What will the next downturn look like? Part 1: Interview with Dr. David Geltner
Author of the most cited real estate textbook in the world peers into the future.
October 20, 2015 BY IAN IPPOLITO
The next recession is not a matter of ‘if’ but ‘when’. Protecting your portfolio is crucial to preserving your net worth.
What will the next downturn bring? It’s my pleasure to interview Professor David Geltner, who is one of the foremost authorities on commercial real estate research. He is the author of two fascinating papers on commercial real estate recessions: “Commercial Real Estate and the 1990-91 Recession in the United States” and “Real Estate Price Indices & Price Dynamics: An Overview from an Investments Perspective”.
He is also the lead author of the most widely-cited real estate investment textbook in the world: “Commercial Real Estate Analysis & Investments”. He has been the faculty chair of MIT’s Center for Real Estate (CRE) Master of Science in Real Estate Development (MSRED) program and is the Associate Director of Research at the CRE, and is Professor of Real Estate Finance at MIT in the department of Urban Studies & Planning and the Director of Rea. In 2011, he received the U.S. Pension Real Estate Association’s prestigious Graaskamp Award for excellence and influence in real estate investment research.
Geltner has served as Academic Advisor to the National Council of Real Estate Investment Fiduciaries (NCREIF), and as Director of MIT’s Commercial Real Estate Data Laboratory which has been involved in developing pioneering commercial property price and investment performance indices based on transactions prices (including the Moody’s/RCA CPPI, the NCREIF-based TBI, and the FTSE-NAREIT PureProperty® Indices). Geltner served from 1999-2012 as the External Academic Member of the Real Estate Investment Committee of the State Teachers Retirement System of Ohio (a pension plan sponsor with over $5 billion of directly managed real estate holdings). He has been teaching graduate level real estate investments and finance since 1989.
TRCR: Recession talk is the hot topic of the day, and you've done some fascinating research on commercial real estate recessions and cycles. In one of your papers, you pointed out that the CRE (commerical real estate) pricing cycle does not actually correspond to the business cycle (three cycles since 1969 versus five). What is it about CRE that sometimes allows prices to maintain themselves (or even increase) during a business cycle downturn (when employment and GDP are dropping)?
Geltner: Commercial property, that is, income-producing property, the type of property that can serve as an investment asset class, reflects pricing in two markets:
1. The space market, where the occupancy and usage of built space is traded (aka, “rental market” or “leasing market”);
2. The property asset market, where the ownership of real property assets is traded (the investment market).
The former, commercial space market, usually suffers during a macro-economic recession, for most types of property in most locations, that is, rents and/or occupancy falls, so net income falls (often somewhat lagging behind the recession, both in the drop and the recovery). But there can be some types of space markets that are income-inelastic, such as moderate-income apartment properties and grocery-anchored retail centers or bargain outlet centers, which do not fall, or not much, depending on the nature and depth or length of the recession.
But more importantly, the other market that determines property prices, the property asset market, which is a branch of the international capital markets, may react more independently of U.S. macro-economic fundamentals. That is, money may flow to investment real estate assets even though current rental fundamentals have taken a downturn. This is especially true for “first tier” properties (well-leased prime properties in prime markets, presently the “gateway six” being: Bos, NYC, DC, Chi, SF, LA), which may be perceived as a type of “safe harbor” investment.
Capital may actually be relatively reallocated away from more risky or problematic asset classes (tech stocks in 2001, long-term bonds in 1981) and towards real estate. This can prevent property asset prices from falling, or from falling as much as they otherwise would.
However, a lot depends on the nature of the recession and the financial system at the time, and also on the state of the space market. If the space market is severely over-built (excess physical supply), as it was in the late 1980s, then even a mild recession can be perceived as very bad news for commercial property, and that can scare the money away (perhaps rightly so, to some extent). Often it depends on how the equity capital reacts. The debt sources, being conservative, almost always shy away from commercial property in a recession (at least, the domestic sources of debt). But if there is sufficient equity capital (domestic &/or foreign) to temporarily take the place of the debt, then the overall property asset market can ride out the storm relatively well.
TRCR: Your research has shown that the pricing cycle has been surprisingly regular, lasting 16 to 18 years. This is amazing, considering that it's driven by things that seem somewhat random (like the attractiveness of CRE versus other assets, interest rates, liquidity). Do we currently understand why it has been so regular?
Geltner: Honestly, we don’t, or at least, I don’t. And I don’t think it is guaranteed to necessarily always be that regular. Three observations does not a large sample make! But it does seem to be related to debt availability. It is tempting to see a little more than a coincidence in the way the commercial property debt lending industry has evolved and developed in relation to these three cycles.
I don’t know that much about the 1970s downturn and recovery, but I think a nascent mortgage REIT industry played a role, and of course that particular type and source of lending did not repeat in a major way. And the (largely life insurance based) commercial mortgage lending industry adopted some “reforms” I think after that downturn, such as balloon loans with no more than 10-year maturities, and participating loans.
Then during the 1980s lending binge the “bad guys” included the life insurance companies themselves, although the even bigger culprits were the newly deregulated thrifts, as well as commercial banks, in both cases short-term-liability depository institutions that focus on construction lending (hence, in part, the over-building boom in the space markets).
To the rescue in the 1990s came REITs and CMBS (commerical mortgage backed securities), the latter of course especially on the debt side. Especially after CRE weathered the 1998 financial crisis, the industry convinced itself that the public markets had brought real “discipline” to property investment and development. But of course CMBS were the “bad guys” in the 2000s bubble. But that one was more a purely pricing bubble in the asset market, not much over-building in the space market (in part perhaps because CMBS were not construction loans).
My point is that the exact source and type and nature of the “debt culprit” has not repeated; it’s been different in each cycle. People have memories, and 16-18 years is short enough that there is a lot of institutional memory from one crash to the next. So, people (institutions) don’t tend to repeat EXACTLY the same specific mistakes. (Some famous person said: “History does not repeat, but it rhymes…”).
For example, in the recovery from the Great Recession banks and special servicers exercised forbearance and “pretended & extended” rather than engaging in the fire sales that overly depressed the market in the early 1990s. But the general pattern seems to be that by a decade and a half or so the memory of the last over-leveraging is faint enough so that a slightly different, new type or source of debt capital is able to go over-board, convincing itself that what is supposed to be a conservative investment actually is still a conservative investment, even though the property prices have by then reached dizzying heights.
But all of this is just story-telling. It is not rigorous academic theory. And it does not tell us exactly when or how the next downturn will occur.
(Personally, I have stated publicly that I think the next U.S. recession may be the first Chinese recession. But what do I know? I am definitely not a macro economist.)
TRCR: The next recession isn't a matter of if, but when. Many economists feel the current business cycle is getting "long in the tooth" and are predicting a downturn in the next 2-4 years. If that happens, do you think we would also see an asset price downturn in CRE? Or do you think it's more likely to be a recession where prices are stable or even increase?
Geltner: I really don’t know. And it could depend a lot on what happens between now and then.
CRE pricing is very high already, especially in top tier markets like Manhattan (and others, though Manhattan really stands out). So, if prices continue to go up at the rate they have been, and the recession doesn’t happen for, say, 3 or 4 years yet, then prices could be so high by then that a recession which inevitably hits the space markets will prick a bubble in the asset market.
Then too, if construction really takes off between now and then, we could also have some over-built space markets, which would exacerbate the situation. And already cap rates (yields) are so low that there isn’t much buffer possible for the asset market to absorb a major hit in the space market.
On the other hand, by 3 or 4 years from now there may have been enough time, if the economy has continued to grow, to allow real long-term interest rates to rise a bit, and rents too, such that there could be some buffer provided against a major crash in CRE asset prices, as high rents can help support high asset prices, and the Central Bank could by then have maneuver room to lower interest rates (again).
In short, and as always, it is hard to say in advance. However, my gut feeling is that CRE prices will take at least a mild tumble overall in the next recession. Maybe not a huge crash like has occurred in the three previous cycles, but at least a serious “correction”.
One consideration is that CRE asset values consist of two components: building structure value and land value. The former is pretty elastically supplied, but the latter is very inelastic, which means the land component of value is particularly sensitive to changes in demand. And I believe that the land value component has increased as a fraction of property value, certainly since the previous cycle trough, but also longer-term since the 1990s. The yield compression we have seen since the turn of the millennium has redounded primarily to land values, not structure values. This could make it more difficult for CRE asset values to escape collateral damage in future recessions than was the case in the late 20th century. (Although, it is also why there is less propensity nowadays to over-build, as high land costs discourage development.)
More investment tips
In part 2, Dr. David Geltner explains more about CRE to help with your investing.
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About Ian Ippolito
Ian Ippolito is an investor and serial entrepreneur. He has been interviewed by the Wall Street Journal, Business Week, Forbes, TIME, Fast Company, TechCrunch, CBS News, FOX News and more.
Ian was impressed by the potential of real estate crowdfunding, but frustrated by the lack of quality site reviews and investment analysis. He created The Real Estate Crowdfunding Review to fill that gap.