Buried on Page B 16 of the WSJ on Saturday, June 10, 2011, there was an article noting that Goldman Sachs suffered a major loss on its investment in the office building at 230 Park Avenue in Manhattan. This investment was part of the Goldman Sachs Whitehall real estate funds. A venture of the fund and Monday Properties purchased the building in 2007 for $1.15 billion (about $821 per square foot). According to the article, the value of the building was “about $300 million less than what it invested. Monday Properties remained in the deal and was recapitalizing the property, bringing in a new partner. Goldman’s exit from the property was part of the deal. The article also pointed out that Goldman’s Whitehall Funds surrendered to lenders the office building at 301 Howard Street in San Francisco and the La Costa Resort-Spa in Carlsbad, CA (near San Diego).
This news story, taken by itself, is no “big deal†but taken in the context of the major financial losses suffered by other investment banks invested in real estate as well as losses suffered by some public real estate companies, the story raises some interesting questions.
General Growth Properties, one of the largest publically held REITs invested in shopping centers went through bankruptcy. Morgan Stanley walked away from its investment in Crescent Properties in 2009 and took over $5.5 billion in real estate losses in 2010. Lehman Brothers failure was attributable, at least in part, to failed bets on mortgages as well as commercial real estate projects. Bear Stearns collapsed under the strain of mortgage investments and major banks took billions of losses on toxic residential and commercial real estate debt.
While much of the heavy property losses impacted private equity funds, those funds used investments from pension funds and thus, the spillover to the man on the street is recognized when the pension fund losses destabilize the ability of the funds to meet their pay out commitments. But, it seems that, with the possible exception of REITs, where individual investors play a roll, the common denominators were “other people’s money(OPM)†and size. The pension funds were investing OPM with private equity firms who then invested OPM. The private equity firms were fee driven as they earned placement fees, management fees and advisory fees. The same was true of the residential mortgage market where all “players†in the chain, except the hapless investor in mortgage backed securities, were fee driven.
The recent track record of the “players†brings into question the wisdom of trusting the judgment of investment vehicles managed by fee driven people who will have no personal “skin in the gameâ€. Part of the problem is size. As the amount of money available for investment grows, so does the pressure to place that money. And, pressure (or a herd mentality) induces managers to “compete†for the few offerings available. This leads to overpaying and/or undertaking more risk than the investment warrants.
The same problem impacts publically held REITs which feel pressured to demonstrate portfolio and value growth. This, in turn, leads to “competitive†investing and the undertaking of more risk than the investments warrant. The dividend yields on REITs have been driven down by investor’s desire for dividends and the REITs have enjoyed excellent appreciation over the last several months. There are a limited number of ways in which the value of REIT stock can appreciate. The first, is increasing rents/and or decreasing expenses leading to an increase in dividend payout (REITs must pay out 95% of their net income). Next is an increase in the value of the portfolio by virtue of improved operating fundamentals and/or a market acceptance of a lower capitalization rate. Finally, growth can be achieved by the acquisition of new properties, accretive to earnings through direct purchase or merger or both. This kind of information is not always transparent in REIT annual reports and it is questionable as to the depth of understanding possessed by analysts as to how real estate works. What is obvious is that executives in some REITs also feel pressured to “compete†for property offerings.
Moving to the size issue, the larger the funds become, the more difficult it is to manage individual property operations. Investment real estate has always been very management intensive and good management requires quick decisions when problems arise. However, with very large portfolios many major decisions require centralized authority and result in delays. There is a risk that decisions will be based on their impact on earnings rather than the needs of the property. The same risk impacts leasing decisions where the market may be ignored in favor of unsupported or unrealistic potential outcomes.
The bottom line in all of this is that the big investment banks, commercial banks and private equity funds may not have earned the credibility and respect that they are accorded. But, greed will continue to induce them to create investment vehicles to entice the big money players, whether the investments are viable or not. The next market collapse will be attributable to different causes but the same players will be involved.
