Real Rates of Return: Does Real Estate Make Sense?
Ryan, James P., Real Estate Issues
During the early to mid-1980s real estate values increased dramatically due to the influx of capital from individual investors, syndicators, pension fund managers and foreign investors. The plethora of transactions during this period provided sufficient data for market analysts and appraisers to abstract capitalization and yield rates. As markets changed over the last several years, the number of transactions has decreased markedly. The oversupply of space, particularly in office buildings, coupled with the overall decline in the economy caused many investors to withdraw from the equity market.
Declines in value also have reduced the underlying security of many loans, restricting banks and other institutional lenders from making new mortgages. In fact over the last two years the value of office buildings in some pension fund portfolios has declined 50% or more. Negative appreciation, as shown in the FRC/NCREIF index since the fourth quarter of 1989, and concern about the economy also have kept buyers on the sidelines.
As values have eroded and returns declined, many investors have withdrawn totally from the real estate market. Low returns and business reasons, such as retiree benefits payouts, have prompted some plan sponsors to redeem their shares in funds, placing additional burdens on liquidity. Although investment managers recognize that it is not prudent to sell in a down market, some must sell to meet withdrawal requests from clients. Investor uncertainty and tight credit policies by lenders have created a void of meaningful data in the market to demonstrate market pricing. The limited data that is available is subject to various influences and pressures and requires significant adjustments by analysts. This article focuses on alternative sources of comparable yield data to support the valuation of real estate.
A structural shift has taken place in the real estate industry. The days of independent entrepreneurs or developers buying or building a project, and their institutional partners supplying most (if not all) of the capital, with little or no control, are gone. Today, pension funds, real estate investment trusts (REITs), foreign investors and other institutional players seek real estate investments with defined objectives and meaningful participation in mind. They are conscious of the risk/reward relationship and expect more direct involvement in the decision-making process. Many institutions have increased their real estate portfolios (in some cases by default of partnerships, foreclosure or other involuntary processes) and can draw upon property level experience to enhance future returns and make informed decisions. The expanded exposure to real estate, particularly within financial institutions and/ or publicly traded companies, has heightened the relevance of performance to an organization.
Today's more powerful computer technology and networked databases also have made data more readily available. Investors no longer simply compare one real estate deal against another or look at the most recent sales in a market to make an acquisition decision; they consider alternative (non-real estate) investments and weigh the risks of a property against them. Far more scrutiny is applied to tenant underwriting and the timing of lease expirations than in the past. Property analysts must examine the industries of major tenants and judge their potential.
The dramatic changes in the world over the last two years and their impact on the U.S. economy have forced investors to delve deeper into the strength of tenant income streams. A few years ago tenants like Wang Computers, Eastern Airlines, Security Pacific, Drexel Burnham, Integrated Resources, etc., were considered to be desirable lessees. Within a relatively short period of time these and other similar companies filed bankruptcy or merged with other companies, potentially reducing their worth to a property. Now the heavy focus on the quality of cash flows requires discounts for weak tenants and more tenant/business analysis during the underwriting process. …