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A Soft Landing for Commercial Real Estate?

Jason Stipp

Jason Stipp: I am Jason Stipp for Morningstar. In addition to the unemployment situation and the woes in Europe, one of the overhangs on the recent recovery is real estate.

Here with me to tell us a little bit about the state of the real estate industry is Morningstar markets editor Jeremy Glaser. He just got back this week from the REIT Week Conference. Thanks for joining me Jeremy.

Jeremy Glaser: You're welcome, Jason.

Stipp: So, first thing, I think, is still on a lot of people's minds is the whole issue of commercial real estate. So, it seems like there is still some problems with residential, but we've worked through a lot of that. Everyone's waiting for commercial to be the next big thing, is it going to be the next big problem?

Glaser: I don't know if it's going to be the next big problem, but certainly a problem, and one that's going to have to work out over the next couple of years. Unlike, residential real estate where we have seen the huge bursting of the bubble, and you've seen a lot of people having to sell at very depressed rates, and you've seen a lot of distressed sales and foreclosures. Things have been relatively quiet on the commercial real estate front. Lenders are extremely hesitant to take back properties that they know they're not going to be able to do a lot with, and a lot of the owners of commercial real estate continue to want to extend their loans and to get bridge financing to hold on to that building as long as they can.

In fact, a lot of the regulators are kind of turning a blind eye to this and are doing what's called "extend and pretend" on a lot of bank loans. So, even though the banks know that they are underwater on a mortgage and should take a write-down, they are letting them hold it at the full value, and that, as the banks get stronger and produce enough cash and have that capital reserve, they'll be able to slowly write down those loans over time.

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And when that happens, then you'll start to see some commercial real estate sales, and you'll begin to see more of the prices come down, and you'll see a lot more transactions, but I don't think it's going to be a huge implosion like we saw in the residential world. And you're not going to see the same systematic risk, because everyone is well aware of it and is trying to take the steps necessary to unwind it slowly over time when the system can take the stress instead of very suddenly.

Stipp: So, it sounds like the hope out there is for somewhat of a soft landing even though there are still some issues to work through here?

Glaser: Absolutely.

Stipp: So, legendary real estate investor Sam Zell was also at the conference, and he had a few sort of broader takes on the industry. What was he talking about?

Glaser: He certainly had some choice words for the Obama administration; suffice it to say, he is not a fan, and thinks that a lot of money that they are spending and the policies that they are doing aren't really helping.

He really focused in on a few areas that he really wants to see changes in. He thinks unemployment is going to continue to be a huge problem for the United States and that the government should really worry about jobs instead of things like health care. He was really concerned about the budget deficit, and is worried about the dollar's presence as the global currency or as a reserve currency.

And he was asked, well, if dollar isn't going to be a global reserve currency than what is? And he said, that you really don't know, that six weeks ago, it would have been ridiculous to say that the euro wouldn't have been a contender, and now everyone is incredibly worried about the future of the euro and worried about the entire eurozone breaking up. Things are moving very quickly, and he is worried that the greenback could lose a lot of power very fast and it's something that kind of keeps him up at night.

Stipp: So, given his relatively bearish take on some areas, then, where is he finding some opportunity?

Glaser: For the past couple of years, he has been investing in Brazil and in other developing markets. He thinks there is a lot of opportunity there. He thinks the United States is certainly maybe a better bet than lot of Europe. He described, Europe as turning into Disneyland, as a great place for castles, but not a great place for investments, but I think that he certainly focused on Brazil. He thinks that that's one the best markets out there right now.

Stipp: So a last point that you heard a little bit about the conference was – the difference between the publicly traded REITs and the private equity real estate and some of the differences in how they performed, and it might be somewhat surprising to some people. What did you find on that front?

Glaser: A study that NAREIT completed showed that the publicly traded REITs actually outperformed the private equity funds over the last real estate cycle from peak-to-peak. Now, the private equity funds have been incredibly popular among institutional investors, were incredibly expensive and were very opaque, and it almost seemed like people were chasing after them, because it seems like an exclusive club, and if it's a big secret then it must be a good idea to invest and they must have some kind of secret sauce.

I think this is something we see all the time across the investment world. You see it in real estate, you see it in hedge funds, you even see it among individual investors who are looking to invest in the next big thing instead of taking the kind of safer transparent approach, but yet again we see that over time those low costs and the transparent approach to buying stocks and to invest in things ends up with better returns over the long term.

Stipp: Jeremy, some interesting insights on the real estate front. Thanks for joining me.

Glaser: You're welcome.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.