Why Were So Many Commercial Real Estate Investors So Wrong?

The New York Times has a super story on the sale of Sam Zell’s Equity Office Properties Trust. The deal and its disastrous consequences are neatly summed up in the first few paragraphs.

In 2007, Sam Zell, the billionaire Chicago investor, sold a portfolio of 573 properties he had assembled over three decades, Equity Office Properties Trust, to the Blackstone Group for $39 billion. It was the largest private equity deal in history, but Blackstone did not stop there: it immediately flipped hundreds of the buildings for $27 billion.

Today, the wreckage of those purchases is strewn across the country, from Southern California to Austin, Tex., to Chicago to New York. Many of the 16 companies that bought Equity Office buildings are now stuck with punishing debt, properties whose values are plummeting and millions of feet of office space they cannot fill.

Few deals better exemplify the excesses of the commercial real estate boom than the dismemberment of the Equity Office empire, and fewer still better underscore their bitter consequences.

Buyers purchased buildings at what, in retrospect, were vastly inflated prices. Lenders provided lavish, even excessive, financing based on unrealistic expectations of rising rents. And now that values are tumbling, vacancy rates are rising and credit has become impossibly tight, many on both sides are struggling against default, foreclosure or bankruptcy.

The impact could ripple beyond the companies that bought Equity Office buildings and the investment banks that financed them. If the owners cannot make their loan payments, it could create a financial crisis for the pension funds, hedge funds and insurance companies that hold securities based on Equity Office mortgages.

The story goes on to detail the cratering of a number of the properties that were sold by Blackstone. I recommend that you read it. For me, it brings back memories of a conference I attended shortly after the sale occurred and the beginning of my own doubts about the viability of the commercial real estate market.

The conference was held in late May of 2007 in New York and was oriented towards commercial real estate investment and private fund investing. The conference was sold out, the mood was ebullient and the general atmosphere was one of wealth and enthusiasm. Lots of very young men and women were on lots of panels describing the speed at which they had raised capital and put it to work. There was talk bordering on braggadocio about sky high returns to investors and future funds as far as the eye could see. Some who had just raised their first fund were optimistically talking about the next two or three and the global expansion that they were planning.

In all of this there were a few more seasoned players that seemed to feel less than comfortable with the direction things seemed to be headed. I still recall one panel participant, a veteran of past wars, who opined that commercial real estate investing had become akin to owning a professional football team. His lament was that the only way to make money was to sell the investment.

That comment was, for me, one of those oops sort of moments. It struck a nerve then and has stayed with me since. Maybe it was because his view was so diametrically opposed to the prevailing sentiment that there was no limit to the upside or maybe I was just more impressed with his credentials but he put his finger precisely on the fallacy. The market had largely discarded the fundamental logic for property investment in favor of a philosophy which held that the cash flow potential of the asset could only go one direction. Once the players-lenders and investors-bought into it disciplined decision making ceased to exist.

What still remains so striking to me is that this all occurred such a short time ago. In less than a year and a half an entire era has been shown to have been totally without merit. I think back to all of those incredibly bright young men and women at that conference and can’t help but wonder how they could have collectively made so many horrible decisions.

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