“I believe that credit markets have been recklessly permissive to the point where instead of traditional risk-adjusted rates of return the market is dealing with what I would call risk-ignored rates of return.”
– Wilbur Ross, Private Equity Pioneer
The day that Jonathan Gray met Sam Zell, sparks flew. The two were made for each other. Gray runs Blackstone’s property arm and was looking for a big trophy deal in Manhattan’s hot commercial property market. Sam Zell, who has been around the block a few times, wanted out of his dull relationship with Equity Office Partners, the group of buildings he had lived with for many years.
The ceremony that followed was smashing, the biggest leveraged buyout ever. For US$39 billion the union was consummated and Gray became master of the EOP portfolio. It was one for the history books and the newspapers. It was also one that cries out for deconstruction.
Think about it. Gray took money that cost him about 6.5% in financing expense and used it to buy properties that yielded a 3.75% “cap rate” return. Right on the surface of it, Blackstone seemed to be guaranteeing itself losses. What gives?
The burthen of today’s column is that, when it comes to credit expansions, all men are created equal – rich or poor, Japanese or American, sophisticated or just-off-the-turnip-truck. As long as the bubble is expanding, they all enjoy the same deceits and illusions. The subprime homeowner lies about his income while the big city slicker forgets to ask for protective covenants. All of them end up in deals they wish they had never heard of.
“Never take financial advice from someone younger than you are,” is an old-timer’s rule. Mr Gray is only 37 years old. He was probably still in school the last time a major season of trophy marriages took place in New York. Then, it was the late ’80s and the ardent suitors were Japanese. Americans couldn’t believe their good fortune; here was a race of the dimmest witted rich people they had ever seen.
The fairytale financial wedding of the era took place in 1989, between the Mitsubishi Estate and America’s own darling, the Rockefeller Center. Mitsubishi spent US$1.4 billion, which was still big money in those days. Then it discovered it needed to fix the roof…and went on to spend a fortune on improvements and maintenance. A trio from Columbia Business School later dubbed the Mitsubishi-Rockefeller connubial one of the “Dumbest Business Decisions of All Time.”
What was so dumb about it was that it ignored the fundamentals of property investment. Buying properties only makes sense if you can get enough out of them in rent to cover your expenses and give you a decent return on your money.
After having invested nearly US$300 billion in prestige properties in the United States in the 1980s, the Japanese quickly decided they wanted out and kept selling for the next 15 years. Prices of commercial real estate in America fell as much as 50% in the early ’90s. The buyers of Rockefeller Center had counted on rising rents; instead, rents fell, vacancies rose and the poor star-crossed samurai were buried in losses. Finally, they lost control of their trophy darling altogether. R.I.P.
It is now almost 20 years later. The drama is still the same, but the dramatis personae have changed. A few days ago Morgan Stanley made the news. All Nippon Airways owned a string of 13 hotels in Japan. It wanted to unload the places for about 100 billion yen and announced it would accept bids. Thirty suitors showed up. One of them, the aforementioned Mr Gray, offered 235 billion yen. But then, along came another hunk, Morgan Stanley, with 280 billion yen; it won ANA’s favor with a bid 2.8 times greater than All Nippon had hoped to get.
Financial marriages, when they result from such fevered bidding contests, are rarely happy ones. Lovers, caught in the heat of the auction, and steamed up by free-and-easy credit conditions, get carried away. A few months later, when money is not so easy to come by, they look over at the unfamiliar head on the pillow next to them and wonder what they have gotten themselves into. Even before Morgan Stanley raised the bar, prices in Tokyo had risen substantially. Dividend yields in Japan’s property sector, compared to 10-year bond yields, have been cut in half in the last five years. Average cap rates in Japan are now only 3.5%. Vacancy rates are below 3%. At the price Morgan Stanley paid, it is likely to soon find itself in a funk, like Mitsubishi Estate 18 years ago.
While Morgan Stanley was becoming one of Japan’s biggest hotel operators, it also paused to pay court to the aforementioned Mitsubishi Estate Co. This time, it was the Japanese who were wooed into selling a stake in their own property, worth – would you believe it – US$1.4 billion, the exact amount of the Rockefeller Center purchase.
At least property investors in Japan can still hope to get enough yield to cover their financing costs – thanks to mortgage rates near 2%. In London and New York, on the other hand, the spread has gone negative.
The biggest deal in British property history took place recently too. This time the suitor was the huge Spanish property giant, Metrovacesa, and the trophy was London’s HSBC headquarters on Canary Wharf. At more than US$2 billion, it was a trophy price too – the highest ever paid for a British building. In London, even more than in Japan…or in New York in 1989…a man looking for bargains might as well go home. Rents are said to be up 25% over the last 12 months. Prices per square foot are twice as high as those in New York. And at the price paid by the Spanish, their new trophy building will yield no more than they could have gotten in Tokyo – 3.8%. But financing costs are a lot higher in Britain than they are in Japan. Even the prime rate in the UK – at 5.5% – is significantly higher than the expected yield on the HSBC building. The Spaniards could get a better return from government bonds – almost without risk or hassle.
It boils down to this. You can learn amortisation schedules in school, but some things you still have to learn on the job. And every generation has to pay its own tuition.
When you approach the final stage of a credit expansion, the bubbleheads rush head first into a flurry of bad investments. And when the confetti has stopped flying and the wedding gifts have been put away, they find that the unions that they entered into in such haste may be regretted.
Markets and Money
Have you ever made a property investment you regretted? Is cheap credit to blame for bad investments? Leave a comment below.