The Dawning of a New Era for Commercial Real Estate Investment. (Focus on Investment Conditions)

By Riggs, Kenneth, Jr. | Real Estate Issues, Fall-Winter 2002 | Go to article overview

The Dawning of a New Era for Commercial Real Estate Investment. (Focus on Investment Conditions)


Riggs, Kenneth, Jr., Real Estate Issues


The last 18 months have been arduous for even the most resilient among us. A recession, the September 11 terrorist attacks with continuing threats of terrorism, corporate accounting scandals and company bankruptcies, the tumbling stock market, and now the likelihood of military action with Iraq have taken their toll on our nation's psyche.

Most investors were hopeful that the economy would be back on a firm growth track by now but that is not the reality. Working off the excesses created during the tech bubble is taking more time than expected. Slow economic growth is killing demand for commercial real estate, and as a result, our outlook is more bearish now than it was just a few months ago.

Despite the slow growth, the U.S. economy has held up relatively well thus far, thanks to consumers and the aggressive low rates initiated by the Federal Reserve. Mid-term elections may be over, but there remains plenty of uncertainty ahead. The expectation is that 2003 will be the year that the business environment shows life beyond the tech run up, but we are not out of the woods yet. Commercial real estate markets will lag behind the economy by six to twelve months, which means that the space markets will not see improvement until 2004.

REAL ESTATE ATTRACTS INVESTMENT

With the debacles of Enron, Global Crossing, Adelphia, Tyco, and dozens of other company failures, the stock market gambling days are over for many investors--at least for the foreseeable future. Instead, investors have directed their investment dollars away from the volatility of the stock market and toward more stable and income-driven assets, like real estate.

However, until corporate earnings begin to increase and transparency and disclosure improve, expect disciplined asset allocations to public and private real estate investment trusts (REITs) and real estate limited partnerships (RELPs) to continue. Consistent cash flow and leveragability also make real estate attractive, but in the long run, demand from portfolios to invest in real estate will eventually help drive down returns.

Meanwhile, however, the low interest rate environment and low return expectations for investment alternatives have resulted in real estate returns becoming extremely attractive. As of this writing, 10-year government bonds are near 4.0% while expected real estate yields cling toward 11.4%, resulting in a yield spread of 7.4%--the widest gap ever witnessed in the 20-plus years that RERC has tracked this relationship. There are many theories as to why this spread is so wide today, but in the final analysis, the result is that real estate yield requirements are being lowered and compressed in the current economic and financial environment. Based on RERC's spread and competitive analysis, yields on solid assets that are properly underwritten should see total yields below 10%.

Buying right and adequately projecting cash flows and values have always been key to successful investing. Like other forms of investing, real estate investment comes down to the balance between risk and rewards. Hotels and office investment have historically offered strong upside potential, but also have been considered high-risk as vacancies can fluctuate greatly and eat away at the bottom line. …

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