Commercial Real Estate and the Herengracht Index

The WSJ reported earlier this week that many of the nation's leading commercial property developers have asked the government to assist them in refinancing their mortgages, about $530 billion of which are coming due in the next three years.

It should be pointed out that the ultimate goal of such a request is to protect the equity value of these properties, not their asset values. As Felix Salmon has pointed out, society has only a limited interest in how the total asset value of its buildings is allocated among equity holders and creditors a few years from now. The equity holders themselves obviously see things differently.

In reading the stories of Bernard Madoff's various victims, I noted with interest just how many of them made their fortunes investing in real estate, particularly New York real estate. Broadly speaking, the return from owning real estate can be disaggregated into the return on the asset itself, i.e. the increase in the price of the land and the building on it, and the proportion of that price increase that flows to the equity holder rather than the debt provider, which is a function of how much leverage was incurred to buy or build the asset and whether that debt avoided default.

It has always been difficult for me to figure how much a given real estate fortune is the result of the former vs. the latter factor. And to the extent it's the former -- price increases -- how much of that is due to the unique ascendancy of New York City in the 20th century?

To speak plainly, on the eve of what could be a commercial real estate crash, I look at all the property moguls and ask myself: "Were they good, or were they lucky?" And a corollary question: When evaluating real estate investments, which today form a large part of institutional portfolios, one must ask: "Am I betting on skill, or on luck?"

One answer comes from a paper by a Dutch economist named Piet Eichholtz, who constructed a multi-century price index for buildings on the Herengracht, which is considered prime real estate in the city of Amsterdam. Amsterdam was the New York City of its day -- wealthy, cosmopolitan, a city of immigrants devoted to commerce -- in fact, the actual New York was founded as an attempt to create a "New Amsterdam" in the New World, which for me gives the paper a special resonance.

The paper's conclusion surprised me: Over the long term, the real value of prime Amsterdam real estate has not increased much at all.

Here's an article in plain (Australian) English about Eichholtz's paper.

Comments

[John Lounsbury:]

While watching the shoe drop (and continue to drop) onm residential real estate, I have been waiting for the other shoe, commercial real estate. Like George Bush, I think I see another shoe coming.

The author's discussion about the failure of Amsterdam real estate to appreciate significantly over time reminds me of a piece I read years ago that claimed the reputed $24 the Indians received for Manhattan was a good deal for the Indians. The contention was that the Dutch over paid.

I don't know how much all the real estate in Manhattan is worth today, but $24 compounding at 8% for 400 years is approximately $562 trillion.

This article is very timely and interestingly written. Thanks.

2008 Dec 27 12:19 AM

[Rob Viglione:]

Expect to see lots more pigs lining up at the federal trough. Commercial developers are just the newest batch, but they will not be the last. Sad that our economy is stooping to this level...it does not bode well for long run health.

Very good article. With your dissociation of real estate returns into equity versus debt holders, you've illustrated the political implications of how some interest groups benefit over others with public policy. Lobbying for political favors is a dirty business.

I fully anticipate a commercial collapse in the near future. An interesting pair trade is long corporate debt, short commercial real estate.

2008 Dec 27 11:52 AM

[{5U}:]

A lot of folks have that trade on and the REIT CEOs know it. So their response is to lobby the heck put of Washington to tar, feather and blame the shorts while asking for a hand out and a change in mark to market accounting.

Reits are the biggest sinners as they are fueled by cheap credit and leverge. If these stocks continue to move up the CEOs will raise more "fresh capital". In other words, sell the stock high and dillute existing shareholders after they are able to get the politicians to change the rules of the game.

If joe 6 pack is under water on his mortgage the reit CEOs certainly do not deserve a bail out as they made billions off of everything that is wrong with America: overleveraging and greed. They are just much better at it because they have Uncle Sam on the pay roll (lobby).

I HOPE this pork roll of corruption will CHANGE

2008 Dec 27 01:13 PM

[Danny Newton:]

The government is already at the commercial real estate trough and has been there for years, especially in the south. The state of Tennessee, mostly city and county governments, have acquired 84 square miles of real estate that is designed to grab the next factory, warehouse, call center or commercial property. The floor space that stands empty right now could serve as work space for 130,000 factory workers. Some counties have even greased the skids for loans to strip mall businesses with loans under the excuse of promoting economic development.

There are additional holdings in the private sector, mostly those holdings are already developed but there is encroachment on that too with the government building infrastructure which is everything from buildings with no clients to utilities with no running meters. Rents are so low it hardly makes sense to build unless you need a highly specialized building like an ultra clean environment or a auto factory.

Even though there is continuous loss of jobs in the mining and agricultural sector, only the manufacturing sector enjoys special privilege in the condemnation and perpetuation of land that someone hopes will be the next factory. The governor of Tennessee plus county and city governments recently came up with a subsidy package of $577 million for a VW factory that might produce 13,477 jobs in the next three years but the state has lost four times that many jobs over the last ten years just in manufacturing. Another new Dow Corning Plant in Tennessee cost state and local governments $125 million in subsidies and provided only 500 promised jobs. This action facilitated a downsizing and a move from another state. The new jobs will not replace half of the manufacturing jobs lost just in the county over the time period from 2000 to 2006. The jubilation on the part of economic development addicts over these jobs is similar to the loss of dignity of a cat on cat nip. The art of counting the hits and ignoring the misses is still paying off.

Trying to understand the economy in terms of jobs lost and gained is much more difficult than trying to understand the economy with respect to dollars. It is easier to inflate job figures than to inflate the dollar. Every chamber of commerce seems to be like a miniature federal reserve bank with unlimited license to alter the discount rate on jobs. The jobs at the VW plant were not counted as 40 hour per week jobs. The number was more in the range of a four day week. Maybe the Germans thought they were building in France?

2008 Dec 27 01:48 PM

[{5U}:]

Well said. This is not about wealth creation for the nation but About nominal job numbers with the under currents of political pork

People are bought to preach the party line

2008 Dec 27 02:29 PM