Commercial property: three weddings, one funeral
By
Bill Bonner Jun 21, 2007
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The day Sam Zell met Jonathan Gray, sparks flew. The two were made for each other. Gray runs Blackstone’s property arm and was looking for a trophy deal in Manhattan’s hot property market. Zell, who has been around the block a few times, wanted out of his marriage to Equity Office Partners, the group of buildings he had lived with for many years.
The ceremony that followed was lovely, the biggest leveraged buyout ever. For $39bn the union was consummated and Gray became master of the EOP portfolio. It was one for the history books. It was also one that calls out for deconstruction. In it, Gray took money that cost him about 6.5% and used it to buy properties that yielded a 3.75% “cap rate” return. What gives?
The point of this week’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 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 run of trophy marriages took place in New York.
Then, it was the late 1980s and the suitors were Japanese. Americans couldn’t believe their luck; here was a race of the dimmest rich people they had ever seen. The fairytale marriage of the era took place in 1989, between the Mitsubishi Estate and America’s own darling, the Rockefeller Center. Mitsubishi spent $1.4bn, which was still big money back then, and then discovered it needed to spend a lot more on improvements and maintenance. A trio from Columbia Business School later rated it one of the “Dumbest Business Decisions of All Time”. It ignored the fundamentals of property investment. Buying properties only makes sense if you can get enough out of them in rent to cover expenses and give you a decent return on your money.
Having invested nearly $300bn in the US in the 1980s, the Japanese quickly became net sellers, and kept selling for the next 15 years. Prices of commercial real estate in America fell by up to 50% in the early 1990s. The buyers of the Rockefeller Center had counted on rising rents; instead, rents fell… and the Japanese were buried in losses. Finally, they lost control of their trophy entirely.
Commercial property bubble is pushing up prices
It is now more than a quarter of a century later. But the world turns in about the same way. A few days ago Morgan Stanley made the news. All Nippon Airways owned 13 hotels in Japan. It wanted to unload these places for about ¥100bn and asked for bids. Thirty suitors showed up. One of them, Mr Gray, offered ¥235bn. But then, along came another hunk, Morgan Stanley, with ¥280bn; 2.8 times what All Nippon had hoped to get.
Financial marriages, when they result from such fevered bidding contests, are rarely happy ones. Suitors get carried away. Later, when money is not so easy to come by, they look over at their bride and wonder what they have got themselves into. Even before Morgan Stanley raised the bar, prices in Tokyo had risen. Dividend yields in Japan’s property sector, compared to ten-year bond yields, have been cut in half in the last five years. At the price Morgan Stanley paid, it is likely soon to find itself in a funk, like Mitsubishi Estate 25 years ago.
Still, 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, the spread has gone negative.
The biggest deal in British property history took place recently too. This time, the suitor was the Spanish property giant, Metrovacesa, and the trophy London’s HSBC headquarters. At more than $2bn, it was a trophy price, too – the highest ever for a British building. In London, even more than in Japan, a man looking for bargains might as well go home. 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 only 3.8%. They could get a better return from Government bonds – almost without risk or hassle.
What gives? When you approach the final stage of a credit expansion, the bubbleheads rush into a lot of bad investments. When it comes to an end, they find that the deals they made in such haste must now be regretted at leisure.
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Bill Bonner
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