Focus on the Investment Conditions: Economic Resilience Paves Way to Good Times for Commercial Real Estate

Article excerpt

THE FLEXIBILITY, CREATIVITY AND RESILIENCY OF THE CAPITAL markets and the economy all came into play during 2006 to place the economy in a better year-end position than most pundits had anticipated. With a decreased threat of inflation, substantially lower oil prices, strong employment, signs of improvement in the residential real estate market, huge levels of liquidity and low long-term interest rates in the capital markets, and the stock markets at near-record highs, the economy was in a very healthy condition as the year ended. As such, the economic and capital market landscape for 2007 is starting off with even more positives than 2006.

The economy is operating at a more efficient and effective level than in past cycles; business and consumers are holding strong and investment returns are continuing to gain. Look no further than the markets at year-end 2006: the Dow Jones Industrial Index surpassed the 16 percent mark, the NASDAQ Composite Index rose more than 10 percent, and the S & P 500 Index was up more than 14 percent. And for the seventh straight year, real estate funds were the year's top-performing U.S. stock sector, up more than 34 percent, according to the Lipper average, with 12-month trailing returns of approximately 18 percent as reported by the National Council of Real Estate Investment Fiduciaries Index.

This kind of performance, along with cheap debt and the amount of capital flooding the market, led to a record number of mergers and acquisitions in 2006. Thomson Financial reports a total of $3.79 trillion in M & A activity worldwide and 55 transactions valued at more than $10 billion each. Private equity firms were involved in five of the top 10 largest transactions in the U.S., including the planned sale of Equity Office Properties to Blackstone Group for a record-breaking $36 billion. With so much capital available and interest rates remaining relatively low, M & A should continue at this level into 2007 unless public market investors fight back.

Real Estate Research Corp. expects the M & A activity for control of commercial real estate assets to continue between the public and the private real estate markets. As you may recall, during the commercial real estate depression of the 1990s, just a little more than 10 years ago, there was a liquidity crisis with no debt or equity capital to be found, so big real estate companies sought relief in the public capital markets for debt and equity. As a result, most large private real estate holdings went public and formed real estate investment trusts to access capital.

Today, because of the deluge of domestic and global capital across all spectrums--and the inability of public companies to be hamstrung by the use of lower leverage and very watchful shareholders and regulators--private capital sources with huge pocketbooks are buying public companies and REITs. This scenario is especially true for investors who are willing to pay more for commercial real estate assets than the public REIT market is willing to price shares. Even Sam Zell is selling because of these capital market realities. The National Association of Real Estate Investment Trusts reports that REITs were involved in deals worth $117.8 billion in 2006, nearly four times as much as in the previous two years combined.

This backdrop brings a luster to private commercial real estate that hasn't existed in some time. In fact, 2006 may well have been the strongest year for real estate pricing in several decades. The question is, will this cycle of cheap money continue in 2007? Will real estate retain its attractiveness? Is the private market "right," and for how long?

RERC suggests that the private market is right--at least for the next few quarters and probably for a few years. Despite the risks--and there are risks, as with any investment--expect interest rates to remain low and capital/credit to be readily available. Employment should remain relatively strong, energy prices should remain reasonable and the residential real estate market should stabilize. …