Partner's Meeting 2011:
Big Questions, Mature Indices, and Sustainable Development in China
Posted June 15, 2011
If you're worried about whether there will be sufficient global capital to fuel real estate development for the foreseeable future, you can relax. "All respected economists feel we're headed into a period of continued excess capital," said MIT Center for Real Estate (MIT/CRE) professor and economist Bill Wheaton to MIT/CRE industry partners, who attended the Center's annual partners meeting on May 10.
The world's savings rate is increasing because the gross domestic product of countries where residents traditionally save a lot – Japan, China and India especially – continues to grow faster than the GDP of the U.S., Wheaton said. Moreover, the world's GDP, which has been growing at a five to six percent rate, will experience an increase to six or seven percent in the near term.
Wheaton was the first speaker in a program themed Leveraging Science, Developing Innovation – the Center's ongoing effort to connect the real estate industry to MIT's disciplines in management, economics, science, engineering, planning and design. The day-long program also featured presentations by David Geltner, chair of the MSRED Degree Program and MIT/CRE's director of research, who updated partners on the commercial property transaction price indices that he pioneered, and Dennis Frenchman, Leventhal Professor of Urban Design and Planning in the Departments of Architecture and Urban Studies and Planning, who offered an informative look at the increasingly important role of clean energy and sustainable development in urban China.
Five Big Questions
Wheaton built his presentation around five important questions that the real estate industry is seeking to answer. The first question -- will there will be enough global capital? – elicited a highly-nuanced answer from Wheaton, and he tempered his sanguine predictions with some conditional observations. He noted, for instance, that risk premiums have recovered, but global capital seeks safe investment. As an example he pointed to the explosion of consumers buying houses in China. In the long run, he pointed out, such safe investment tends to drive risk premiums up.
Wheaton also observed that global capital lowers government bond rates and drives the provision of debt, reducing illiquidity premium. Predicting that cap rates will stay low for the next decade, he said, "There are things that might upset this, such as a bout of inflation, but that's cyclical."
He underscored the availability of money by noting that China, Brazil and India haven't absorbed all the global capital despite the fact that they are engaged in development on an extraordinary scale, but Wheaton also cautioned that plentiful capital creates financial crises. Comparing equity bubbles with debt bubbles, in which everyone levers up until the bubble bursts and there is no money left to borrow, he talked about the importance of appropriate securitization as a means of disciplining debt.
"Securitization (right now) is very undisciplined," Wheaton said. Noting that originators have to keep a share of the risk, "or they'll try to game the system," he said that what's needed is a rating model where rates are independent and not paid by those who create the pool. He argued for a model that balances asset disposition between tranches, which should involve any system risk guaranteed by the federal government.
The State of the Industrial and Residential Markets
Addressing his second big question – what will drive the industrial market? – Wheaton observed that there are two types of industrial markets in the United States: the major path-of-goods distribution markets, which have enjoyed huge growth over the past 15 years, and other markets whose industrial markets are all local.
Store and trans-shipping propel warehouse growth, he stated, and inventories – not imports or exports – completely predict warehouse demand. Nevertheless, he did note that the U.S. research and development market continues to grow and bears monitoring.
While Wheaton foresees growth in the industrial market, he offered a note of caution about the rate of development. "We keep building a lot of industrial space," he said, "but we don't get rid of the old space."
Wheaton's answer to the third question – what will drive the office market? – began with a comment on the market's trend toward decentralization. "The finance sector grew rapidly from 1960 to 1999, but that may be a thing of the past," he said. "There were fewer finance jobs in New York City in 2007 than there were in 1999."
That job migration is compounded by shrinkage of the financial services market, Wheaton added. "The financial services market is not growing," he said. "So much of what goes on in finance is automated now." But he was also quick to point out that "the value-added of finance is growing even if jobs are not." Bottom line? Finance jobs are peaking and may never return to pre-2000 levels.
What will happen to retail? Wheaton answered this fourth question by noting that the retail picture remains glum. Store demand is recovering slower than other sectors. And the Internet has proven to be an immense threat to traditional retail. "E-commerce continues to gain market share," he said. "Nothing I can think of is optimistic for store space demand."
Wheaton wrapped up his presentation with his final question – how important was speculation in creating the U.S. housing crisis? Since speculation is the purchase of additional houses beyond one's primary residence – mainly for investment purposes – Wheaton said the U.S. government helped to fuel speculation by making a substantial portion of the value of additional homes tax deductible after 1998.
To illustrate his point, he referred to the situation in four states– Florida, California, Arizona and Nevada – where half of the post-1998 mortgages were for second properties. Today, conversely, half of the nation's foreclosures and "under water" loans are clustered in those states.
Prices for homes, Wheaton suggested dourly, may never return to the record spike that immediately preceded the bursting of the bubble. And he observed that many people in the industry are bullish on apartments right now. Their enthusiasm might be rewarded if a high percentage of homeowners with under water loans decided to simply walk away. (See Wheaton's presentation Five "Really Big" Real Estate Questions.)
Commercial Transaction-Based Indices Mature
David Geltner first began contemplating the possibility of a commercial transaction-based index (TBI) back in 2001, when the volume of data available and the absence of tools capable of analyzing those data made the idea, if not impossible, then highly challenging. "You need very sophisticated econometrics to make this work," Geltner told the partners.
Geltner was undaunted. Five years ago, in February 2006, he introduced the NCREIF-based TBI. Published quarterly, it was the first TBI. But not for long. By the end of that year it was joined by MIT/CRE's second commercial transaction index, the REAL Commercial Property Price Index (CPPI) based on data from Real Capital Analytics, Inc. So effective was that index that within a year it was adopted by Moody's.
Last summer those two indices were joined by the The CoStar Commercial Repeat-Sale Indices (CCRSI). Employing data from the world's largest commercial real estate data company, the CCRSI measures the movement in prices of commercial properties based on actual sales prices at the time of the sales.
The three indices, unimaginable a decade ago, are increasingly used by the professional and business media, Geltner told the partners, and are frequently published as a complementary set. They collectively offer the real estate community some significant informational advantages, he added.
"They are based directly and purely on actually consummated sales," he said. "Consequently, they can correct appraisal smoothing and lagging biases and they are more directly comparable to stock and bond indices and they are more objective and replicable than appraisal-based indices."
Using a variety of graphics to compare and contrast the three indices, Geltner explained how the sophistication of the indices has evolved rapidly over the past five years and how the three, used together, offer highly detailed, often complementary pictures of the commercial market. The indices reflect the actual timing of cash changing hands and they can track property populations not regularly appraised, such as REIT properties and CMBS properties, Geltner noted. "They raise the credibility and depth of understanding of private real estate asset classes among a broader constituency," he said. (See Geltner's presentation Commercial Property Transaction Price Indices: Some Perspective After the First Five Years.)
An Energy Pro Forma for China
Dennis Frenchman is an expert on the application of media technology as a tool to aid in the design of urban environments, and he began collaborating with Beijing's Tsinghua University in the 1980s. Frenchman told the partners about research he is currently involved in funded by The Energy Foundation, a partnership – focused principally on the United States and China – that strives to encourage use of energy efficiency and renewable energy ideas and technologies in the design and construction of new buildings.
"China's urban population has doubled since 1990," Frenchman told the partners, "and it is set to increase by some 350 million people over the next 20 years." By 2030, he said, China will have more than 220 cities with over a million residents.
"People are demanding more and better space," he said, but China's huge cities are running out of land to annex. The consequence is vertical concentration. To accommodate the increasingly huge urban population, China is contemplating construction of some four to five million new buildings and at least 50,000 buildings in excess of 40 stories. The question, said Frenchman, is "Is it sustainable?"
Since China is committed to rapid, planned construction of entirely new cities, his recent work has focused on the creation of clean energy templates for those cities. To aid in their creation he is developing an energy pro forma, modeled after financial pro forma tools. The pro forma, he said, will focus first on the energy embodied in the actual construction, including site, construction materials and transformation of land. Then it will look toward on-site energy production to potentially neutralize the energy consumption.
The pro forma, he was quick to assert, must be useable by real estate developers. But many of the data needed to create it don't exist. So, Frenchman and his team – composed of MIT and Tsinghua students – have focused on Jinan, situated about halfway between Beijing and Shanghai, as a demonstration city. There they have surveyed 8,000 people, in 20 neighborhoods, on a wide range of housing-related issues, from design to transportation.
Jinan has been built, he noted, using just four basic types of buildings, some of which accommodate energy efficiency better than others. He explained how, using the pro forma, he has designed several ways to creatively adapt the four construction types in order to maximize their energy efficiency.
While he is upbeat about the prospects of reshaping attitudes toward energy efficiency in China, he was quick to note that the project is extremely challenging. Creating the pro forma is only one step, and it has been a very difficult one. In order for it to have a meaningful impact on the future of Chinese development, the developer community must agree on it and then it must be established as policy. To aid in that process, Frenchman said, he is also working on the creation of a vocabulary of energy efficiency for China.
From an economist's view of major trends shaping the industry to an update on the Center's innovative commercial transaction-based indices to an insightful look at the importance of sustainability in the astounding redevelopment of urban China, the meeting offered a multi-faceted look at the extraordinary world of real estate and the role that MIT/CRE is playing in its evolution.
Partners Mteeting 2011 was held at MIT's Brain and Cognitive Sciences Building. A showcase of sustainable design and construction, the building received a LEED-Silver certification from the U. S. Green Building Council in 2008. It uses such innovative technologies as high-performance exterior materials, gray-water recycling for toilets, heat recovery exhaust air stream, and interior finishes that minimally impact air quality. It was MIT's first LEED-certified building.