About $600 billion of commercial mortgage-backed securities are scheduled to come due in the next few years, but real estate veteran Sam Zell doesn’t see that as a major boon for the industry. In fact, he anticipates that the expected CMBS maturities will create an additional drag on the property sector.
“We extended and pretended our way significantly beyond what I would call reality,” Zell said, speaking at the Talmage 2013 Credit Conference in New York on Tuesday.
He anticipated that the refinancing of that debt likely will lead to more “extend and pretend,” referring to the common practice of banks extending the term on a nonperforming loan to give the borrower more time to pay back the debt rather than foreclosing on the mortgage. Such a practice “in effect is another way of screwing the real estate industry for another few years,” said the founder of Chicago-based Equity Group Investments, which includes private equity firm Equity International.
The impact of “extend and pretend” on the commercial real estate industry was the absence of true identification of values that would come from banks clearing real estate off their books. “We created artificial pretend and extend debt that artificially impacted the values,” said Zell. “In my judgment, I don’t think that made a lot of sense. I think everybody would have been better off had we faced up to whatever our problems were in 2006, 2007 or 2008, and today we would have had a much, much healthier commercial real estate market.”
Meanwhile, a low interest rate environment isn’t helping to reinvigorate real estate investment activity. Zell referred to the age of basketball prior to shot clocks, when the game was focused on keeping the ball away from the opposing team rather than scoring as many shots as possible – and basketball scores were in the low double-digits.
“The interest rate situation is such that it’s having the same impact as no shot clock,” Zell said. “Interest rates are part of the shot clock. Interest rates cause a sense of urgency.” He noted that, in 1990, he was able to buy a significant number of empty office buildings in the US because the seller had a seven percent cost of capital and therefore was motivated to sell. In 2008, with the cost of capital at one-quarter to one-half percent, the motivation to liquidate was limited.
Zell equated low interest rates with low growth, adding: “I don’t think low interest rates are healthy, despite the fact that obviously I’m a significant beneficiary. But everything is relative, and the answer is I made a lot more money when interest rates were seven than when interest rates are half of a percent, and it translates into every deal.”
Zell also said that increasing supply in the market would translate to inflation, and that inflation in turn would have a short-term negative impact on the real estate market. While real estate costs would immediately go up during an inflationary period, the increase in rental rates – and therefore income – would lag by five or so years since leases lock in rental rates for a certain period of time.
“The ‘inflationary protection’ that real estate offers is true, if you have the staying power and if you have a very long-term perspective,” Zell said. “On a short-term basis, however, I don’t think that real estate historically has been an inflation hedge.”