We still wonder at the exquisite timing of the deal. Apart from REFIRE and only about fifty others, not too many industry veterans can claim to have been there when, early in 2007, the legendary Sam ‘The Gravedancer’ Zell showed up on a panel in Frankfurt, along with some other US heavyweights, including Jeff Immelt, the head of General Electric Real Estate, a major real estate investor at that time, Wharton Professor Dr. Peter Linnemann, and the German CEO of Eurohypo, who were financing everything in that euphoric era.
Also on the panel was John Carrafiell, at the time the global co-head of Morgan Stanley real estate, who was hell-bent on buying up everything in Germany on the grounds that it was all available for far less than its replacement cost. This was a good opportunity to teach the Germans an Anglo-Saxon-style lesson in how to make money in real estate, intimated Carrafiell.
The Gravedancer pooh-poohed the Morgan Stanley approach, predicting it would prove very painful for investors in those Morgan Stanley funds, many of whose properties were half-empty at the time. Prices were much too frothy, said the Master of Timing, while the quality of many of the assets he’d observed riding in from the airport that morning left him unconvinced. Besides, he said, what was it going to cost to get those properties up to speed to fill them with new employees, and extract decent returns on the assets?
samzell.com
Sam Zell
We did not know it then, but within a week Zell had signed a deal to sell the biggest owner of US offices, Equity Office Properties REIT, to Blackstone for $39bn, at the very top of the market. Blackstone were no fools. Within months they sold off large chunks of the huge portfolio, retaining only the choicest trophy assets. Having dumped the dross, Blackstone reckoned it tripled its investment on the remaining assets over the next ten years. The buyout of EOP is widely considered to be one of the most successful real estate private equity deals of all time.
Sam Zell died just a few weeks ago. We’ll not forget what a magnetic character he was, and what sound instincts he had through most of his astonishing business career. Those Morgan Stanley funds, by the way, went on to lose their investors billions.
We suspect Zell would have been selling a year ago were he still involved in US offices. From across the pond, reports are accumulating of US banks taking real losses in selling performing property loans, in a stampede to get out of the sector ahead of a wave of delinquencies on debt secured against offices that nobody wants to work in any more. Keeping their books clean and avoiding extra scrutiny by regulators or investors is seen now by many banks as a priority, in advance of an almost certain wave of losses. Selling now, at a modest discount, is viewed as smart business. Loan brokers are reporting the highest activity in three years.
Among US developers, there are now numerous reports of office towers being sold for two-thirds of their recent valuations, as the reality of working from home and the new interest rate environment begins to sink in. These are pretty shocking markdowns - and these are not the second-grade properties that Zell included in his EOP mega-bundle for Blackstone, before they, in turn, quickly proceeded to pass the parcel.
Still, at least these sales represent the market trying to crank itself back into gear and find some sort of price level to lubricate the market. The Americans are always more pragmatic about this than the continental Europeans, who will faff around for years before accepting the reality of lower (often, much lower) valuations. For offices, the market is now sifting the real jewels from the less worthy stones. As in modern life, the top properties get to play in the Champions League, while large numbers of their erstwhile brethren will be destined for relegation to the lower divisions.
Across the board, we’re already seeing a broad shift in emphasis from acquisition and deal-making to asset management, and reallocating resources to the most currently rewarding activities. Deutsche Bank’s announcement this week that it is drastically slimming down its property lending operation with the loss of hundreds of jobs is a simple recognition of what lies ahead. And a timely signal to the industry at large.
With three separate lending entities, and €182bn in property loans outstanding, mainly to private borrowers in Germany, the bank is consolidating its property financing into one unit. New lending this year, in common with other banks, is already down by half on last year, is earning the bank lower margins, and is facing a wall of equity-related regulation on it lending practices. Future demand will be less for big swashbuckling prestige projects, and more for thousands of smaller loans related to domestic energy refurbishments, the installation of heat-pumps, insulation, and the like. With about a million existing borrowers on its books, the bank will be plenty busy meeting their needs.
Other banks are facing similar problems. While a major correction, which could have been expected to be triggered by COVID, was avoided - instead of which property prices roared ahead - the new interest rate environment is proving a game-changer. The lack of transactions has masked the real drop in office values, which will have to be recognised at some point. Sadly, rising rents in logistics and housing, along with the buzz generated by newer asset classes such as data centres and life sciences - won’t be enough to cushion the blow of a transformed landscape when the office markets stutter back to life.
That’s going to take time though, given the structural changes affecting how companies plan to use their offices. Much will depend on the availability of financing, although with levels of new underwriting by traditional lenders down at half last year’s level, the signs aren’t encouraging. We’re seeing ominous rumblings here in Europe as well, such as Blackstone’s recent default on a Finnish office portfolio, and its and KKR’s imposition of limits on fund redemptions. These won’t be the last. As in 2007, in advance of the storms to come, are Blackstone again just ahead of the chasing posse?
