REITs: A New Dawn?
Private Equity's Big Day In 
Commercial Real Estate
by Joe Duarte, MD
Joe-Duarte.com & IntelligentForecasts.com
February 12, 2007

The MSCI U.S. Real Estate Index (RMZ) shot up to an impressive new high on 2-7, as the Blackstone group won a long and difficult bidding war for the Equity Properties Trust. Yet, the charts and the deal itself suggest that the pace of commercial real estate is unsustainable, as the market clearly revalued the commercial real estate market after the deal’s details filtered out.

To be sure, calling a top in any kind of brisk market such as the real state investment trusts have been for the past several years, is difficult. But, when oil was at $80 per barrel last summer, the calls for $200 oil were the norm. And as the recent action in oil shows, $60 is now a tough ceiling for crude.

Every major secular bull market, eventually meets its maker. And one of the sure signs that something might be about to change is when a big deal gets lots of press, and either falls through, or is interpreted by the market and the media as the deal that will take the market to yet a new and more amazing paradigm.

The Blacktone/Equity Properties Trust deal fits the latter category, as the Wall Street Journal noted: "Blackstone Group's $23 billion buyout of the owner of the biggest portfolio of U.S. office buildings will send ripples through the real-estate world, with a good chance it will raise the ceiling on already-record prices."

The Journal added: "With office buildings in red-hot demand as investment vehicles, Blackstone's control of prime properties likely will put it in position to demand prices on its individual buildings high enough to make the private-equity firm's bid pay off. The deal, approved yesterday by Equity Office Properties Trust after rival bidder Vornado Realty Trust bowed out following weeks of bidding, also cements Blackstone's clout as one of the most powerful investors on Wall Street."

But in the same article, the Journal noted that part of Blackstone's strategy to make the deal pay off is to sell choice properties in Equity's choice portfolio of Manhattan buildings, the crown jewels of the portfolios, as they deliver record level rents.

Blackstone says that one of the reasons it continued to outbid its rival, Vornado, was that there were so many buyers ready to take the big buildings off of their hand once the deal got done.

In fact, what Blackstone is hoping to do, is to sell the Manhattan buildings to hot money as "Blackstone already has agreed to sell -- or is close to lining up buyers for -- a substantial piece of Equity Office's holdings, including much of its prime Manhattan portfolio. Demand for such buildings has been frenzied. Sales of U.S. office buildings rose 32% in 2006, with relatively modest new construction. The investors include foreign oil magnates seeking a haven to park cash, pension funds looking for reliable returns and private-equity firms wanting a percentage of their portfolio in real estate. If Blackstone scares off some potential customers by demanding higher prices, it is confident others will queue up to take their place."

To us, this sounds like the latest round of the greater fool theory, much as when the Japanese bought Rockefeller Center in the late 1980s, just as the Japanese economy was about to implode, and the U.S. savings and loan debacle was about to hit its stride.

In fact, there is plenty of bravado being thrown about on Wall Street these days, as "Market observers say Blackstone's win is a vivid illustration of how private-equity firms now have a leg up in the battle for control of companies and assets such as commercial real estate in the U.S. and elsewhere. Among the reasons: the closely held investment firms are more comfortable putting loads of debt on their targets than publicly traded buyers at a time when the debt market is willing to provide massive amounts of money at record low prices. In addition, private-equity firms can move more quickly, with no need for messy shareholder votes."

In other words, private equity is willing to take huge risks that a publicly traded company would not normally take, aside from Enron and Worldcom types along with others destined for the trash bin.

The problem with that scenario is that at some point, debt has to be serviced. And when it is so large that creditors start to balk, life can become very difficult for the groups that took on the leverage in the first place.

A perfect example of deals going bad is the warning by banking giant HSBC about its upcoming earnings. The company is taking a $1.76 billion charge due to mortgage payment defaults.

Talk about buying the top. According to Marketwatch.com: "The problem is with the bank's portfolio of sub-prime mortgages, which it snapped up in 2005 and 2006, before the U.S. housing slowdown began to bite."

Somehow, HSBC, the world's third largest bank, in 2005 and 2006 couldn't figure out that the U.S. housing boom would eventually end, and Wall Street analysts are shocked.

According to Marketwatch: '"This a material negative surprise for HSBC. Moreover, the timing of this news is also surprising as this is the first time in our memory that the bank has pre-announced material information so close to a formal results announcement," said John-Paul Crutchley, an analyst at Merrill Lynch. '

Conclusion

To us, it looks as if the Blackstone Group is likely to get away with its strategy. Obviously, somebody pawned off a sizeable portfolio of bad loans onto HSBC. And if indeed there are already buyers lining up to take the big buildings off of Blackstone's hands, then congratulations to all concerned.

But then, if you just spent months fighting to own those highly coveted assets in Manhattan, why would you be selling them even before the deal closes?

Could it be that the Blacktone Group knows that the commercial real estate market is about to take a powder and it's getting out of the highest risk properties as quickly as it can before the market crashes?

If we were big rich guys from the oil patch, we'd be buying natural gas deposits in Forth Worth right now, just like Exxon Mobil is, not ridiculously priced Manhattan real estate at the end of bull market.

But, what do we know? We're just sitting here looking at stuff on computer screens and trading for a living.

One thing's for sure. It wouldn't be the first time somebody on Wall Street sold some poor sucker a bill of goods.

© 2007 Joe Duarte, M.D.
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