Mature and Yet Imperfect: Real Estate Capital Market Arbitrage

Article excerpt

Executive Summary. The familiar boom-and-bust pattern of the real estate market has been tempered recently by an increased amount of discipline administered by the capital markets, and by the debt markets in particular. Additionally, due to the emergence of the public REIT and CMBS markets in the 1990s, and the accompanying proliferation of data concerning not only property market conditions but also capital flows and broader industry trends, the industry's ability to detect property and capital market imbalances has greatly improved. While this is generally a positive for the industry, this informational efficiency has created an environment in which it has become increasingly difficult for real estate investors to obtain excess returns.

However, while real estate capital markets are much more competitive than they were a decade ago, they are still exceptionally fragmented due to the unique supply and demand characteristics of real estate properties, markets and real estate-related securities. This fragmentation or "market segmentation" leads to inefficiencies than can be exploited by investors desiring excess returns.

In this article, we examine the overall characteristics and trends of the real estate capital markets that have led to increases in efficiency. Subsequently, we explore the inefficiencies and segmentations that still remain in the market, and demonstrate how a general real estate investment strategy can be enhanced by capitalizing on opportunities to arbitrage valuation discontinuities and inefficiencies between and within these segments.

Commercial Real Estate Market-- Developed Yet Imperfect

In the United States, the commercial real estate market represents the third largest asset class, totaling roughly $4.5 trillion in size (Exhibit 1). This large and relatively mature market is unique in that it shares characteristics that are consistent with both competitive and non-competitive market structures. For example, the market structure is efficient in that there are a substantial number of both buyers and sellers and there are established means of conveying real estate interests with sufficient legal precedents in place to minimize potential transaction risks. Moreover, structural changes over the past decade, such as the dramatic increase in public market penetration (Exhibit 2), combined with recent advances in information technology have considerably improved both the transparency and liquidity of the market.

Despite the improvements in transparency and efficiency, the commercial real estate market is still heavily segmented and, at times, surprisingly inefficient. The underlying value of most real estate properties is not only a function of their physical characteristics (i.e., the quality of the building or improvements), but also of other characteristics such as location and tenancy, making each real estate property unique or substantively unique. Furthermore, economic interests in real estate properties can take a variety of forms, including direct and indirect, private and public, and a spectrum of equity and debt securities linked to properties. The preferences of investors as well as the value they assign to the various interests in and facets of a given real property investment also vary considerably, and are affected by such factors as differing perceptions of risk and reward, preferences for appreciation or growth versus current cash flow, and sensitivity to taxes. The resulting market segmentation creates numerous opportunities for arbitrage, which can be exploited by investors in order to generate excess returns.

There are a variety of potential arbitrage strategies within the real estate investment universe. To simplify the discussion, three broad axes will be defined to describe the fundamental characteristics of real estate investments: (1) public/private; (2) debt/equity; and (3) taxable/tax-exempt (Exhibit 3). By moving properties or property-linked securities along these axes, investors can add substantial value to their investments, realizing "hidden" value through financial arbitrage. …