Trumped Towers

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If you drill it, they will come. Last summer, I met with two Dallas-based energy hedge fund players to chat about the state of the energy sector. The two young men made mention of all manner of reasons that for the foreseeable future oil might just hang in there, above $100 a barrel. One anecdote, however, had given them pause. It had to do with plans to build a 58-story tall skyscraper at 303 Wall Street. That is, 303 West Wall Street in Midland, Texas. It would be the sixth largest in the state and the tallest between Dallas and Los Angeles. Did this tall tale, I asked, seem a bit, well, much? It did indeed, they replied, especially in light of the last time something so bold had happened upon the streets of this West Texas outpost, population 111,000. The skyscraper announcement echoed stories of an ill-fated Rolls Royce dealership, which in 1983 had optimistically opened its doors for a less-than-one-year Midland run. The oil price collapse laid ruin to not only the dealership but also one of the most spectacular energy booms in Texas history. And as we all know, Silver Ghosts don’t run well on cheap oil. Just ask any Saudi.

Of course that was then. Today, Texas has an appreciably more diverse state economy than it did the last time oil prices tanked. And that wasn’t the part of the story that struck the most worrisome chord. Rather, it was the source of the financing for the proposed lofty development that proved arresting – that is, private equity (PE) from near and far. ERP, or Energy Related Properties, a PE fund founded and headquartered in Midland, was to be the developer of the proposed $400 million project. Wexford Capital, a multibillion investment firm with over $6 billion in PE investments, was to be, but as it turned out, alas not to be, the financial partner on the deal. Wexford, for its part, calls Greenwich, Connecticut and Palm Beach, Florida home – depending on the season, that is.

It’s no exaggeration to say there’s been a fevered rush of money flooding commercial real estate (CRE) in recent years – private equity financed and otherwise. It’s also reasonable to characterize the land grab as global in scope. When Hong Kong and Singapore skyscrapers became too rich even for the rich folks’ blood, investors turned to the streets of London for relative bargains. When Canary Wharf eye candy was also deemed too pricey, the double-barreled money cannon was aimed squarely across the pond at New York’s fabled canyons, where iconic cloud kissers were downright cheap by comparison. Marquee markets always retain their value, the thinking goes, hence the justification for paying record prices.

By the time last summer rolled around, CRE prices had fully recovered their 2007 peak levels. It’s the since then that’s presumably caught Federal Reserve Chair Yellen’s eye. “Valuation pressures in commercial real estate are rising as commercial property prices increase rapidly,” the Chair said in a mid-July Congressional testimony. She then added, redefining understatement along the way, that, “underwriting standards at banks and in commercial mortgage-backed securities have been loosening.”

Maybe the fair chair has been added to the distribution list of Richard Hill, who I’ve come to know well over the years. Morgan Stanley’s eagle-eyed CRE analyst sets himself apart by following trends beyond commercial mortgage-backed securities to form a more holistic view of the broad landscape. Richard, working closely with his capable teammate Jerry Chen, was the first to point out that the Fed’s paring of purchases associated with its quantitative easing campaign, which threatened to push up interest rates, would trigger a reversal of money that had been fleeing US markets for years in search of higher yielding opportunities overseas.

As it so happens, the tapering of Fed open market purchases coincided with an explosion in foreign CRE purchases, which clocked in at $48 billion last year, amounting to 10 percent of transaction volume. Canada has traditionally been the biggest buyer of US CRE and led the way in 2014 with $16.7 billion in buying. But Asia wasn’t far behind. Investors from the Far East scooped up $10.7 billion in properties comprising 22.5 percent of cross-border transactions. The Chinese alone poured $3.4 billion into the U.S. to buy some 55 properties.

It could be that what has the Fed in a tizzy is the fact that 2015 sales have already wiped 2014 off the map. So far this year, foreign buyers have plunked down over $54 billion to fund cross-border investment. More notably, their share of the purchase pie has doubled to 20 percent. But here’s where things get really interesting. Asia’s share has leapt to 33.6 percent of transaction volume this year – that’s $18.2 billion in buys. And Singapore has unseated Canada as the biggest buyer, which is saying something about the depleted buying power of our neighbor to the north’s loonie (somehow discussion these days always leads back to oil prices) as well as Norway, which has traditionally come in second (did someone mention oil?).

If you’re beginning to detect a trend, don’t. Yes, weakening currencies have played their part in the changing composition of foreign CRE buyers this year. But at the very core of this frenzied buying is a recurring word that keeps appearing in one news item after another following Chair Yellen’s red flag raising (Any time the world’s most powerful central banker shines a harsh light on an asset class, it’s sure to garner attention in the media). That word is “stable,” which raises a huge red flag for me, and should for you as well. Not only do hard dollar assets shelter weakening currencies, they offer the promise of “stability” during times of market turbulence. If only.

Have I been struck with a bout of obtuseness? Do I not understand the basic diversification capabilities of hard assets when stocks and bonds are misbehaving so?

Maybe it’s the devil inside the transactions that torments me. Dig into the figures and the fastest area of growth this year is in sales of brick-and-mortar properties. Yep, retail stores are selling like hotcakes with transaction volumes up by a third over last year. This less than fashion worthy trend is being fed by activist shareholders, many of whom are akin to Gladys Kravitz of yesteryear’s Bewitched sitcom, busybody neighbors with too much time and other’s people’s money on their hands.

This is where the devil enters stage left. These shareholder activists – think spotlight-grabbing hedge funds – have been strongly encouraging failing retailers (we know who they are) to “unlock” the true value of their name brands by selling off their real estate holdings while prices are at record high levels and then leasing them back. So, cash out and then proceed to fail, but as a tenant instead of an owner. To think that a few brave analysts have dared question these moves which have effectively increased the risk in real estate investors’ portfolios by loading up on overpriced properties with shaky tenants.

Of course, the fastest and loudest money activists will shed their exposure to these retail properties faster than a molting snake in the hot desert sun. Not to mix metaphors, but really, who can blame them for being the bullies on the playground? Muscling weak retailers who won’t be with us in years to come to capitalize on an overheated real estate market can’t hurt their investors, at least in the short term.

The problem is someone on this playground will end up holding the proverbial deflated ball. If you harbor any doubts about the state of retail CRE, consider that through the first six months of this year, retailers have announced 5,130 store closings, nearly the same number as 2014 as a whole. Is it any wonder that retail prices have recouped the least among major CRE sectors compared to their respective 2007 peaks? Of course, this stands to reason. At 13 percent, the eCommerce share of retail sales is over three times what it was 20 years ago. Meanwhile, the average selling price of a unit of apparel has plunged 12 percent since 2001 to $21.75. What value, exactly, are activists “unlocking” by monetizing the structures that house the floundering merchants?

Not all that much given the recent performance of securities backed by commercial loans. Pardon the jargon but to ascertain performance, one must understand the basic concept of net operating income, or NOI, which is the annual cash flow generated by an income-producing property after accounting for all expenses incurred to operate said property. According to Morgan Stanley’s Richard and Jerry’s latest August tally, 42 percent of loans underwritten in the five years through 2014 have NOIs that are less than what was baked into the loan’s original underwriting. Delving deeper into the data, negative NOIs rise steadily from 21 percent for the 2010 vintage to 55 percent for 2014. To not be outdone, two loans that were underwritten this year went delinquent in August. One of these was an East Orange, NJ apartment complex. The other – wait for it – was a mixed-use retail development in Ft. Worth, Texas. (Oil anyone?)

Is commercial real estate in a bubble? The media attention following the Fed’s public angst that this could be the case prompted one publication to ask just that of 13 “top economists.” Twelve denied, denied, denied. One, though, Texas A&M Real Estate Center’s Mark Dotzour, ventured this far: “It’s a tale of two markets in the US commercial real estate market. Properties that are purchased by REITs, pension funds and foreign sovereign wealth funds are clearly in a bubble. But the vast majority of properties across America are highly priced, but not in a bubble.”

Being a Texas Longhorn myself, even on the eve of football season, I’ve got to give Mark this much – he is brave, even for an Aggie. The problem goes back to those aggressive foreigners. So far this year they’ve quadrupled their CRE purchases in non-major U.S. markets. Clearly they’re having a hard time stomaching the astronomical price tags in such trendy cities as San Francisco and Chicago.

Foreign investors could just say no. But that’s a bit of a challenge when total property allocations earmarked by sovereign wealth funds now top $6.3 trillion, more than double their 2008 levels. To make matters worse, foreign investors are having to compete with others who are equally yield-starved, all of whom are desperately seeking the philosopher’s stone of “stability.” Life insurers are serious contenders as are U.S. pension funds that have 7.7 percent of their assets invested in property, up from 6.3 percent in 2011. And they’re both increasing their allocations to the sector aggressively.

The big daddy though is private equity (PE) dry powder. PE real estate has racked up the fastest growth rate within the broad PE fund-raising universe: they’re sitting on $254 billion in highly combustible dry powder as of the end of June. Not only is this dollar figure unprecedented, it’s up 37 percent from year-end 2014 when it stood at $185 billion. Color me cynical but PE bigwigs, one of whom purchased the old Sears Tower in Chicago for $1.3 billion earlier this year based on a multiple of two times his past year’s personal income, don’t tend to return investors their committed capital. Rather, they deploy the capital, perhaps with regret. Perhaps not.

In the case of the Midland tower that never was, the potential deal proved to be too pricey, even for the powder-toting PE guys to ignore. If prudence prevails, 2015 will not be a record year for sales. As things stand, the year-to-date transaction volume of only $366 billion suggests a run rate just shy of a half trillion, which will fail to dethrone 2007’s record volume of $574 billion. But what if Trump does end up needing some extra moola to fund his runaway campaign after all? If the PE kingpins get really crafty, they could unlock some more big paydays by collaborating with the Donald. The hotly contested value to license the name of the world’s most bombastic man is purportedly topped only by his commercial real estate claims to fame, that is unless you throw into the running the overblown height of his ridiculous hair.