The Trouble with the Bubble


The torrid pace of risks and valuations reached a new level in the business known as Real Estate Investment Trusts (REITs). Required by federal law to pass on most of their earnings to their shareholders, REIT shares have been going up and up for eight straight years, with this year clocking an unexpected 30% rise all by itself for commercial real estate.

Judging by the absence of warnings from financial writers and columnists about soaring REIT stocks and the recent record prices paid by debt-loaded private-equity firms to buy publicly held REITs listed on the stock exchanges, the tempo is still bullish-full speed ahead!

That’s when you know that trouble with this bubble lies on the horizon. When it’s all bulls and no bears.

Twenty years ago, Felix Rohatyn, leading partner of Lazard Frères & Company, a major investment bank, told me he worries a lot about speculative excess on Wall Street. "The thing that strikes me in a lot of this is how little real professionals," he said, "understand risk. The leveraged buyout is a risk evaluation. People take a pedestrian company with 20 percent debt and 80 percent equity and they turn it into 80 percent debt and 20 percent equity, all of a sudden you have a terrific business. It doesn’t make any sense."

It may not have made sense then, but for the first acquirers it usually made them a lot of dollars. Mr. Rohatyn saw "a massive and deeply institutionalized gap between those who risk and those who pay."

I wonder what he thinks about gaps, risks and valuations now as he looks out of his Manhattan suite at New York’s real estate spiral. He could envision the following prudent behavior. That these commercial apartment and office buildings would be valued at about ten times their net annual earnings. Or he could observe what is really going on when these structures-individually or in clusters-change hands.

In recent days, private-equity companies are reported to be interested in buying public REITs that are trading between 30 and 55 times earnings. When the Blackstone Group paid about a ten percent premium to acquire Equity Office REIT-already selling at its high for the year-Equity Office’s largest shareholder, Cohen & Steers, thought the sales price at $48 was too low. C & S’s Jim Corl explained his appraisal by declaring the cost of buying all the properties in Equity Office’s portfolio would have been in the $60 range.

One New York City-based REIT saw its stock double in the past twelve months to $138 a share from a then record high. It is presently selling at 55 times earnings and yielding 1.7 percent. Like many other REITs, this one experienced a sharp share increase the day of the Blackstone acquisition news announcement that was seen by Wall Street as possibly signaling a takeover binge by these cash-loaded private-equity firms.

Now, to repeat, apartment and other commercial buildings are bought to make profit. Why would a buyer pay, not ten times the net annual income, but 30, 40, 50 or more times? The answers to that question would probe deeply into the ways complicated financial deals hand off that risk to other investors, tier the risk through instruments such as "toggle" bonds, and take advantage of accommodating tax breaks and low interest rates in a period of bulging capital surpluses looking for appreciating investments.

The Wall Street Journal’s Jennifer S. Forsyth was intrigued enough to interview Sam Zell, called the legendary Chicago-based real estate mogul who sold Equity Office to the Blackstone Group. Zell quickly told her that "this is the greatest period of monetization in the history of the world. That huge amount of liquidity that’s floating around is not something that would be absorbed in weeks. I think it will take more like six years."

Ms. Forsyth asked why are so many REITs being taken private? Ever the booster, Mr. Zell replied that private investors are willing to work at higher risk-levels than the public markets which have fiduciary obligations to their shareholders and therefore have adopted "a philosophy of very conservative leverage." Most public REITs pay between 3 and 7 percent dividends. These private investors are really seeking quick capital gains for the risk-a more risky adventure.

Now comes the key question. She asked, "You’ve said that the public markets undervalued your company. Why?"

Mr. Zell’s response: "Basically over the last few years, the analytical community was continually behind in their evaluations of office assets." Whew!

The absence of any concern about excessive risk, any reference to the slowdown in the economy, any mention that the amount of space companies leased during the third quarter was significantly lower than the first half of 2006, any reference to continuing construction of new buildings, or most remarkable, the huge debt loads that are being incurred.

Mr. Zell has been around since the Sixties and has seen busts followed by booms in real estate. Yet he seems to see nothing scary on the horizon.

Tiers of debt always are scary, especially when Uncle Sam does not actively bail out real estate and its financiers. Millions of younger, middle-age and older adults find it scary because they are being driven out of cities due to unaffordable rents and condo prices. So too do small businesses find it scary having to close their stores when their leases expire because they can’t come close to paying the new rents.

Maybe the major question of them all is: Who is real estate for first? Real people or speculating financiers. Real people or corporations playing with bricks-and-mortars as if they were just a numbers game in a fast turnover bazaar.

Speak out, Mr. Rohatyn.


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