Looking Back: From Flying High to Financial Earthquake

From a commercial real estate perspective, the last 10 years have been among the most dynamic and volatile in the post-war era. The industry went from the dot.com boom of the early 2000s to the post 9/11 slump; back up again in the mid 2000s before declining in the Great Recession. On the investment side of the industry, we went from flying high in the 2000 to 2007 period to experiencing a cataclysmic financial earthquake beginning in the summer of 2007 leading to the worst economic downturn in most of our business lives.

When markets are rising there is a tendency to forget about the relationship between risk and reward. There is almost always a perception that “this time it’s different” and risk can be discounted. By the peak of the cycle in 2007 the cap rate on a prime property in a major US city was 5% or less, at a time when the interest rate on the ultimate risk-free investment, a 3-month Treasury-Bill was 5.0%. In other words investors saw no difference in the valuation risk of owning a property and owning T-bills.

There was also a mispricing of risk at the cash flow level. With the economy booming, vacancy rates falling and rents surging, cash flow projections became more optimistic and investors were paying a premium for vacancy, believing that rents would continue to increase at accelerated rates. Property fundamentals were rationalized to justify pricing and achieve value.

If risk were properly priced, investors would have sought to shrink the liabilities-side of the balance sheet. Instead, as risk rose, liabilities rose as investors piled on more debt to increase assets. 

The second major trend was the institutionalization of the flow of investment money into real estate. Real estate became a “must have” asset whether equity or debt. Historically, investors in real estate were large institutions (pension funds, life insurance companies) or private groups. But with the large number of public REITS that emerged in the 1990s and early 2000s, individual investors suddenly had the ability to invest in commercial real estate. Mutual funds devoted solely to real estate and even to specific asset classes within the sector (core, core plus) proliferated. This gave the public companies greater access to capital than ever before.

On the private side, real estate equity funds created a myriad of products as allocators across the risk and geographic spectrum. You could find core, core plus or opportunity offerings in many locations around the globe. And of course we cannot leave out the liquidity provided by debt, with the CMBS market increasing from $61 billion in 2000 to more than $300 billion in 2007.

This combination of not appropriately pricing risk and a flood of capital led to another important development during the boom period: A number of people “bet the ranch.” They gambled everything, boosted leverage to unheard of levels and did it just as the market was peaking. And so we saw excellent operating companies like GGP and Centro over lever their balance sheets and wind up in bankruptcy or restructuring. We also had a number of very large private companies do the same.

As I look back over the past decade, there was a sense in real estate markets that this time really was different because of the institutionalization of real estate reducing fundamental investment risk. This caused investors of all types to misprice the value proposition of real estate. However, once again “perceived” liquidity was volatile.

This time around we will know better.  I will write this column 10 years from now with a bet that this historic statement is once again breached.

Glenn Rufrano is president and CEO of Cushman & Wakefield. Prior to taking the post in March 2010, he was CEO of Australian-based Centro Properties Group, and also served as CEO of New Plan Excel Realty Trust Inc. from 2000 to 2007. Previously, he was a co-founder of The O’Connor Group (currently known as O’Connor Capital Partners), which has invested in real estate internationally.  He also spent more than five years at Landauer Associates Inc. where he was involved in the sale of some of the most prominent office properties in the United States.