of willing buyers and sellers, therefore a good indication of the spot house price.

Steven Pearlstein: Right, although Florida is probably at the extreme end of this, because of all the speculation in second home properties. I doubt there is, or will be, that much of a decline in too many other places.

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Washington, D.C.: What are your thoughts on the recent merger/acquisition of Trammell Crow Company by CB Richard Ellis? Do you see this type of consolidation as a continuing trend?

Steven Pearlstein: I think it is unfortunate, actually, merging developers and brokers. It will result in less interesting development. Trammel Crow was once a great, great company -- visionary, risk taking, entrepreneurial. CB Richard Ellis is, well....

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Baltimore, Md.: When a residential real estate bubble pops, overbuilding is often a critical factor. Witness all the condo projects around DC being abandoned or converted to rental, the luxury single family home communities offering tens of thousands in closing costs help, all while mortgage rates remain historically low. My question is, how much is overbuilding likely to play in to the decline of commercial real estate that you see coming?

Steven Pearlstein: The official line is that there is no overbuilding in the office market. I wonder if that is true. There's a lot of buildings going up right now where the developer is expecting to get rents higher than today's prevailing rents by the time the project is finished. Whether there is enough in the pipeline to overwhelm expected demand, I can't say. But I can say that, at some point, the price of downtown Class A real estate will reach a tipping point, and law firms and others simply won't pay it for so much of their operations. They'll move stuff out of downtown, or they will jettison from their practices the lawyers who don't earn the premiums to justify those rents. IN any case, I think it is folly to assume that demand is price insensitive. So not only is there possible problem in the supply chain, but demand might begin to flag. And that's not even factoring in the chance of a further slowdown or recession.

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Silver Spring, Md.: Mr Pearlstein, You commented in your piece on the prevalence new mortgage instruments such as sub prime and interest only loans. While they are common in the personal housing market, including speculators, in the greater DC area are they so in the commercial market as well?

Steven Pearlstein: Much commercial lending now is interest only, at 100 basis points over Treasuries, or even less. As for the subprime part, there are not subprime loans, per se. But loans are packaged and then sliced in such a way that there are AAA rated tranches, AA, BB, B etc tranches, all the way to highly risky "toxic" tranches where the lenders will be the first to lose everything if payments are not met or the collateral proves insufficient in the case of default. That is the commercial version of subprime. And its a hot part of the market right now, with premiums that, in my opinion, don't even come close to reflecting the risk.

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Wash, D.C. : Steve, I think your article was great and the analysis is really good, but you made one wrong conclusion. The decline in the value of the dollar will increase the value of commercial property not decrease it. Private equity firms realize the dollar is plummeting and will continue to plummet because of our governments poor fiscal policies (deficit spending, trade imbalances etc.). As the dollar continues to decline, the real costs of building commercial real estate will skyrocket as it has already done over the last 5 years. Steel, bricks, Lumber, concrete, and all of the other basic materials used to make these buildings are set on the global market and the costs of these objects will probably stay flat in real terms, but will cost more due to the dollars lower purchasing power. The tremendous cost of building new commercial properties, is going to scare investors away from building new properties, which will create a supply and demand imbalance, and ultimately continue to push up rents. In other words, they are investing in one of the worlds oldest and safest inflation hedges, real estate.

Steven Pearlstein: You are right, I hadn't thought of that impact from a weak dollar into the supply of new buildings. What I was thinking was that if foreign investors come to expect that the value of their US real estate loans and equity investments are going to decline 10 percent a year, after conversion into their own currency, then a tipping point might be reached where they start pulling out in droves. Over the short term, that will have a big impact on the prices being paid because foreign investors are a big part of the "greater fool" story in the commercial real estate bubble. They are disproportionately the ones paying the higher prices for property. If they leave, prices fall.

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Fairfax, Va.: How much (if any) of the bubble-burst will trickle down to the retailers? Will shirts and blankets at Target be cheaper because of lower rents and lower corporate overhead?

Steven Pearlstein: Not much, I'm afraid. Rents will be lower than they otherwise would have been in the future, but that's pretty theoretical. Retail is a bit tricky, because it depends on location and the number of nearby malls, for example. Its a bit more idiosyncratic. But it is not immune.

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MacroquantTrader: Hi Steve, Your article is right on. We deal with many hedge and private real estate funds, and the flipping is definitely there. People are not buying commercial for the cap rates, you can get more out of MLP pipelines. They are buying because they think someone else will pay more. Also if you look at financial cycles there does not always have to be a proximate cause for a bubble to burst. Assets of all kinds go from under to very overvalued in long cycles. Bubbles simply exhaust themselves.

We need only to look at the Saudi, UAE, and Oman markets this year. Macro economically the countries are booming and there is ample liquidity. Many of those stock markets collapsed by 50 percent even when crude was over $70/pb. When assets get too expensive an even greater amount of liquidity is required to keep them going.

Steven Pearlstein: Interesting. Thanks for that. Can you define "macroquant."

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Silver Spring, Md.: I know your column was about commercial RE, but a quick note on residential if you will? One common theme that I've been reading (and feeling, as a 20-something renter) is that there's a HUGE gap now between those who already owned a home prior to the build up and those who didn't. The thought of saving 20 percent of current home prices is almost unfathomable for people who don't have equity already to use. So while people talk about this burst, slowdown, correction, whatever you want to call it lasting a few years - I see a multiple decade problem here. It seems to me there's a LONG way to go before salary inflation and housing market downturning before any significant number of NEW homebuyers can afford to get into the market again. Am I wrong that there's a long term problem here? Because from a personal perspective, I'm above average income for my age, and even if I could save 20 percent of my take home income, it's at least 8 or so years til I'd have a down payment for even a condo in this area... I'm guessing that proportionally, for every one of me over that 8 years, there's probably at least 2 elderly folks LEAVING the housing market. Do you agree that analysts are perhaps a bit to limited in the scope of this "downturn"?

Steven Pearlstein: Sounds like a PhD thesis to me. The data on affordability doesn't support you concern in the aggregate, but that is for all age groups. I suspect you are right for young people, who in the new economy start out making less, relatively, but make up for that by the time they get to the 30s. On the other hand, they are delaying marrying and having children (cause? effect?). In the long run, however, all this should even out as supply and demand come into some equilibrium at a price people can afford. The house may wind up being smaller, or population may need to shift away from costly urban areas. But I suspect it will happen -- and, in fact, is already happening. So don't worry too much. Save, wait and have a good time.

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Tysons vs. Reston: Your piece on "edgy" Tysons Corner had my wife (an urban planner) and I in stitches. Great satire!

Steven Pearlstein: Well, it wasn't meant to be -- but you knew that. Remember, the Tysons I was talking about was as much in the future as the present.

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Hedger: If the reader does believe this:

"Steel, bricks, Lumber, concrete, and all of the other basic materials used to make these buildings are set on the global market and the costs of these objects will probably stay flat in real terms, but will cost more due to the dollars lower purchasing power."

There are only two currencies that cannot be printed by central banks: gold and silver. The USD has already collapsed against both since 2001. Gold has more than doubled and silver is up over 250 percent. Most investors are not on yet. I would expect to see a flight to these instruments.

Steven Pearlstein: Ah, a gold bug.

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Macroquant: We just look at long waves and historical analysis. The fundamentals tell us what to buy or short. The fund flows and technical indicators attempt to find an optimal point to put on the trade. The macro is that we do any market, currency, option, or commodity across the world where we feel there is value for investors. So right now some of our longs are crude, Japanese yen, Malaysian palm oil, small cap steel makers, Ukrainian equities, precious metals, corn, some farm land. Some shorts with the Russell 2000, wheat, and some of the tech firms (hedged by being long Taiwan).

Steven Pearlstein: Okay, glad I asked. Sounds way over my head.

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Steven Pearlstein: That about exhausts this subject for today, folks. Hope to see some of you next week. Cheers.

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