Re-Engineering Real Estate
Top Minds Weigh In During Center's 25th Anniversary Conference
By Jim H. Smith
Posted October 26, 2010
"The title of our conference is important," CRE Chairman Tony Ciochetti told an overflow crowd of nearly 300 guests – including many of the Center's nearly 850 alumni – as he welcomed them to MIT's celebrated Media Lab on Friday, October 1, 2010 for Real Estate Re-Engineered: Leveraging Science, Developing Innovation, MIT/CRE's 25th anniversary conference. "This represents our goal to connect the industry to the broad set of disciplines – in the areas of management, economics, science, engineering, planning and design – that make MIT such a famous institution," he said.
And, indeed, the conference kept the spotlight focused squarely upon the crossroad where professional real estate encounters the Center's mission "to improve the quality of the built environment and to promote more informed professional practice in the global real estate industry" and the scope of innovative research being done at the center and elsewhere at MIT.
Months in the planning, the ambitious anniversary conference featured everything that distinguishes the Center for Real Estate – education, pioneering research and opportunities to bridge the gap between theory and practice by uniting industry leaders with the Center's faculty and students.
Shadow Banking and Other Complex Systems
The day-long program got under way with a panel entitled "Financial Re-Engineering" moderated by Professor William Wheaton. Panelists included Bengt Holmstrom, Paul A. Samuelson Professor of Economics at MIT; Andrew W. Lo, Harris & Harris Group professor of Finance at MIT's Sloan School of Management and director of the Laboratory for Financial Engineering; Jiang Wang, Mizuho Financial Group Professor of Finance at the Sloan School; and Nobel Laureate Robert C. Merton, distinguished professor of Finance in the Sloan School.
Wheaton set the tone for the dialogue – lively despite its one hour and forty-five minute duration – by asking his four panelists to identify what they felt was the most critical factor in creating the financial crisis.
That there is no single, simple answer to that question was underscored by the range of answers from the four panelists. Holmstrom was quick to pin the blame on the so-called "shadow banking system," the many non-bank financial institutions that function as intermediaries between investors and borrowers. He noted that the global economy, flush with money, was looking for a "parking space" for that wealth and investors thought they had found safe investments in the US. "That perception wasn't surprising," he said, noting that the US had gone through 75 years without a major financial crisis.
Jiang concurred. "We let the market manage the risk," he said. "This is reflected in the growth of the shadow banking system. We need to think about the driving forces behind shadow banking. There's no such thing as a free lunch."
But while Lo was willing to implicate shadow banking as a factor, he expressed a broader perspective. "Trying to pin the problem on one thing is not realistic," he said, adding a cautionary note. "The financial system has gotten so complex that the possibility of systemic shocks exists even if all the parts seem to be working well."
Merton agreed that there were multiple causes for the problem, and described the multiple factors as so complex that some are not known even now. "There were plenty of fools and knaves," he said, adding, "We have to focus on structural problems if we are going to learn from this for the future."
Regulating a "Trusting System"
Exploring other possible causes of the crisis, Wheaton turned the dialogue first to the issue of securitization. Noting that the US uses it more than any other country in the world, he said "it gets a lot of blame" for the financial crisis. And he articulated some of that criticism: "There's never been a '100-year flood.' It's too complex. It's not transparent. You can't resolve investor disputes."
Securitization is part of the reason "we could pump hundreds of billions of dollars into home loans," said Lo. "Being able to repackage obligations and distribute them…allows ordinary borrowers to tap into the power of global capital markets." However, he was quick to note, "Along with the growth came some problems and unintended consequences."
Lo employed a metaphor to describe how those problems can turn into major catastrophes. Western forest fires, which once routinely consumed a few thousand acres, now seem to consume millions of acres. A study revealed that because the forest service now has a policy of putting out all fires, swiftly, brush grows unchecked and creates the potential for huge fires.
"There is no major institution in the world – including all the central banks – that can function without derivatives," said Merton. "It's not feasible. Securitization, or its functional equivalent, is essential."
When Wheaton turned the discussion to the suggestion that the regulators, who had been in charge of managing systemic risk, had been "asleep at the wheel," Holmstrom said the system is a "trusting system," with so much collateralization that consumers don't feel the need to ask questions. "Things are liquid, basically, when people don't have a need to collect information," he said. "Banking has never been, and I doubt it will ever be anything but opaque."
Lo pointed out that well before the financial crisis occurred there were warnings that the system was overstressed, many of which were ignored by regulators. "Regulators don't have the tools to get the timing right," he said. "Regulation has limited ability to manage those risks."
The Lesson of April 14, 2000
Having discussed a range of possible culprits responsible for the financial collapse, Wheaton asked the panelists what policies they would want to change in order to prevent another fiscal catastrophe in the future.
"New systemic risks will develop," said Jiang. "We can't rely on the market to control the risks. We need a new regulatory body to gather information and decide where we are and where risk is brewing."
But Merton countered, "Within the government, regulators had enormous power before. Just giving them more power doesn't necessarily solve the problem."
Lo was even more adamant in his opposition to giving the government more regulatory power, suggesting an alternative kind of federal agency instead. "I disagree strongly that the Fed should be given more power," he said. "It's supposed to manage systemic risk, but we also expect it to stimulate the economy. Those ideas are fundamentally conflicted. I think we should create a new federal agency along the lines of the National Transportation Safety Board. It has no regulatory responsibility. It sifts through the crash site and it can criticize. It is beholden to no one."
Wheaton asked the panel where capital was most likely to land next and where future crises could be developing.
Lo pointed to three examples of "bubbles" that are building now – gold, emerging markets and commercial real estate – each of which bears monitoring. "There's a trillion dollars of commercial debt that needs to be rolled over in the next two years," he said, noting ominously that much of it is held by small institutions. "I suspect that over the next two years we're going to see a record number of failures of small and mid-sized banks for that reason."
"Some bubbles seem to have no chance of creating a crisis," said Holmstrom. "The problem is when [the bubble] hits collateral and backs up credit. That's the kind of bubble [that is problematic], and not surprisingly it's very often housing."
Lo was quick to pick up on Holmstrom's point, asking the audience how many remembered April 14, 2000. When only a few hands went up, he pointed out that on that date the US stock market dropped six and a half percent, erasing more than $1 trillion in wealth. "And most of you don't even remember that day," he said. "Systemic risk isn't just losing money. It's when the wrong people lose money, people who can't afford to lose money." The "wrong people" would include a money market or a pension fund or a bank with investors, he said.
"What about debt?" Merton asked. "I don't say it's a bubble, but I don't know how we're going to reconcile in any of our models the enormous debt we've built up. What you see measured as debt is far less than the total amount of exposure. Just think of all the guarantees that everyone has written that are off balance sheet. Those guarantees are worth a lot. They're real."
Sustainability and Resiliency: Buildings that Work
"What percentage of energy do buildings consume in the US?" Ciochetti asked the audience, as he introduced the morning's second session, a panel discussion entitled "Re-Engineering Buildings – Innovations in Building Technology" which he moderated.
That percentage is a whopping 39 percent! "Buildings consume more energy than the industrial or transportation sectors," the chairman said, adding that the percentage of energy consumed by buildings climbs to nearly 65 percent when the energy required to manufacture the buildings' steel, glass and concrete is factored into the equation. The issue of how to reduce that excessive consumption through better design was the focus of the second panel.
Its members were John A. Ochsendorf, associate professor of Building Technology in MIT's Department of Architecture; Alex "Sandy" Pentland, director of MIT's Human Dynamics Laboratory and the MIT Media Lab Entrepreneurship Program; and Sarah Slaughter, senior researcher at the MIT Energy Initiative.
Ochsendorf began by talking about initiatives at MIT designed to aid architects and builders with life cycle planning for buildings. "When automobiles are designed, performance matters," he said, "and people on the street are literate about what automotive performance means. Buildings use more energy than cars. They are bigger capital investments. And we have practically no literacy about the energy performance of buildings."
Referencing the growing demand for quantification of buildings' use of energy, he described a number of MIT initiatives that are currently exploring the life cycle of buildings. The goal is to develop ways to reduce emissions and costs at every stage of a building's life.
Slaughter spoke about innovations in building and infrastructure systems with special emphasis on "high performance buildings" that more effectively enhance the health, safety and well-being of their occupants. "The impact of the built environment on our health and well-bring is enormous," she said, noting that Americans are estimated to spend over 85 percent of their time indoors. And she reminded the audience that return on investment only happens because buildings are providing value for their occupants.
She added that an issue closely related to sustainability and increasingly of concern is resiliency. If sustainability is about lowering the overall energy requirements of buildings, then resiliency is about buildings designed to survive disasters and quickly resume functionality in their aftermath.
She identified a set of characteristics that distinguish healthy, sustainable and resilient buildings:
- Strengthened structure and exterior enclosure to endure extreme loads
- Dry (avoiding accumulation of excessive moisture)
- Comfortable, in air quality and temperature
- Quiet, with improved acoustical quality
- Well-lit, with adequate natural and artificial light
- Clean and durable surfaces and systems
- Views of nature
Studies of disasters such as the Haiti earthquake and the catastrophic disruption of life in New Orleans following Hurricane Katrina, she said, has led to significant recommendations concerning post-disaster provision of critical infrastructure requirements. Many hospitals, she said, are now required to have a significant supply of reliable energy on hand and there is increasing interest in multi-nodal systems built around localized provision of energy and supplies that could sustain buildings after disasters.
Slaughter noted that studies have shown immediate, quantifiable benefits for the creation of sustainable and resilient buildings. She cited studies that, for instance, tracked measurable of reductions in capital costs, increased workforce productivity and higher rental rates. And it was on that note that she introduced the new Center for Advancement of Building and Infrastructure Systems currently being developed at MIT.
"There are near-term opportunities to increase efficiency and reduce energy and water use by over 40 percent through building and infrastructure upgrades," she said, "and there are also significant opportunities to increase disaster resiliency."
The new center, she said, focuses on research that explores how to effect change through increased focus on the value-added chain of parties with an interest in the building. Toward that end, a research and development partnership of some 120 organizations through New England – from builders to government agencies – has been assembled to help advance the center's research. "We really need to engage deeply with everyone in the chain," Slaughter said. "We believe this linkage among all the parties is going to significantly speed [progress]."
Nervous System for Humanity
Pentland talked about research into how buildings are used, and how that use can be coordinated and reorganized in order to make buildings more efficient and productive. He referred to it as "coordinating a nervous system for humanity."
Roughly 80 percent of complex information within organizations flows from person to person in face-to-face communications, he said. If you can measure that or enhance the flow of communication, you can use it to produce a host of positive changes, such as improvements in retention of employees, reduction of stress levels and increased productivity.
"Research shows that relatively small [workplace] changes can result in productivity gains of as much as 40 percent," he said. To illustrate the point, he cited research at a Bank of America call center that resulted in a very small change in the timing of coffee breaks. That tiny change, which cost the company nothing, increased face-to-face communications and saved the company some $15 million annually at that one center.
Pentland's presentation focused on mechanisms for gathering and analyzing data from many different sources – such as cell phone data, credit card data and transportation data – in order to understand and predict a wide range of human behavioral patterns, which he described collectively as "patterns of commerce."
Noting that it is possible to predict a wide range of things – from gross domestic product to life expectancy – by analyzing such data, he suggested doing so could "promote a very different view of development. These patterns are interesting from a real estate point of view." And he added, "You can imagine building things to take advantage of those patterns."
Reactions and Prognostications
An afternoon panel of prominent practitioners, assembled to react to the broad slate of ideas discussed during the morning sessions, kept the postprandial audience attentive by practicing their "crystal ball" techniques and offering a diverse chorus of predictions about the industry's future. Moderated by Raymond Torto, chief economist for CB Richard Ellis, the panel included Joseph Azrack, managing partner of real estate for Apollo Management; Brad Case, vice president of research and industry information for the National Association of Real Estate Investment Trusts; Lynn C. Thurber, chairman of LaSalle Investment Management; Thomas Garbutt, senior managing director and head of global real estate at TIAA-CREF; and Douglas T. Linde, president of Boston Properties.
The lively panel discussion got under way with reactions to a question from MIT/CRE alumnus Jacques Gordon Ph.D., global investment strategist for LaSalle Investment Management. Gordon noted that while complexity was a central concept in both of the morning presentations, the luncheon speaker – the redoubtable Gerald D. Hines, founder and chairman of Hines, the giant international real estate investment, development, and property management firm – had offered an overview of his company's success that was decidedly simple. Gordon asked the panelists to commend on that contrast.
"One of the big challenges of people coming into the business is seeing the forest for the trees," said Azrack, advising practitioners to "Discern what is important and what is 'noise.' What are the big [issues] that will determine success or failure?"
"There is tremendous complexity," Thurber conceded, but "The ability to lead is the ability to simplify and focus."
Garbutt concurred with her. "The real value proposition is not to propel complexity, but to break it down," he said. "Students today are more technically trained than ever. The key is to be able to simplify the complexity. Investors want to get to Hines' perspective."
Turto asked the panelists to offer a single word for MIT/CRE students that encapsulated, for them, the future of the industry.
"If you have high aspirations for the business and some day want to run a significant platform, I think the one word would be global," said Garbutt. "The world is becoming increasingly interconnected." And he urged young real estate professionals to get experience outside the US.
Thurber picked risk management. "We have talked in this industry about risk management for many decades," she said. "Today, whether you're investing, developing or running a publicly-traded REIT, it's important to really be able to articulate what risks you're taking, how to assess them and [their] likely impacts on your company. Taking risks is what our jobs are all about. It's being able to understand risk and price it correctly."
Case, whose choice was discipline, said, "What we saw in the last couple of years was a large destruction of value, and that came from a lack of discipline." He said that simply having a capacity to take risks is not the issue. If one takes risks and they do not pay off, one is not acting in a disciplined manner. "It's not enough for an individual to have self control," he added. "Do you have mechanisms in place that discipline your decision-making processes so that you minimize the opportunities to destroy value?"
Glimpses of Tomorrow
The panelists next turned their attention to a pair of assertions made by panelists during the morning sessions – that there would be systemic risk and real estate bubbles essentially forever, and that a trillion dollars in debt, due to be rolled over in the next few years, would create significant problems in the commercial real estate sector.
Linde argued that while "the macro issue" of bubbles and systemic risk is real, there still seems to be a large appetite for "high quality, better located real estate projects."
Azrack said the commercial debt was closer to $2 trillion and "probably $500 billion doesn't really exist and another $500 billion needs to be equitized. "Those staggering numbers notwithstanding, he predicted, "It won't be Armageddon, because the Fed won't allow it. But it will be a huge drag on the economy" and, he added, both a challenge and an opportunity.
"In general," Garbutt said, "many small and mid-sized banks have big problems because a lot of their assets are of inferior quality. Time is helping. Capital markets are adjusting. When I talk with CIOs and ask why they are moving back into real estate, [they say] there are very few alternatives where they can put their capital today."
"In 2008-09, almost everything in every market was going down," said Thurber. "Now, we're in a recovery period and markets are going up in different ways. Investors are uncertain. Some are risk averse and want core assets and they are paying up dearly." But, she hastened to add, no one answer will solve all problems going forward.
Torto asked the panelists what changes they had seen in the industry, and what they thought those changes meant. "As we go forward, I think there will be major changes in how capital gets invested," Thurber said. "Eighteen to 20 months ago, people talked about how the idea of co-mingled funds was dead and institutional investors wanted to invest directly in real estate. That's not possible. Most of them aren't large enough and don't have the resources. But we will find many of the larger ones will be doing direct investment. It is already beginning. Capital is being raised and new funds are being formed."
From the investment management side of the equation, Azrack said that there was a difference in perception of real estate. "We [no longer] have to explain it to re-sell it," he said. "It's a given asset class and probably allocations will go up." But, he predicted, "Leadership will change. I think the financially-sponsored investment firms most probably will get sold, or they will go into more proprietary investing. There's going to be a major watershed."
"It's a huge pressure on the start-up firms," Azrack added. "The economics are such that you have to get to your second or third fund before you can make a decent living. Basically, the music has stopped and there aren't enough chairs to go around. I think you'll see consolidation coming from both ends – the very large and the very small."
Garbutt noted that "in the lending community, there's a tremendous amount of caution still. To get leverage today is very difficult. It's loosening somewhat, but underwriting standards are stringent. It's the natural course of events at this point in the cycle after lenders have been burned and asset values have dropped. We're seeing virtually nothing in the securitized market. The confidence level has been tremendously eroded. Some life companies are bringing capital back into the market, but they'll be fairly conservative."
"The REIT industry went through an interesting time from 2005 to 2008," said Linde, noting that a field of approximately 150 REITs contracted to about 85. However, after the collapse of Lehman Brothers and the changes in the financial system, "Public access to capital became important and REITs were able to recapitalize themselves," he noted. "Everyone thought REITs were going to be the next big source of equity."
He added that "what is currently going on is a huge disconnect between what the investor world wants and what is potentially being thrown out there from the various underwriters. Effectively very little is getting done. The premium that appears to be required to get a new REIT going is pretty strong. There just doesn't seem to be a compulsion right now for a market where the supply of capital and the demand from the product side are meshing."
Case observed that for most of the past three and a half years new money from the institutional investment community has been going into private equity real estate funds; very little to REITs. But, he said, "In the last few months we've seen a big change in that trend. There are large institutional investors who are extraordinarily unhappy about what happened to them over the last several years and they're looking at REITS."
Referencing data that track REIT performance over nearly 40 years, Case said, "REITS have been outperforming essentially every other way of getting returns in real estate. Institutional investors [now regard] REITs as a better way of investing in real estate."
But his optimism was tempered by a less sanguine view of the outstanding commercial debt. "I don't expect real estate property values, on average, to show any significant improvement before the end of 2012," Case said. "I expect 'pretend and extend' to come to an end sometime before that. "The wave of debt will come due at the worst time for those who have assumed the debt. There will be tremendous opportunities for REITs and, in general, for investment managers who have access to capital. On the other hand, there will be huge bad news about commercial real estate. We haven't seen the beginning of it yet."
"The REIT industry leads the private side by a year and a half," Case cautioned. "So, you won't get information from the private side that will help you make REIT investments."