In the 20 years since he founded Starwood Capital Group L.L.C., Barry Sternlicht has built a big name for himself, both as a hotelier and as a private real estate investor. Reflecting on his experience building Starwood Hotels & Resorts Worldwide Inc. into a hotel juggernaut and then launching Starwood Property Trust, he offered his own lessons learned and his predictions for emergence from the economic crisis during a one-on-one interview session at the NYU Schack School of Real Estate’s Capital Markets conference on Thursday.

Interviewer James Kuhn, longtime president of Newmark Knight Frank and himself an industry veteran, started with branding, an area Sternlicht commandeered during his days leading Starwood Hotels & Resorts Worldwide. Today, the chairman & CEO of Starwood Capital believes branding is both “over-rated and under-rated in real estate” – and much easier to achieve than it ever was, thanks to the greater availability of word of mouth.

That capability traces back to the Internet, and in particular social media, which he believes is far too underutilized by the real estate industry. In Brazil, he noted, some real estate companies are selling their properties entirely online.

Sternlicht learned his first business tenet early on, when he went to work for Neil Bluhm. “I learned there are no secrets – just hard work,” he said. He applied that when Starwood purchased the Westin and Sheraton brands in 1998 and incorporated it into what then became one of the world’s largest hotel companies. There was no luck involved in the purchase and development of that brand, he noted – “we knew exactly what we were doing.”

Another lesson he picked up, from a finance professor, was “Find the freight trains in your life and get on them instead of in front of them.” Europe may be one such freight train. While Sternlicht sees opportunities there, he warned that it may still be far too early to step in, there being a 25 percent chance that the world or at least Europe could collapse, he warned. And the banks are difficult to track to their origins: “You have no idea where these jellyfish go.”

On the other hand, in July he made his first big investment in Brazil, purchasing a 33.3 percent stake in warehouse manager MRV Log for $159 million, and he has confidence in China’s ability to succeed with its investments, although he admitted that given the lack of market research in this “company masquerading as a country,” it is difficult to understand how the real estate gets filled up.

In general, he has altered his strategy for the market, sticking to larger investments but with wider (and lower) return expectations. “What there isn’t to do is make five times your capital,” he commented, blaming the politicians for the lack of recovery.

His final lessons from Bluhm: The flow of funds overwhelms fundamentals. And people want to be in New York City.

Q: What’s different about investing in lifestyle properties versus more traditional property areas?

A: The biggest difference is it requires a tenant between you and the real estate. Because these are asset categories that are not subject to the REIT Modernization Act of 2001 … these have to be held as net-leased assets to an operator who pays you rent.

Q: You’ve recently expanded into seniors housing, a sector that I’d think of as being more of a demographic play rather than having the recreation focus of your other lifestyle properties. Are there any other new investment areas that you’re looking at?

A: There are two areas that we wanted to be investing in where we have not found the right transactions, and that would be outdoor lifestyle — which is also a very popular demographically driven phenomenon: hunting, fishing and camping. And the other would be spa, fitness and wellness, which will play into our healthcare thesis for the next fund especially, because we do see spa, fitness and wellness as an important piece of the American demographic.

Q: Do those tend to be separately owned properties?

A: To date, the spa, fitness and wellness industry is largely housed in inland leased space, as opposed to freestanding real estate. But now you do see it grow in the medical office building space toward the wellness industry, with everything ranging from chiropractic to homeopathic being integrated in with traditional medical practice. So I do think the statistics would prove it’s an industry worth watching that will continue to gain maturity in the real estate marketplace.

Q: And what about the hunting, fishing and camping space? What types of properties does that tend to entail?

A: Well, I guess the most logical would be to see the resilience of companies like Cabela’s and Bass Pro (Shops) through the recession—to show that, really, in times of economic uncertainty, those basic-level recreations associated with the outdoors, like hunting and fishing, still are very passion oriented and continue to do pretty well.

So as we look at that space, it could range from stores like Bass Pro and Cabela’s — although they’re very expensive to buy — to campgrounds to … one of the assets that we looked at doing in CNL Lifestyle Properties was an Orvis-branded fishing community. Those types of assets definitely have a place in a demographics story. I mention it because it is something that we continue to evaluate and watch. We just haven’t found the first appropriate deal.

Q: Do you see other companies buying them on a larger basis? Or is that really kind of a new area for a real estate investment firm?

A: Sam Zell bought Thousand Trails campgrounds (in 2008), which is the nation’s largest campground company. Blackstone owns the largest camping company in the U.K. So private equity and large real estate funds have discovered this niche. But most of them are still held in the hands of private mom-and-pop owners. In fact, many of the assets that you’ve seen CNL buy through the years have started as aggregations of mom-and-pop industries. That’s where the assisted-living industry was when we started in that back in 1998 or 1999. That is clearly true of the marina industry. That’s also been true of many of the ski mountains that we’ve bought.

Q: Does that make it tougher— kind of a bigger job for you, because you’re having to aggregate them?

A: It does require a well-executed acquisition strategy to penetrate the industry, build the relationships in the industry and start the aggregation process in the industry. We go into industries and become active in organizations like IAAPA in the attractions industry, NSAA in the ski industry, MRA in the marina industry, so that we go in and establish ourselves and then become a preferred capital provider to those industries. NGF for golf.

Q: And what do you see as the pros and cons of these properties? The risks and rewards?

A: I actually like the fact that you can take businesses that have seasonal and cyclical characteristics and smooth the rent payments across a timeline and then share the rent payments with the investors the way we do through our distribution. It shields the investors from the operational volatility, because there’s an operator between the investor and the REIT that is smoothing those operations into a rent payment. It allows the investor to participate in businesses with a steady distribution, as opposed to being an equity investor in the operations of that business.

Q: What about on the risk side?

A: On the risk side would be what we saw in the Great Recession. We made it through the recession without a single tenant bankruptcy, thankfully. But we did have some tenants lose their operating lines of credit, like we saw in other businesses. At that point, we had to restructure some leases and help our tenants through that process. But the good news is, in these businesses, what really revealed itself was that these affordable drive-through businesses had very strong visitation even throughout the recession. The per-cap spending fell and is now coming back. But it told us that even in tough times, people continue to pursue their passions. Entertainment Properties Trust saw the same thing, with respect to movie attendance. I think when times are tough economically, people still find ways to enjoy affordable outlets. A skier still tries to ski, even though more affordably, by driving instead of flying. A golfer still tries to golf, although they may take advantage of day courses with discounts. And a parent or grandparent still wants to take their children to a theme park. They just may go to the regional or local theme park instead of getting on an airplane.

Q: So you just sort of adapt for the conditions and the impact they have on the consumer.

A: Exactly. But yet, the desire to do it and the passion to pursue that did not go away.

Q: It’s certainly been interesting in this recession, as tough as it’s been. I’ve read similar observations elsewhere, as well.

A: Well, you look at, in the ski industry, Vail and Aspen being down 25 and 30 percent. We didn’t see that in our affordable day ski visitation. It was flat to even slightly up in some resorts.

Q: Do you see this as an area for specialists only? Or might more traditional real estate investors, say retail investors, expand into this area? Do you see new competitors coming from those types of real estate investors?

A: Not so much from the REIT spaces I’ve seen. I have seen it in the private equity world. You’ve seen Blackstone make big bets in the attractions space with their acquisitions of Anheuser-Busch Entertainment, their growth and their investment at Universal with the Harry Potter exhibit, their activities with Legoland and Merlin and Madame Tussauds. Blackstone’s probably been the most active private equity firm. Apollo has been an investor in the golf industry. Q Investments recently recapitalized Cedar Fair Entertainment. So we’ve seen private equity really come in. Entertainment Properties Trust is the most obvious public example of a REIT that has come into the space through their acquisitions of some ski resorts and vineyards, to complement their movie theater investments.

Q: With so much of the lifestyle sector still mom-and-pop owned, what are the growth opportunities?

A: If you think about most of these industries being non-institutionally owned, there’s still probably some aggregation opportunity in each of the spaces. The marina space, for example, is ripe for aggregation. The ski business still has acquisitions that can be made from private ownership hands. The attractions business, same thing. Healthcare is a trillion-dollar real estate industry that’s still 85 or 90 percent privately owned. And so I think there’s a lot of aggregation work that can still be done.

Q: And are these properties actively being put up for sale?

A: There are some that are. We don’t typically play in the brokered transaction market. We’re more off-market relationally based. But yes, I think healthcare real estate has really moved into the mainstream and has gotten a lot of institutional attention of late with the transactions like ManorCare and Genesis (Healthcare) by the big players. The larger portfolios—$100 million and above—are really getting a lot of institutional interest. But those transactions $100 million and below are very appropriate for consideration by funds like us.

Q: And with the existing properties, what are the opportunities you’re seeing for improving their value?

A: This weekend, I was up in Seattle at our Wild Waves theme park there, looking with the operator at some ideas for expansion. Each of the theme parks and ski resorts always has new ideas that can be employed. This year, we opened a mountain coaster at Mt. Cranmore in Conway, N.H., which has been a huge success. And we also opened what I believe is the largest winter tubing park in North America. We have just completed a $60 million renovation of the Mt. Washington Hotel in New Hampshire, which added a spa and conference center, and redid all the rooms, and that has been a terrific beautification process that is also driving occupancy. George Soros just had an international economic summit there, because that’s where the 1944 conference on the gold standard had been held, and so he wanted to reconvene economic leaders there. And it got high marks, especially in light of our renovation.

You’ll see enhancements at our theme parks and ski resorts, and in golf courses we doubled the size of the common area at the Cowboys Golf Club in Dallas. So we’re looking for ways to grow the businesses that we’ve invested in, as well as looking for add-on investments to the portfolio.

Q: Now, did you alter your strategy at all during the recession?

A: Yes, we did. We realized that golf was not as much of a growth industry as we thought it was when we started. Our research showed that a golfer in his 60s played three times as much golf as a golfer in his 30s, and someone at the time was turning 60 every seven seconds. So we thought golf really had a big growth run. What we didn’t realize is that they may play three times as much but they’re going to look for three times as big a discount on that round of play.

Whereas visitation and playership really stayed pretty constant during the recession, per-cap spending declined and discounting really increased in order to maintain that playership. So we saw that was an adaptation we had to make, and we stopped buying so much golf. Thankfully, that’s beginning to reverse now. We’re seeing membership sales trend up again and per-cap spending trend up again, and ClubCorp, which is the largest player in the industry, is doing quite well. They’re a good bellwether for the industry’s recovery.

Q: And are you making changes now to address the improving economy?

A: We are. We are very excited to be able to reach back into the opportunities related to the seniors demographic. Our pipeline has add-on acquisitions for our businesses in golf, ski, attractions, marinas. But it has some more bets that we’d like to make in seniors-related and medically related real estate.

Q: Among government initiatives, what do you agree with and what are you concerned about as it relates to real estate?

A: What had to be done was done with TARP. … Many years from now, when all the histrionics are over, people will gauge that it was both necessary to have done it when it was done, and then it was executed actually rather well in a crisis; and No. 2, that the net result was that it did save the system at the lowest possible cost that one can imagine. … The biggest negative is the government has introduced over the last several years a high degree of uncertainty—uncertainty about how you’re going to get taxed, how much intervention there’s going to be, which sectors of the economy, of the marketplace it will support or not support. The more uncertainty there is in the system about what government policy is going to look like, what tax policy is going to look like, where government intervention may or may not occur and to what degree, the less it is desirable for someone to make a long-term investment. And the difference between real estate generally as an asset class and most other asset classes is that we’re making pretty long-term commitments. …

I would argue that the support for the financial system, the conservatorship of the GSEs, the introduction of TARP, the stress testing of the banks, the getting the plumbing of the system right, the re-start of securitization—all of these are results of actions that, when we look back upon them in later days, we’ll say, “You know what? There was a cohesion here. Yeah, it might have been done by bootstraps. But at the end of the day people did what they were supposed to do, and our system actually worked.”

The flip side is that what happened during the period of extraordinary growth is there was excessive spending by everybody—the federal government, the state governments and the local governments. And you look at the budget deficits, and you start to wonder how could they have done that. That was pretty profligate. When you make money, you’re supposed to also save money. Nobody did. The federal government didn’t, state didn’t, local didn’t, the household didn’t, and most companies didn’t either, by the way. So we all participated in this period of extraordinary consumption for it looks like probably close to a decade and a half. And then it came back home to roost. …

I would suggest that the biggest thing we have to think about (regarding) policy and government in the future … is where is the job growth going to come from, in what sectors and what markets, and for what reason. … In real estate, we are heavily dependent upon the fact that there are jobs being created and workspace is needed and housing is needed. Otherwise, we don’t have work to do.

Q: Do you think we have reason to fear the outcome of the GSE debate?

A: Well, of course we do. On the other hand, we probably don’t for reasons that are more obtuse. We should fear it because it could lead to a massive disruption in capital flows in one sector of commercial real estate—specifically multi-family housing, which to some extent has benefited and been propped up by the presence of the GSEs, unlike retail, industrial and office, as an example, and hospitality. So we do have something to fear.

But on the other side, the good news is that multi-family—and I’m fond of saying this—is very much part of the solution and not part of the problem. And the reason is, statistically multi-family loans have outperformed—by the GSEs by the way, Fannie and Freddie—any other types of loans in the ABS as well as the commercial real estate factor. And the GSE books have therefore held up better, operated better, functioned better. So there’s a startlingly good reason to say, “Hey (to policymakers) “that one thing over there that works, please don’t screw it up.” There’s a really good argument here. I’m not sure if rationality (will) prevail … but nevertheless it is a very strong argument.

The second thing is that it is where housing is going. We are beginning to see the formation of a real renter nation now. We had 68 percent, 69 percent homeownership—it’s already down by several points. Some statistics say that for every million households that’s a 1 percent reduction in homeownership. It’s going to be hard to see how homeownership, unless it becomes again more housing of choice as opposed to a piggybank, comes back into vogue and goes back into those high percentages.

So we need renters, we need rental housing, we need institutional rental housing, we need financing. And good news: It’s worked. If we try not to screw it up and really continue it in a form that makes sense, while keeping the role—perhaps changing the role of government through the GSE vis-à-vis this—we’ll be fine. But I would be very watchful, because I see the temptation to say, “It works, so make it fully private.” Or, “It works, then make it fully government.” And the answer is probably right in the middle, and it’s a complicated answer, and I hope people even in these very polarized political times will find a way to think about these complex issues and come up with the right solution.

Q: You’ve recently said the FHA insurance program has worked for the multi-family sector for many years. Do you think that can be replicated for the commercial real estate sector? And in general how can we boost capital availability for the commercial real estate industry?

A: The big interesting thing about FHA is that it is completely unknown and extremely sleepy when it’s not needed, and then it becomes huge and gigantic when it is needed. I would suggest to you that’s exactly what we want of it. … In 2006, the FHA constituted in single-family less than 4 percent of the total market. In multi-family it constituted even less. We were doing $2.5 billion to $3.5 billion of loans insured by FHA, whether they were construction loans or rehab loans. Guess what happened in the last year? It went in the single-family business from 4 percent to 35 percent, and in the multi-family business, it’s 20 percent of the market. So it quadrupled. Fannie and Freddie’s total volumes have dropped because the private market has almost disappeared, and FHA skyrocketed. It’s exactly what we want. … It’s very inefficient, it’s very cumbersome, it’s got very limited programs, it delivers them as best as it can under the circumstances, but when it’s needed, when everything else has fallen apart and doesn’t exist and you need a source of capital for this, that’s where you go. …

Now, I believe—and this is not going to be astoundingly met with approval by most of the people in the commercial real estate arena—that that’s what the rest of the industry needs as well, as a backstop. I know we love to hate the government … but if you thought about what you need as a backstop for values, how do you prevent things from going not just below replacement cost, not just into obsolescence, but how do you prevent the spiraling down of values when capital disappears from a market, which we just saw and saw in the early ‘90s as well? You’ve got to have a backstop. You’ve got to have one place where there’s catastrophic intervention that says, “We’re going to allow this to happen because that’s the market and that’s reality, but we’re going to put some kind of floor underneath it, and here’s the FHA.”

To me, how this can happen potentially is first the FHA has to change and become more efficient. That’s not a bad idea; that’s a good idea. The second is, it doesn’t have to become much more of the market in my view. If it had 5 or 10 or 15 percent of the market at all times, that’d be great, and in really bad times 20 percent—wow. It puts the floor underneath the market, it provides a certain standardization and influence.

The way this can happen in CRE is first, we look at the fact that housing and healthcare and commercial development are now part of something—whether it’s transit-oriented or it’s urban friendly, it’s a great idea to do them together and not think of all of these things as segregated. We’re trying now to build neighborhoods, and it’s an amazing concept. These things actually coexist. We underwrite them as though they are completely independent and unrelated to each other. What if we started to underwrite a new mixed-use model for development, and the FHA could actually insure that? We know that people will say, “Well, let’s underwrite the commercial component this way and the multi-family this way and the hospitality this way and the industrial that way.” But somehow we should be able to build a model that (allows the) government (to) provide a certain level of insurance. Perhaps it does it with risk-sharing partners. … I would slowly ease them into it so that at the appropriate time and if needed that insurance could be available for commercial property development as well, but in limited quantities, probably delivered with great study and with deliberation, and in quantities that were relatively limited. But still, a catastrophic backstop.

Q: Interesting. And the idea of treating the mixed use as a single unit is interesting. Oftentimes, you’ve got different developers, different investors, different partners, and they are treated very differently.

A: Right, but if I can find one parcel and I’m going to build all these things on it and I can see how occupying the housing unit may actually benefit the retail center, which might actually help me with the office and might make it greener and more affordable—if I could actually look at all those components together, perhaps I could come up with an insurance program that enables debt financing so it’s done in a more efficient manner. That would be a great revolution. They’re thinking about it. It’s a logical step, and it seems to me that’s the way very carefully an agency like that treads into this arena. And then it may lead to more things. Who knows?

Q: What about the low-income-housing tax credit program? We’ve heard there’ve been some suggestions of pushing it off the table. Are you concerned about the outcome for affordable as well as working class housing?

A: I don’t think it’s off the table. I think it’s absolutely still alive. It’s being used across the country. It is developing housing. It’s right now almost the only source of new construction of multi-family out there. But we live—and I’m going to make this comment, by the way, about the debt markets as well—in what I would call a highly bifurcated market. Some things are really, really good, and everything else is really, really bad.

What happens when you misprice risk across the spectrum to begin with is that you’ll misprice the risk for a long period of time because you’re looking always in the rearview mirror. What I mean by that is, a property in an urban infill location of a certain size, done by a certain kind of developer—100 people will want to do that deal. And the same kind of property, perhaps build with the same quality, by perhaps the same developer, in a significantly less desirable location—i.e., a second-tier city or an older suburb—will have no interest whatsoever. We’re seeing that bifurcation occur with equity capital and debt capital, and it’s the way markets tend to behave.  They tend to all rush into the perceived safest place and rush out of everything else. But that cascading effect is having a very dramatic effect, in my view, on the perceptions of risk that is completely not borne out by the facts. With LIHTC today, you get a 60-unit property in an infill location. If you had it in San Francisco, (you’d have) five bidders paying you top dollar: 85, 90 cents. You take that same thing and move it to Merced in an inner-ring suburb, and you will be at 75 cents and you may get one bid. Same deal. And you go further out and you’ll get zero bids. And that, by the way, is exactly what’s going on in the debt markets as well. Smaller loans, second-tier markets, more industry, less diversified are being completely excluded from the re-entry of the capital markets today.

I think it’ll change as risk perception changes. And by the way, I’m not arguing. We used to misprice risk in the sense that we said all loans everywhere should be the same price—it doesn’t really matter anymore. That makes no sense either, right? Why should a 30-year, fixed-rate, single-family mortgage be priced the same in location A and location B, with two different borrowers? One would assume that some perception of risk and value are different.  But the fact that one is unavailable and the other is available is wrong also.

What’s the biggest threat to tax credits? Actually, two funny things—only because they’re obvious. You have to have profits to use credits, so you need companies that generate profits. It can’t just be about CRA. Even if it is about CRA, it has to be about that entity being able to use the credits—i.e., having profits. So the downswing on credits was overdependence on a very small number of players: Fannie and Freddie, to be exact. They exit, there’s a big vacuum, and then there’s not enough profit in the system, so the whole credit market was disadvantaged. Profits re-emerged, the same institutions are back, but there’s a bifurcated market. Long run, if we think about it, there will be a re-entry and it will, again, right itself. It just takes a period of time and correction.

But the second slightly funny part to me is, the really big threat to tax credits is tax rates. Who knows if this will ever happen or could ever happen, but if we actually moved to eliminating credits and lowering tax rates dramatically, that would be the biggest threat to credits, because credits work because of where the tax rates are. And if you dramatically lowered tax rates, you could easily argue, “Why do I need credits now, I’ve got a fairer tax system; I collect as much tax revenue and the tax form doesn’t require 600,000 accountants to prepare it for all of us. So there is a long-term threat, but it’s a threat not just to low-income-housing tax credits—to, I think, credits in all forms.

Beekman Advisors managing partner Shekar Narasimhan spoke with editor-in-chief Suzann D. Silverman about the real estate and real estate finance markets. An icon in commercial and multi-family real estate circles, Narasimhan has spent the past 30 years in the industry, working in nonprofits, property management and real estate development before moving into banking and the mortgage business. In December 1997, he took WMF Group public, selling it to Prudential Mortgage Capital Co. in 2000. In 2003, he started Beekman Advisors, which serves as a strategic advisor to real estate firms in the United States and a principal investor in India. For more on his views of government policy, click here.

Q. Given your industry experience, what lessons have you learned and how have you been applying them?

A. I’ve learned two lessons, and I think they both are relevant to today’s times. The first really is, if you’re in this business, expect the unexpected. Because (with) the things that you know, you can plan, you can measure, you can quantify and you can evaluate. It’s the things you don’t know and don’t expect that are actually either the best opportunities or the biggest pitfalls. And so it’s important to plan for what’s on the other side of the door that’s unseen, as opposed to what’s obvious and seen. And that distinguishes true leadership and vision from just operational excellence. That’s important in real estate today and real estate finance. And the second is something people don’t want to hear, and in real estate particularly because it’s entrepreneurial … which is that government policy affects everything.

Q. Among government initiatives, what do you agree with and what are you concerned about as it relates to real estate?

A. What had to be done was done with TARP. … Many years from now, when all the histrionics are over, people will gauge that it was both necessary to have done it when it was done, and then it was executed actually rather well in a crisis; and No. 2, that the net result was that it did save the system at the lowest possible cost that one can imagine. … The biggest negative is the government has introduced over the last several years a high degree of uncertainty—uncertainty about how you’re going to get taxed, how much intervention there’s going to be, which sectors of the economy, of the marketplace it will support or not support. The more uncertainty there is in the system about what government policy is going to look like, what tax policy is going to look like, where government intervention may or may not occur and to what degree, the less it is desirable for someone to make a long-term investment. And the difference between real estate generally as an asset class and most other asset classes is that we’re making pretty long-term commitments. …

I would argue that the support for the financial system, the conservatorship of the GSEs, the introduction of TARP, the stress testing of the banks, the getting the plumbing of the system right, the re-start of securitization—all of these are results of actions that, when we look back upon them in later days, we’ll say, “You know what? There was a cohesion here. Yeah, it might have been done by bootstraps. But at the end of the day people did what they were supposed to do, and our system actually worked.”

The flip side is that what happened during the period of extraordinary growth is there was excessive spending by everybody—the federal government, the state governments and the local governments. And you look at the budget deficits, and you start to wonder how could they have done that. That was pretty profligate. When you make money, you’re supposed to also save money. Nobody did. The federal government didn’t, state didn’t, local didn’t, the household didn’t, and most companies didn’t either, by the way. So we all participated in this period of extraordinary consumption for it looks like probably close to a decade and a half. And then it came back home to roost. …

I would suggest that the biggest thing we have to think about (regarding) policy and government in the future … is where is the job growth going to come from, in what sectors and what markets, and for what reason. … In real estate, we are heavily dependent upon the fact that there are jobs being created and workspace is needed and housing is needed. Otherwise, we don’t have work to do.

Q. What are the key characteristics of finance companies that have stood out in your work in recent years, and do you see any patterns emerging among the finance companies that you’ve been advising?

A. We went from essentially balance sheet only to a form of contingent balance sheet where I still needed a balance sheet but I could sell it. And this is the evolution of the Fannie Mae DUS program, for example, or bank loan participations or syndications or so on. I leveraged the balance sheet more—to securitization, which was essentially a way to sell off balance sheet, but in some cases with some residual risk, with some operating risk, with potentially, as we’ve learned, some buyback risk.

And now we’re sort of reverting back to a form in which you say you do need a balance sheet, but given the changes that are occurring in accounting rules and the world at large, how do we find capital players of different kinds to do one deal? … And then how do you aggregate this and do this? You’re going to need an extraordinarily interesting company that has capacity to hold some paper, to take some off-balance-sheet risk, and has capital market savvy to become the finance company of the future. And one of the most important things about that company is—and it will be a new hybrid—that it will have to have really strong risk management and control systems to be able to survive.

Q. Do you believe many companies will be able to achieve that model?

A. Sure. In the market as it is emerging, you have a private market and you have a public market. … The private market is most of the finance companies, most of the mortgage banking companies. You then have different kinds of capital in these companies. You have private equity, which has a particular focus. While many people in private equity say they are long-term thinkers and long-term planners and long-term doers, the fact is they all need an exit some day.

So that’s what I call … patient equity with a clear objective. And you have regulated capital, which is the market in which banks operate, and where to a large extent how much capital they have to hold and what they can pay in dividends is dictated by regulatory standards. And then you have people who have a balance sheet—a permanent balance sheet—and those who do not. So three broad characteristics. …

Personally, I’ve always felt that the best model would be one where you had a true mortgage banking company where you accessed multiple sources of capital for your clients, and those sources of capital both shifted and changed over time, but you also had an investment management model inside of it where you raised third-party capital that was discretionary and potentially proprietary and you could actually utilize that to benefit your clients by helping in enabling them to be more successful. … A number of people are trying it. I tried it 15 years ago. Large-balance-sheet companies try it; non-balance-sheet companies try it; regulated capital companies try it. But the entrepreneurial model with a source of stable capital and a limited balance sheet strikes me as the best one. Because if you have a real balance sheet and you can keep growing it, you tend to, in my view—just over time—become less disciplined. … What this kind of company needs, where it can both create capital and deliver it itself … is it has to have a culture of its own. It has to know and believe this is a good thing and that’s not a good thing. The discipline of knowing that and managing that, in an environment where growth is seen as the only sort of driver of value, is a very, very difficult thing.

All our systems—compensation systems, the kind of people we usually have working in these kinds of enterprises—are driven by growth—and often by growth of volume, of business, as opposed to just simply growth of profitability or recurring earnings. So to the extent that we have mismatched in real estate finance and not created these companies, it’s because we haven’t measured them properly. And so my biggest pitch to companies, and (where) … we might be able to help the most is trying to help them do strategic planning out of the box and giving them metrics to measure performance that might not be the logical things that they would look at, and saying how do you now build a rigorous financial model, a way to measure this so that you can actually start to export it and create a culture.

Q. Do you see some of the types of lenders that have historically been active, especially some that have dropped out, staying out for the long term rather than making these shifts?

A. I sold WMF Group in 2000 to Prudential. Starting then, for the next 10 years essentially, we had this evolution of entrepreneurial companies that became midsize and then sold to larger institutions. … Some of the entrepreneurs stayed and most didn’t. Now we have the reverse phenomenon, because we have this confluence of events going on … (a) combination of Dodd-Frank, Basel III, FASB 166 and 167 and the introduction of international financial reporting standards. … Any one of them alone could have been dramatic and somewhat Draconian. The combination of those is kind of a cocktail mix. If you take enough pills, unless you’re incredibly smart and have a general physician who knows this, you don’t know whether three of those neutralize the other two or create side effects for which you need a sixth. I feel like we’ve created an interesting cocktail mix, and I’m not sure there’s anyone out there that can fully tell you what the impact is and what the world is going to look like five years from now. Except, it’s pretty volatile out there. …

What kinds of businesses are these entities going to be in? How are they going to look? I think that what happens is, a lot of the parts that they might even have bought within the last 10 years start to go back into the private market. So I do see the pace of M&A quickening; I do see that there is going to be now another level of the private market that will be the “major market.” A number of things we’ve been involved with in the last two years point to this: that it’ll be larger capitalized, better capitalized private players in the commercial real estate finance business playing this role of both mortgage banker as well as investment manager, and in some cases finance companies with a balance sheet. …

Where do I think the vacuums might be? … A vacuum, as you know, by definition is a place that gets filled. So it’s (really), where are temporary vacuums? And one place that really worries me as I think about commercial real estate is construction lending. … The country has to have construction. … How is that sector going to come back? One of the things is, you’ll see in the FHA multi-family program, even though they’ve been very cautious, a big spurt in their construction lending and multi-family, because no one else is doing it.

Q. What’s your outlook for the coming real estate market?

A. I think we’re through the worst. And it’s probably partly because the crisis wasn’t really created by us. Obviously, we did overleverage real estate pretty heavily in ’06, ’07 and even ’08. And then the economy tanked, and then there were capital shortfalls and withdrawals. But now we have better-capitalized operators, the capital structures of the properties are much more rational and I think we’ve learned complexity is the enemy of the problem. … People will actually pay you more for a simplified structure than a complex structure, if they have a choice. So I do see, for the capitalized operators and with capital structures being more rational, lots of upside in commercial real estate. I do see capital re-entering; I do see a more robust market. But I gave you three caveats: How do you maintain discipline, who’s going to do construction loans, and how do we avoid having a seriously bifurcated market of haves and have-nots? We’ll muddle through this, and yes, the next generations of companies will address those vacuums and find creative strategies with discipline to employ.

And then the one other thing they’ll all do, which I think will be extremely helpful to the industry, is … people are going to do the right thing in investing in their own businesses in the future. And I therefore tend to be … not optimistic … just sort of cautious and positive.

I think there’s more information, more transparency, higher-quality people entering the business. In the 1990s, when we came out of the last downturn, we lost a whole generation of people who would have normally come into real estate and finance. So by the time you got into the 2000s, it was like building a bench. We have that bench today. It’s the strategic thinking and the thoughtful leadership that there hasn’t been enough of. And I strongly feel now that we have more of it than we’ve had in 25 years.

That’s why I tell you I’m cautious and positive. I do believe that all the indicators are right, and if the real estate industry would turn its sights with its leadership now to government policy and job growth and really thinking about the macro issues and how we can support those, I think we’ll be in pretty good shape for another 10 years. Before the next whatever.

Q: What will be the main elements of Jones Lang LaSalle’s global strategy for the next several years? In particular, which of your service lines appear to be especially well positioned for growth?

A: If you can have a “good” recession, we’ve had one. We did a very astute acquisition of the Staubach organization before the recession, and we were able to integrate the two businesses. We continue to be able to pick up on the momentum that we had during 2006, 2007 and 2008. So we start the 2010-2015 period with a lot of confidence and a lot of momentum.
Obviously, the agenda is growth. We see a lot of opportunity for LaSalle (Investment Management) to grow its investment management business worldwide. … We see growth opportunities for our corporate services business. For us, it’s a very appetizing strategic menu for the next couple of years.

Q: Generally speaking, what do you expect to account for the majority of Jones Lang LaSalle’s growth globally over the next few years?
A: Our principal driver is organic growth. We have set the entire business (plan) by that agenda. If you have a business that’s focused on organic profit growth, you’ve got the right sort of mindset across the organization. Selectively … as our confidence in the business and economic recovery is strengthened, we will be looking at acquisition growth.
Clearly, the economies that are internationally in better shape are the BRIC (Brazil, Russia, India and China) economies. We’re in a very fortunate position of having been in these countries for 15 and 20 years, such as Russia and China. That gives us a very good position in these economies.

Q: By all accounts, the global economic cycle is in a time of transition, if not turmoil. Which concerns should be foremost for real estate executives around the world?

A: The good news is, the depths of the recession are behind us and economies are growing. Although things are moving forward, there will be periods where individual countries or individual businesses will go backward for a while.
You can’t drive a business forward by looking in the rearview mirror. We are moving the business forward—we are committed to a growth plan. … We are just getting on with life, and that’s what I believe the rest of the business world has to do.
To my mind, there’s a great opportunity for real estate. Gradually, over a period of time, transparency in all markets is improving. … By transparency, (we mean) honesty in dealing with people, (simple, understandable business structures), legal guidelines, and visibility in pricing and returns.

Q: On another front, what operational and strategic challenges are on your mind these days?

A: (In running) an advisory business, an investment management business, there is a whole raft of continual improvements. The challenge is in technology, in training people, in hiring the best people, in joining up businesses between countries.
All of these are challenges that any business wanting to grow can address. We at Jones Lang LaSalle have always chosen a comprehensive approach to the demands of growing a business. Because as a business we are very collaborative, we’ve deployed methods for moving all these agendas forward.
The big challenges of developing all those areas of a business are ones that we are (approaching) on an increasingly worldwide basis. To me, the challenges are managing a very broad-based business going forward in the most efficient possible way, making sure that the best practices are spread. We are increasingly finding ways of connecting up our businesses, client needs and business systems around the world.

Edward Mermelstein is a real estate attorney and founder of Edward A. Mermelstein & Associates. He helps foreign and US entities find and purchase real estate in the US and abroad. He is also the founder of Mermelstein Development – a subdivision of his firm engaging in the acquisition, ownerships, investment, management and development of residential, commercial, and mixed-use properties.

Mermelstein spoke with MHN Online News Editor Anu Kher about the commercial property loans crisis in the U.S., its impact on banks and lending institutions and how the government can deflate the bubble before it bursts.

MHN: What is the problem facing commercial property loans and will be it be as big as the single family mortgage crisis?

Mermelstein: No one has a full grasp of how big this is going to be. It depends on the government and the lenders. Right now lenders are holding on to non-performing notes that today are worth only 50 to 80 percent of what they were when loaned against the property. Instead of starting the foreclosure process, lenders are extending notes, which is causing an artificial condition. There are trillions of dollars on lenders’ books but they are actually worth only 50 percent of that. The government is not forcing lenders to mark the notes down.

MHN: What is causing this?

Mermelstein: Commercial property values are in a free-fall, vacancy rates are soaring, and refinancing is no longer an option.

MHN: When is the bomb expected to go off?

Mermelstein: The bubble could either burst or deflate gradually over time, depending on how the government regulates the lenders’ books. Unfortunately, nothing can be done from the investor and owner side to alleviate this situation. The lender cannot go on extending the notes indefinitely. Eventually the house of cards will crumble.

MHN: How many banks are likely to fail due to this problem? And how will this affect the overall economy?

Mermelstein: Right now the government is artificially keeping several banks afloat. But in the next few years, about 1,000 lending institutions are expected to fail. They cannot be allowed to fail all at once, because this will cause a major loss of confidence in the banking system, which is not good for the overall economy.

MHN: What percentage of these problem loans are multifamily?

Mermelstein: While I don’t have this figure with me, this is more of a problem for the office, retail and hotel sector. The multifamily sector is in much better shape because there is liquidity in that sector due to the agencies and some lenders as well.

MHN: What can be done to prevent a disaster from happening?

Mermelstein: My concern is the rate at which banks will be going under. As long as the closings are controlled by the government, we should be okay. It depends on whether, going forward, the non-performing notes will increase at a rate that can be controlled?

MHN: When do you think recovery will take place?

Mermelstein: There is some increase in the returns that investment banks and trading firms are now seeing. So the freefall will stop in the next six to eight months. But in terms of a recovery, I think it’s going to take at least another six to eight years.

MHN: What happens to the properties with the non-performing loans?

Mermelstein: Most lenders are extending these loans, or are starting the foreclosure procedure. In a place like New York, it takes about one to two years to fully recover the asset but the lender is just accelerating the final outcome. Lenders discounting what’s on their books by 10 to 15 percent on a quarterly basis, because they won’t be able to take the loss all at once.