Ditch debt and downgrade return expectations - then focus on tomorrow's problems. Industry leaders tell Shayla Walmsley what we should learn from the current crisis

Rachel McIsaac, CEO

Invest for income
The property sector's immediate concerns, according to Rachel McIsaac of the Association of Real Estate Funds (AREF), are valuations and income. "Income will be the headline for 2009," she says. "It's about cash, maintaining income streams, and the survival of [tenant] retailers.

The problem, she suggests, is their property got way too complicated and far removed from fundamentals. Real estate investors should have been prioritising location, asset quality in terms of tenant demand through cycles, income and the quality of income. Instead, they fixed on yields.

"We've seen the decoupling of investment and tenant demand," says McIsaac. "It's about sticking with the basics. Is that sophisticated? No - it's common sense."

But does the industry have enough to learn the lessons? Judging by the experience of the last downturn - yes, she says. She claims AREF's members don't have huge development portfolios after the late 1980s because they learned from the mistakes of the late 1980s over development in secondary locations.

In fact, she suggests, the industry will emerge stronger because the downturn will instigate an attrition of inexperience.

"We've seen it all before. When there's a downturn, those of us with decades of experience get called back in - in contrast to people with two years' experience selling derivatives within banks. What will matter is experience, more grey hairs, and the ability to see cycles and to manage through cycles."

The net result of lessons learned will be "a more sophisticated market with a longer-term view and a bit more common sense. Investors will be forced to take a good, hard look at the fundamentals."

Andrea Carpenter, acting CEO

Time to reflect

With little clarity of value in the market, now is the time for investors to pause and reflect, says acting INREV CEO Andrea Carpenter.

"There is little confidence in valuations, so fund managers would rather wait a year or two. It isn't because they think the market is going up. Rather, it's a question of not knowing.

"In the past few years, it has been a fast market. Funds were raised fast, and investors make quick decisions. Now it will be a period of reflection, with more due diligence. Investors are getting better at negotiating," she says.

The onus is on fund managers to adjust to the new market dynamic. Catch-up clauses, which operated to the benefit of fund managers because they had low hurdles, are a case in point. In contrast, now, investors are looking at what happens when "catch-up" fees kick in.

"Investors will be looking at alignment of interests, and fund managers will be keen to keep key personnel in place as investors demand ‘key man' clauses. It's what both sides want - it isn't out of balance in favour of one side or the other."

Although the balance has tipped in favour of investors and away from fund managers, some longer-term shifts around fund manager performance metrics will benefit both sides. "Fund managers are falling out of the performance structure because the structure is geared towards a rising market," says Carpenter. "You need to motivate fund managers in bad times, as well as good."

She identifies two further upcoming challenges for the property sector: a "culture change" around leverage and reevaluation of investment styles. The result will look again at strategic frameworks, and at how much of a risk factor is involved in the style they choose.

"Can you have a core fund with 50% leverage? Is it then still a core fund? It's a good time to the industry to reflect more," she says. "These are fundamental shifts - about what core and value-add mean, and what proper reward means for those fund managers."

Liz Peace, CEO

Return to reality
The three issues in property will be managing income streams, ensuring happy clients, and managing assets for the long term, says British Property Federation (BPF) CEO Liz Peace. "Good people in the industry have long focused on these three issues. The current crisis was sure they were right to do so."

One lesson to be learned from the current crisis is that the industry has learned the lessons from the last one. The problem is that the lessons apply to an irrevocably changed market.

"We learned from the last recession, which is why we haven't got massive overcapacity," says Peace. "At the moment, we aren't seeing oversupply. There are variations, but across the country there is nowhere near as much as there was last time. In the same way, although there is a rise in vacancies in London, the rate is nowhere near as high as it was before."

Yet the industry has transformed since the 1990s. "Now it is part of the capital markets, securitisation and more sophisticated projects. It is a complex financial web, based largely on packaged debt. The whole financial system is based on that edifice. When it falls, the crash reverberates. The result is that although the basics of the industry are better than the early 1990s, the impact of the crash is much worse."

The inevitable consequence of industry transformation is that investors were looking in the wrong directions - "mesmerised by capital growth when they should have focused on income". Yet she is unwilling to absolve the property industry for its role in what amounts to investor self-delusion.

"It wasn't just bankers. People forgot that property is cyclical, and that what goes up must come down. You had inflation of value, with debt on top," she says.

"It's probably the end of capitalism - not of capitalism itself but of capitalism as we know it. People will look at very, very different things. Property will never go back to where it was. It will rebase at a new level, but it will not support the CDOs (collateralised debt obligations) and the rest that it has in the past.

"If you look at the companies that are doing badly, they are highly geared. They assume that yield compression would wipe out their loans, no matter how much they borrowed. There has certainly been an overemphasis on capital appreciation."

After the inevitable re-evaluation, long-term investors such as pension funds with realistic expectations of real estate returns and an orientation towards income will remain in the market.

"When we come out of this, businesses will still need somewhere to do business. Rent will still be paid, and so will dividends," says Peace.

"Property still offers what pension funds need: an income. After the recession, they will get a nice income yield. If I were a pension fund, I'd see the next six to 12 months as a good time to go into property, because they don't need debt."
In the meantime, the market will be in abeyance, waiting for the bottom.

"For the next three months, people will be getting drunk and going skiing. Nothing will happen until March, even if they there is no sign of recovery until 2010," says Peace.

Philip Charls, CEO

Confidence in local solutions
There has never been a better time to focus on transparency as the property industry lowers its toleration for complicated, opaque structures, says EPRA CEO Philip Charls.
"We do not envisage this level of tolerance going forward," he says.

Quality information on the performance of real estate and real estate company management will become a "prerequisite" for fundraising. "It's likely that all industries - not only real estate - will be forced to adhere to this requirement or face severe difficulties raising capital. What's happening is happening on a global scale," he says.

 The credit markets will be a key issue in 2009. Some European players will face challenges refinancing short-term credit lines, and it is important credit lines are made available for quality portfolios.

"Getting banks to lend is no easy task. Credit is one solution, equity another. Money will flow to countries that are transparent, with good corporate governance."

Although the introduction of an EU REIT is "probably low on the agenda", the development of national REITs regimes, for example in Spain, Finland and Italy should help to encourage greater flows of capital to these sectors.

"I have confidence in local solutions. It's a question of making optimal use of the instruments available - country by country, but with EPRA also playing a role in Brussels, then Brussels influencing national regimes."

Steven Wechsler, president and CEO

The clear case for cash
Steven Wechsler, CEO of the US National Association of Real Estate Investment Trusts (NAREIT), identifies the three lessons from the property meltdown as caution - amounting to aversion - over leverage, a need for greater transparency, and a taste for liquidity.

In all three cases, he stresses that the reclaimed wisdom applies not just to public and private property but to capital markets more generally.

"The lessons to be learned from the current situation are largely the same for REITs as for any other property asset class," he says. "The lessons should be learned by financial institutions throughout the world and investors throughout the world."

The first lesson is that "it's better to have less than more leverage". Deleveraging in parts of the market, both in property and other types of investment, is tied to a new awareness of risk associated with debt and refinancing. "Risk had been forgotten in both the property sector and the financial sector," says Wechsler.

The second lesson - that liquidity is better than debt - will encourage investors to gravitate towards liquidity and encourage a bias towards listed property.

The third is the importance of transparency - "ensuring that those who have the money know where it's going". Hence the belated concern with small print on the part of investors. "There has been investment in a variety of vehicles, some of them very difficult to comprehend," says Wechsler. "Now investors will demand transparency and regulators will require it."

The revived importance of diversification - both in terms of asset classes and geography - will increase scrutiny of some asset classes. "There has been a lot of confusion in the marketplace between asset classes and investment strategies. Investors will begin to ask whether private equity is an asset class or a different way to access it. From my point of view, it isn't an asset class."

The impact of these lessons, especially the focus on transparency, will last for "as long as a human memory feels pain" - at least a decade. In the meantime, Wechsler claims the industry will throw up "tremendous opportunities", including opportunities to provide senior credit to real estate. Assuming a return to growth, fiscal stimuli in China and Australia, for example, will also provide significant opportunities in construction.

 All this, of course, is threatened by the potential for economic contraction. "Capital is on the sidelines waiting to enter the market but real estate does well if the economy is doing well. Property houses the larger economy. If the economy is weak, it will be difficult for real estate to do well."

Peter Verwer, CEO

Fight off the fruitcakes
"There are differences between the Australian property market and other markets but there are common themes, and the most common is the need for strategies to restore trust," says Peter Verwer, CEO of the Property Council of Australia.

"Trust is the question we're getting from investors - all investors, not just pension funds. They expected a particular return and are not getting it. Those expectations were sometimes unrealistic. But collateral damage has been done to the brand of the property sector."

Verwer claims the sector will eventually right itself in any case as repricing rotated investors back into property. Rebranding the sector will accelerate the process of rebuilding damaged confidence.

The critical success factors for the industry, he says, will be the performance of alternative asset classes and the strength of the underlying economy. But investors are also looking to a more transparent marketplace, notably with new, clearer definitions for gearing and bottom-line performance.

"When people talk about gearing, they're talking about six different things. We need to have a common language. It's important that the sector takes a leadership role in agreeing definitions. Otherwise there is a risk that the decision will end up with the regulators, and regulators have a poor record of understanding the sector."

After standards, the main challenge for the sector comes from what Verwer describes as "fruitcake politicians and bureaucrats. That is what they do - they regulate. There are too many examples of politicians who tried to regulate achieving the exact opposite of what they intended."

Is there a danger that public pressure on politicians to "do something" will result in unwise property regulation? "At the moment, lip-service is being paid to regulation but the government priority is - as it should be - on coping with what the Australian prime minister calls the GFC - the global financial crisis."

Peter Mitchell, CEO

Credit in crisis
Two issues currently dominate Asian property: frozen credit markets and the need to mitigate the impact of a downward trend in equities on listed real estate. The industry's immediate priority is less lesson-learning than firefighting.

"The main thing for Asia is that, as in other parts of the world, the real estate market is in danger of being strangulated by the freezing of the credit market," says Peter Mitchell, CEO of the Asian Public Real Estate Association (APREA). "In vehicles that are in fact very conservatively geared, that are due for rolling over in 2009, that whole rolling-over process is somewhat problematic, given the frozen credit market.

"It is beyond the control of the real estate market, which is otherwise in general in pretty good shape. The solution is what can be done at government level to get the credit markets moving again. I don't think there's much the real estate industry - like any other industry - can do about it."

Second on the agenda is the need to rescue regional REITs from "savaged" equities markets.

"All around the world, there's been an unusually high correlation in the downward movement between listed real estate and general equities. It's a reflection of the fact that listed real estate has been sucked down by the exodus from equities," says Mitchell. He points to the sharp drop in REITs prices in some markets, and to a halving of market capitalisation of Asian REITs over the past six months.

"Regulators need to examine why investors have left and where regulation can be improved to ensure that, when the market picks up again, those investors come back into their REIT markets," he says.

"The reasons vary from market to market but, for example, they include local tax changes proposed in Singapore and Japan. There are suggestions that capital management tools need to be expanded so there is less reliance on short-term debt. Certainly, an expanded capital management toolkit has been strongly recommended in Japan. A number of our members would like to see internal management suggested as an option for REIT structures in both Singapore and Japan."

Jim Fetgatter, CEO

Plus ça change
A survey conducted by the Association of Foreign Investors in Real Estate (AFIRE) in Q4 last year found considerable uncertainty among cross-border real estate investors before the onset of recession.

"The sequence of events was a shock to everyone," says AFIRE CEO Jim Fetgatter. "No one could have anticipated exactly what happened, or its magnitude. But investors knew something was amiss and they don't like uncertainty."

With the flight to quality, he says, the best opportunities will be in prime in established markets. "Investors are coming down the risk curve. Investors are not going out on the risk curve. In general they still need to diversify but diversification will mean perhaps a stronger focus on traditional markets."

In the meantime, investors are coming to terms with the fact that "there will always be market corrections -- but you never know where it will come from", says Fetgatter.
"Investors tend to go back to the last downturn and think: that isn't happening now. But old rules never get repealed. Trees don't grow up to the sky."

He adds: "The last major downturn in the US was in the early 1990s and it was characterised by oversupply. As a result we had tighter control on construction spending.
"It took care of that issue but that's not where the problem was this time. You could adhere to the rules but there's always something else to defeat us. There will always be cycles."

The impact on the industry will be to focus once again on due diligence - lost, in some cases, in a swollen appetite for assets.

"When you discard reasonable business practices such as due diligence, something is going wrong; it's getting out of control," says Fetgatter. "We're already seeing standard practices coming back into play - investors are going back down to fundamentals, with reasonable assumptions."

Stephen Renna, CEO

No smoking gun
It isn't just property players who must learn lessons from the recent crisis, according to Stephen Renna, CEO of National Association of Real Estate Investment Managers (NAREIM). There are just as many lessons for banks, data providers and rating agencies.

The problem is, no-one has yet figured out what happened, let alone how to address it. "You see how the sub-prime crisis has affected lending and the secondary mortgage market but in commercial property there is no smoking gun as there is in residential," he says. "In some sense everyone is a victim of the financial crisis."

Renna acknowledges that some investors' expectations had been unrealistic. "The assumption was that values would only go up. Then the music stopped," he says.
But they were often acting on flawed AAA-ratings from agencies that similarly failed
to anticipate the correction.

"Companies and investors looked to data providers, such as Moody's, to tell them how well the economy and specific markets were doing. Everyone uses this data but it didn't predict what happened," he says. "People were paying the prices - and using leverage - for certain properties that were triple-A-rated. They were doing all the right things. So the problems lie in all different areas - banks, ratings agencies, and data providers.

"What went wrong with rating agencies? What went wrong with banks' underwriting - and with secondary mortgage market services? We need to understand what happened. At the moment we have more questions than answers."

It isn't yet clear how the real estate landscape will be remade - though attrition and consolidation are likely as it does - but less risk, more equity, and more stringent lending requirements will characterise it for the foreseeable future.

"The way business is done will be different. Investors won't go back to the same old models and the same old ways. There will be changes in risk management - and especially risk repricing," says Renna.