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Going Through the Roof
Waiting for the Bubble to Burst? Don't Hold Your Breath
By Dana Hedgpeth
Washington Post Staff Writer
Monday, February 9, 2004; Page E01
Three years ago, real estate investor Adam K. Bernstein plunked down $57 million for a well-known office building in downtown Washington.
Last week, when he closed on a deal to sell the 40-year-old building at 2100 M Street NW, he was quite pleased. He got $95 million.
Washington real estate is hot. But is it too hot?
Even Bernstein thinks it might be.
"You've had a huge run-up in prices," said Bernstein, president of Bernstein Cos. in Georgetown, which invests in real estate for pension funds. "I don't think it can continue to anywhere near this level."
Some canny investors are wondering the same thing, such as Carlyle Group, one of the largest private investment funds in the country whose senior advisers include heavy-hitters like former secretary of state James A. Baker III and former Securities and Exchange Commission chairman Arthur Levitt Jr. Carlyle sold about $195 million worth of buildings around the Washington area in the last three years.
"This market," said Chip Lippman, managing director of Carlyle's U.S. real estate group, "is just too expensive."
Real estate, of course, is a notoriously cyclical business. The last time commercial real estate crashed here, office buildings reached an average $245 a square foot in 1991 before plunging to $110 in 1992. After hitting as much as $400, prices for some Class A office buildings dropped as low as $50 as their burned bankers sold them for a song. What made the market fall especially hard was that a lot more owners back then were heavily leveraged and went belly-up when they could not pay their big mortgages.
"You were having a fire sale on buildings," said Mary Petersen, a senior vice president at the big real estate manager and broker Cassidy & Pinkard. "Lenders were selling them off at tremendous discounts."
Perennially optimistic developers like to argue that this time around things are different. In this case, though, they may be. At least, there are big differences between now and the years before the last crash.
From 1990 to 1992, 14 million square feet of office space went up just in the District, let alone its prosperous Maryland and Virginia suburbs. That was twice as much as was built in the boom from 2000 to 2002, meaning there is that much less space to fill up and fewer buildings for investors who wanted to buy.
Then there is this: In 1992 the vacancy rate in these buildings had edged up to 13.5 percent. Today it is half that.
Now more of the owners are huge institutional investors like pension funds or insurance companies with lots of their own money in these buildings, compared with the old days when smaller, local developers borrowed heavily from banks to build and buy office buildings.
And finally, the Washington economy -- always steadier and more durable than much of the rest of the country, thanks to government spending -- is stronger now. In 1991 unemployment averaged 7.8 percent. Last year it was 6.6 percent.
Add all this together and you get a market investors are clamoring to get into. Last year $3.5 billion worth of Washington real estate was sold, up by two-thirds over the year before. That was second only to the much bigger Manhattan market, which doubled to $12 billion.
Average sale prices in the District rose by a quarter last year to $344 a square foot. Few other major cities saw anything like it. In Manhattan, prices actually fell 4 percent, to $335 (that includes less prestigious neighborhoods outside Midtown). They have started to fall in Chicago too. And Los Angeles. In fact, the average sale price for office buildings in American downtowns fell to $196 last year from $200 the year before and $193 the year before that "D.C. is crazy," said Benjamin B. Lacy, chairman of Lacy Ltd., which advises a large German mutual fund on investing in U.S. real estate and has bought three downtown buildings for $274 million. "We're seeing things that are very expensive, very overpriced and that provide lesser-quality returns. But people want them."
And there are a lot more investors chasing buildings these days, which means there will probably be a "greater fool" to take an expensive building off investors' hands. With interest rates well above 7 percent a decade ago, bonds and other investments competed with real estate for investors' money: It was often more profitable to lend money than to borrow it to buy buildings. Now, with interest rates hovering around 5 to 6 percent for mortgages, real estate looks good to many big investors compared with bonds and stocks.
Take Brookfield Properties Corp., a publicly held company in New York that owns $10 billion worth of office buildings, primarily in Boston, New York and Toronto.
"We tried for 18 months to break into the D.C. market," said Ric Clark, Brookfield's president and chief executive. "It's been very competitive. It's a high-demand city, and it's supply-constrained."
In December, Brookfield finally snared a building. It paid $157.5 million for a 12-story building on I Street between 16th and 17th streets downtown that is only half-leased. At that price, the capitalization rate -- a common measure of profitability that divides net operating income by the price of the building -- was only about 7 percent.
"We think once it's fully leased in the next year or so, we can get it to an 8.5 percent cap rate," said Clark. "It's risky, but we think we'll be able to hit it." Or sell it, since there is so much interest in this market.
Thanks to all those people like Clark, D.C. has already grown too pricey for more conservative investors.
"We're more on the sidelines these days," said Tom Bakke, a senior vice president in Washington for Equity Office Properties Trust in Chicago, the nation's largest real estate investment trust. "There's a lot of German and other foreign money coming in and looking at D.C."
The foreigners can make lower returns work for them because they can borrow cheaply and get certain tax advantages, he said. And in fact the average capitalization rate for Washington buildings is 7 percent compared with as much as 10 percent a decade ago.
"There's a total disconnect between the money coming from capital markets and real estate fundamentals," said Raymond A. Ritchey, executive vice president for the large developer Boston Properties Inc. "We have an irrational exuberance from investors who are desperate to get a foothold in the Washington market."
To be sure, the Carlyle Group sold real estate not only in Washington but across the nation -- $3.5 billion of its portfolio in the last three years.
In Washington, it says, prices will finally either fall or flatten in the next year. And then Carlyle will start buying again.
"Is there a bubble in D.C.?" said Lippman, the Carlyle Group managing director. "No, I don't think so. You won't see buildings appreciate as much as they have, but you won't seem them drop in downtown."
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