The Great Recession of 2008 left its mark on many aspects of our society, from real estate investment to job numbers. Though it’s been almost a decade, we’re still struggling with its legacy, from sluggish economic growth to an employment rate that is finally beginning to match pre-recession levels.

It’s hard to understate the lasting, profound impacts of the Great Recession. Yet as painful as this time was for so many, I did learn some critical lessons, particularly where it concerned investing. In fact, the Great Recession later proved to be an opportunity for me, as it was one factor that led to my departing Morgan Stanley and striking out on my own to form GreenOak Real Estate.

The Danger Of Financial Instruments

Several years ago, I had the opportunity to sit down with Todd Henderson of RREEF Real Estate and Steve Tomlinson of Kirkland & Ellis at a Privcap discussion. In retrospect, what struck me about our conversation was that the crisis didn’t come out of nowhere; in fact, there were a number of warning signs that are much, much clearer with hindsight.

In spring 2007, I attended a dinner hosted by Bob Rubin, a consummate finance professional and a good friend of mine. What most alarmed me about the meeting was the various (and complex) financial instruments that we spent most of our time speaking about: these included the structured investment vehicle (SIV) and its closely related cousin, the special purpose entity (SPE).

In essence, a SPE was a shell corporation: Though they were supposedly independent from a larger company, SPEs were actually controlled by executives, and served as a way to offload liabilities (and losses) onto another entity. SIVs were similar: They were pools of investment assets, borrowing money from investors (short-term) and investing on long-term things like subprime mortgages. They earned money on the spread between short-term debt and long-term investments.

Needless to say, being an equity investor, I was shocked and concerned about the recklessness (and inherent complexity) of these instruments. I spoke to my team about this sort of financial engineering, and though we were worried, we still thought that perhaps the damage would not touch real estate equity. After all, we were (and still are) equity investors, and we thought that perhaps the financial engineering would not affect us.

But I would soon realize that this wasn’t the case — and see firsthand the danger of these financial instruments in action. As Todd pointed out, yet another early warning sign was the turmoil surrounding mortgage-backed securities. This led to the fall of Bear Stearns, which as many of you remember, came from a lack of liquidity: Bear executives found out on Thursday, March 13, 2008, that their reserves were essentially depleted. This was an unfortunate consequence of an over-reliance on risky financial instruments, from collateralized debt obligations to subprime mortgage-backed securities.

Stay Away From Public-Private Transactions

Another valuable lesson I learned from the recession was the value of public-private transactions, in which previously public assets are spun off and sold to private investors. Unfortunately, I’ve only been involved in one public-to-private transaction that was successful (a deal in London’s Canary Wharf), but even that had speed bumps and hiccups in the process. More importantly, the vast majority of the negative alphas, where the asset underperforms in line with the market, have been from public-to-private transactions.

The Great Recession blew open some flaws in our investing strategy. We used short-term corporate financing (two-three years), rather than the typical five-to-seven year, property-based mortgage financing. In this type of deal, the assumption would be that we’re able to flip a sufficient amount of assets within a brief period of time. Unfortunately, this strategy relies much more on the type of financing rather than the amount of financing.

And when the recession occurred, we got squeezed on three sides. First, there was a traumatic market event (recession), followed by an inability to execute our business plan (we couldn’t sell off non-core assets) and the short-term nature of the financing. Another additional variable is rents, which quickly corrected downward and fell — which meant reduced revenue.

To be sure, this was a perfect storm of events, but in retrospect, everything was wrong about the strategy.

Real Estate As A Financial Instrument

The most important lesson of all was this: If real estate was to be treated as a financial instrument (subject to manipulation and creative engineering that was morally and legally questionable), then it would become overused and incredibly vulnerable.

Part of the reason that real estate became a financial instrument in the first place likely had to do with real estate’s evolution, from a non-institutional asset class to an institutional asset class. Twenty years before the recession, there were very limited opportunities for real estate exposure; by 2007, this was obviously not the case, given the real estate instruments available at the time.

Still, one thing is clear: We’re much more cautious in terms of financing than we were in 2007. Increased regulations have made it much harder to engineer the sort of risky financial instruments that caused the last crash. As a result, it’s important to raise capital the old-fashioned way — earn it from investments or raise it from investors. Either way, we’re certainly much more cautious now, especially where it concerns financing.

Ultimately, the Great Recession, whose effects we are still recovering from now (though it will likely have a huge impact on our society and economy for years to come) left some valuable lessons for professionals of all kinds in the real estate industry. My team and I certainly remember them, hard-won as they were.

Source: Forbes

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