Surrounded by problems. Now what?

With Europe looking at re-entering recession territory, ULI Europe’s recent conference — “The Only Problems Left Are the Big Ones”— was timed perfectly. While solutions to the big problems are still frustratingly hard to come by, at least the problems were starkly laid out — and you can’t solve a problem if you haven’t defined it.

When everything is crashing down around you, it’s easy to focus on the short term. Your main goal is survival. Once the crisis has passed, we then tend to think that the worst is over and begin feeling pretty optimistic — unless you’re an economist. If you’re an economist, then the good news is just a short-lived teaser; the real disaster is yet to come.

Professor Andrea Boltho, emeritus fellow at the University of Oxford and director of Oxford Economics, spoke about his view of the future — and it’s not very pretty. In the short term, things look OK. The euro zone will probably be moving back into recession this year, but it will be short-lived. Other economies should show positive growth through 2014. China might be showing a downward trend, but an 8.8 percent GDP growth rate is something to lust after, not fear.

So all looks good, right? Not so fast. According to Boltho, the real danger lies in the medium and long term when we might enter a Japanese-style era of stagflation. Boltho presented a series of charts overlapping what happened in Japan in the 1980s with what has been happening in the West, beginning with the housing bubble and moving into the recession and today’s slow recovery. The trend lines are eerily similar. We’ve been saying that this crisis is so hard to define, because it is so different from past crises — are we now saying it is only different from past crises in the West? Should we really be looking toward Japan in the 1980s instead of the United States for a model on what to expect?

But stagflation might actually be the best of the possible scenarios presented. The breakdown of the euro zone is a real, if improbable, possibility — and the resulting chaos would be much worse than stagnant growth rates. According to Boltho, a number of factors could precipitate a crisis:

  • Failure to roll over maturing debt in the absence of sufficient “bailout funds” could impose an exit.
  • Bank runs might force countries to leave the euro and bring back capital controls.
  • Insufficient ECB action could encourage destabilizing speculation.
  • Never-ending fiscal austerity may persuade countries that only exit can restore growth. Hello, Greece.
  • And if one country leaves the European Monetary Union (EMU), contagion could quickly spread.

Yes, Greece would likely be the country that starts the contagion. Being part of the euro zone has done nothing but hurt its economy, and staying part of the zone is unlikely to help it recover. Leaving the EMU and allowing its currency to float would allow Greece to regain some of its competitiveness and work its way out of a projected 21 percent unemployment rate. Spain and Italy also lost their economic competitiveness, compared to countries like Germany, when they entered the euro zone. Could they, too, opt to leave in order to save their economies?

What happens if the EMU loses some members, presumably countries in southern Europe? Nothing good. Introducing new currencies is difficult. Banks and financial markets may have to be closed; deposits might have to be frozen; capital controls would seem inevitable; and contracts would have to be renegotiated. Currencies would swing wildly, with the euro still in use by a smaller group of northern Europe countries strengthening and the currencies of southern Europe depreciating sharply. The turmoil would last for years, creating a much more severe recession than the past one (or the current one, if you don’t believe we ever really came out of the past one). With consequences like that, it’s assumed the finance ministers and politicians of the EMU members will do everything possible to avoid a break up of the zone — but is what is possible enough?

On the flip side, if the euro zone manages to hold together, who will finance the deficits that are continuing to rise in the weaker countries? Within countries, the deficits of less competitive areas are financed by the richer regions, as happened in Germany when reunification of East Germany and West Germany took place. Such a mechanism, however, is missing from the euro zone. In its absence, either the weak countries manage to improve their competitiveness (unlikely) or they are condemned to years of low growth and high unemployment (much more likely).

And, as if problems with the European Monetary Union aren’t enough, demographics argue against a growth scenario, not only in Europe but in much of the world. Dr. Amian Roy, managing director and head of global demographics and pension research at Credit Suisse, provided an overview of the changing world landscape — and again, it’s not very pretty for Europe.

The pension fund model that most of the world uses is unsustainable. Otto von Bismarck chose 65 as a viable retirement age back at a time when the average person only lived to be 42. The system was never intended to provide 20 years of retirement income.

Aging populations are a problem throughout the world, particularly in emerging economies that don’t have the infrastructure to support their elderly. South Korea, for example, has done nothing to help its elderly and consequently has the highest retiree poverty rate in the world. China’s aging population is also growing faster than expected when compared to its youth. Who will take care of the elderly there?

Providing care and medical facilities for the elderly could very well shortcircuit the promise of growth in emerging markets — and in doing so, shortcircuit the promise of global economic recovery.

For the real estate industry, demographics will have a significant impact on housing. There will be smaller than average price gains in aging countries, such as Germany, Japan and Switzerland, with massive price increases in relatively young and fast-growing economies, such as Australia, Canada and New Zealand. In the United States, the baby boomers were estimated to have increased real house prices by 40 percent compared with neutral demographics during the past 40 years. Now demographic factors are expected to reduce U.S. housing prices by 30 percent compared with neutral demographics in next the 40 years. Demographics giveth, and demographics taketh away.

Finally, Dr. Ernst Ulrich von Weizsacher, co-chair of the international panel for Sustainable Resource Management, pointed out that climate change and global warming are real. One of the most noticeable results of the change is the breakup of ice in Greenland. If the Greenland ice breaks loose, it will have catastrophic effects on coastal cities. (Translation: Don’t invest in South Florida.) According to von Weizsacher, the increase of carbon dioxide in the atmosphere is directly tied to the increase in temperature. One of the ways to stop the growth of carbon dioxide is to let energy prices rise, which should reduce the use of carbon fuels. Von Weizsacher asserted that high energy prices don’t have to stop growth. He pointed out that Japan flourished during 1980s, which was a decade of high energy prices. He also posited that becoming more energy efficient can be good for economies. Retrofitting the office buildings in Germany (and presumably elsewhere), for example, could provide trades jobs for a decade.

But, as always, it comes down to “who is going to pay?”

The panel of “three wise men” was thought-provoking and entertaining. But it left me with the feeling that we have seen the enemy (in fact, we’re surrounded by the enemy), now whatta we gonna do?

Some quotable quotes:

Dr. Ernst Ulrich von Weizsacher — “The fear people have of high energy prices is close to mental illness.”

Graham Colclough, vice president, global public sector, at Capdemini and moderator of the panel discussion — “We talk about urban sprawl, but over time, all major cities have remained the same size in terms of commute time. The outer edge of a city used to be how far you could walk in an hour. Then it was how far you could ride a horse in an hour. Now it’s how far you can drive or take a train in an hour.”

Andrea Boltho — “There is a perception that the southern European countries are more corrupt than the northern ones. Can we have a union where laws — or at least the enforcement of laws — is so different?”

Andrea Boltho — “Avoiding taxes in Portugal is a national sport. Avoiding taxes in southern Italy is a national job.”

Sheila Hopkins is managing director – Europe at Institutional Real Estate, Inc.

Big boys mix it up

If you are a small or mid-sized investment manager currently in the market trying to raise capital for a fund and you thought the going was rough, well it may get even more challenging for the little guys. A number of well-established, seasoned opportunity fund managers are in the market, touting multibillion-dollar funds and competing for capital. Post–global financial crisis, many investors have been steering their money to veteran investors with proven track records, such as The Blackstone Group. The behemoth private equity firm is currently in the market with its Blackstone Real Estate Partners VII, which has a $10 billion fundraising target and has raised more than $6 billion to date.

Expect the competition for limited institutional capital to get even more intense. Other managers that have multibillion-dollar high-yield funds in the market or in the planning stages include Angelo, Gordon & Co. (target of $1.25 billion), Brookfield Asset Management ($3.5 billion), Cerberus Real Estate Capital Management ($2 billion), Colony Capital ($1 billion), Fortress Investment Group ($1 billion), Rockpoint Group ($2.5 billion), Starwood Capital Group ($3 billion), Walton Street Capital ($2 billion) and Westbrook Partners ($2 billion).

During 2011, 81 private equity real estate funds announced final closings, raising an aggregate $48.3 billion, up from 70 funds with equity of $46.8 billion in 2010, according to Institutional Real Estate FundTracker. Not bad totals, but consider this: The two largest funds to close in 2011 were both sponsored by Lone Star Funds — Lone Star Real Estate Fund II and Lone Star Fund VII — and their cumulative capital haul of $10.1 billion represents 21 percent of the total equity raised during the year. In addition, the top five largest funds accounted for a third of the total capital raised in 2011. Those figures could be even more lopsided when a number of the above-mentioned big boys put their funds to bed.

Larry Gray is editorial director of Institutional Real Estate, Inc.

Who ya gonna blame?

We’re now well into the first quarter of 2012 and, with a clear view of final numbers for 2011, industry commentators are looking back at the year with disappointment. Yes, economies and markets are better than they were in 2009, but they aren’t as good as everyone was hoping. In fact, the euro zone is likely heading back into recession by the second quarter, and the talk of a London bubble is gaining momentum. Things just aren’t moving in the right direction at all.

Some like to point out that the problem is that the markets don’t seem to be moving in any direction, much less the right direction. Elisabeth Troni, global real estate strategist at UBS Global Asset Management, noted in her presentation at the Thomson Reuters Global Property Outlook conference that 2011 was a year of decidedly mixed messages. It was a year when a lot happened — Arab Spring uprisings, earthquakes, tsunamis, political upheaval — and a year when nothing happened — Occupy Wall Street is still occupying, and nothing has changed; Greece is still being Greece, and nothing has changed. It was a year of investing in core as a safety hedge, yet accepting a 4 percent return to do so. It was a year of investment in China’s cities, but also a year of worrying about bubbles in China’s cities.

So who are we going to blame for the markets still being unfocused and floundering three years after the crash? If you listen to the keynote speakers at the outlook conferences and read the overview reports, it seems just about everybody.

Blame the Dutch

INREV released its newest Investment Intentions survey at its annual Winter Seminar. To no-one’s surprise, investors’ preferred fund style is core. Preferring core in and of itself isn’t a problem. But when investors prefer core to the exclusion of everything else, it drives the returns down to a point that investing in it is unsustainable. Is a four cap really worth the effort? Can anyone say that is a safe investment? So who is driving the increase in core prices? Overall, 69 percent of respondents said that core was their preferred style, but 92 percent of Dutch respondents preferred core while fewer than 45 percent of German respondents did (the Germans preferred value-added). It was suggested that the Dutch focus on core funds almost borders on obsession — and the irony is that the over-reliance on core actually increases the risk in what is valued as a safe investment.

Blame the Corporates

At the Thomson Reuters event, David Bowers, managing director and global strategist at Absolute Strategy Research, asserted that government deficits in the mature markets are only partly due to government spending. The primary culprit is the behaviour of corporations — they are operating to increase dividends rather than increase growth. If corporations continue to save and hoard cash rather than invest, things can only get worse. If they spend, then things will get better. For corporations to change behaviour, however, they will need to feel confident that the world will not collapse. And how can they be confident in that when at times it really does look like the world — or at least the world as we know it — is on the verge of collapsing.

Blame the Banks (and Regulators)

Emerging Trends in Real Estate 2012, the annual look at consensus market sentiment by PwC and the Urban Land Institute, reports that the prospects for any turnaround in 2012 hinge on how recent regulatory measures will affect banks’ willingness to make commercial loans, as well as whether another financial industry collapse caused by sovereign debt issues triggers a widespread release of assets by banks to investors. Everyone was hoping that lending and deleveraging would grow in 2011 — but it didn’t happen. Now there doesn’t seem to be much confidence that it will happen in 2012, either. In fact, Emerging Trends predicts that property financing will become a major casualty of the measures that banks take to move into compliance with new regulatory measures.

It’s the bankers themselves who are most pessimistic about the availability of debt in 2012. Of those surveyed, 92 percent believed that there will be moderately less (42 percent) or substantially less (52 percent) financing available than there was in 2011 — and there wasn’t all that much around then. And if they don’t think that they are going to increase lending, it doesn’t seem reasonable for anyone else to think that banks will increase lending.

Banks are subject to significant regulatory pressure to reduce their assets to meet capital requirements even without the new requirements working their way through regulatory bodies, and the widespread view in the Emerging Trends report is that commercial real estate lending will be hit disproportionately by banks’ need to rebalance portfolios. When debt is found, it will be expensive, as financing costs for banks continue to rise, even without the capital cost of meeting regulatory requirements.

If things are going to get better in 2012, the banks are going to have to start lending, and that simply doesn’t look promising, given the costs of meeting regulatory requirements. One possible bright spot is the projected need of the banks to delever and finally release assets into the market, providing investors with investment opportunities. However, even if banks begin to release more assets (as people have been predicting every year since the crash), it appears that both banks and investors intend to stick to their guns concerning valuations — and those guns are pretty far apart.

Blame Capitalism

Much of the upheaval in the real estate markets is a reflection of the upheaval in worldwide political and economic markets. The Arab Spring uprisings were more about the middle classes of those countries being able to feed their families — and the current governments being unable to control food prices — than they were about creating democracies. Rising oil and food prices created a free-floating anger, and those in power at the time became the target. A similar, if less violent, movement is occurring in the United States, where the activist Tea Party has gained strength on the back of the frustration felt by those who see their jobs being off-loaded to more competitive countries. Their demands have paralysed the US Congress, and left corporations and financial institutions hanging while they wait to see what will happen with regulations and taxes. This is not a climate conducive to improving real estate markets (though some would argue that a do-nothing Congress is better than one actually passing legislation).

Blame the Rabbit

Bowers of Absolute Strategy Research began his presentation at the Thomson Reuters conference with a John Kenneth Galbraith quote: “The only function of economic forecasting is to make astrology look respectable.” But listening to much of the talk in the break room, you’d think that astrology, at least Chinese astrology, was already quite respectable. Much of the talk centred on the hope that the year of the dragon would quickly supplant the stagnation of 2011, the year of the rabbit.

According to Chinese tradition, the rabbit brings a year in which you can catch your breath and calm your nerves. Although slowing down can be a good thing, if you are already at a standstill, a little bit of forward movement would be much appreciated. The year of the dragon is traditionally associated with new beginnings and good fortune. It signifies success and happiness. Whether respectable to believe or not, it would certainly be nice if the promise of the dragon comes to fruition; instead of asking at the beginning of 2013, “Who ya gonna blame?”, we could be asking, “Who ya gonna thank?”

Sheila Hopkins is managing director – Europe at Institutional Real Estate, Inc.