Real Estate Pricing-It's All Relative

Article excerpt

There has been no shortage of discussion lately among real estate investors about the "frothy" pricing of real estate in today's market, particularly in the context of deteriorating real estate market fundamentals in most sectors. This much talked about disconnect between market fundamentals and pricing is a direct consequence of real estate rightfully being tied to the broader capital markets. Capital flows to real estate, both equity and debt, have remained strong due to sustained investor demand that has been fueled as much by historically low interest rates as by the lack of appealing alternatives. These strong capital flows continue to underpin real estate values in today's market and, we believe, represent a rational response to the current investment environment (see Exhibit 1).

Also driving demand for real estate are the attributes that continue to make it a compelling investment in today's capital market environment: diversification with stocks and bonds; strong, consistent yield; downside protection; and the potential for appreciation in line with inflation. Real estate is the only asset class that can deliver these advantages simultaneously. Consequently, investors have increasingly come to recognize that real estate merits inclusion in the mixed-asset portfolio. In a recent Plan Sponsor Survey (Kingsley Associates, 2004), results indicated that $44 billion is targeted to flow into real estate in 2004, the highest amount in five years.

However, even as capital flows remain strong, current yield expectations are clearly lower than the yield expectations for similar investments over the past ten years. Weak real estate fundamentals have caused earnings growth declines and increased vacancy. Exhibit 2 illustrates the precipitous decline in rent and earnings that began in 2001 across all property types except retail. Furthermore, the expectation is for continuing weakness in earnings growth over the next few years. The combination of rising values and falling income has led to the sharp decline in cap rates (see Exhibit 1). These yield expectations, along with today's low cap rates amidst weak real estate fundamentals, have kept some investors on the sidelines believing that the sector is overpriced.

In light of the reduced income expectations, prices today would have to be lower to deliver future yields that would be comparable to the yields five year ago. As we see, this is clearly not the case as prices have risen despite the decline in income production from real estate. To fully understand today's pricing, consideration must be given to long-term historical returns, current risk premiums and investment alternatives.

Historical Performance

Exhibit 3 shows the weighted average (trailing) cap rate for the NCRIEF Index over the 1982-2004:Q2 period. Over this 24.5 year period, cap rates ranged from 6.2% to 8.9%, with an average rate of 7.7%. Over the first portion of this period, 1982-1993, the average cap rate was 7.1%. It increased to 8.3% over the second half of the overall period (1994-2004:Q2)-a time that included the overhang from the worst real estate depression in history. In addition to the weakened confidence in real estate investments during this latter time period, investors witnessed consecutive years of remarkable returns in the stock market. Thus, competition for investment dollars was particularly strong from equity investments, an environment which put upward pressure on required real estate returns. As of 2004:Q2, the overall NCREIF cap rate was 7.3%. Even as capital has flowed into the real estate market and cap rates have compressed, the current cap rate is within 40 basis points of its long-term average, a finding contrary to many investors' perception.

Risk Premium

To further put today's pricing into context, it is important to consider the measurement of risk premium. An analysis of the real estate cap rates and dividend yields1 relative to the underlying risk-free rate (e. …