Getting Real about Investment Real Estate
by Richard
It’s high time we took a look at one of the other asset classes, while global equities continue their stomach churning whipsawing. Like legislation and sausage, its not pretty watching the market as it is in the process of re-pricing and wringing out its worst excesses.
Best to recall the wisdom of the oracle of Omaha, Warren Buffet, who correctly defined the market as a voting machine in the short run, but a weighing machine in the long run. Yes, the market is driven short term by fear and greed, but long term, it prices out fairly.
The other asset classes are Cash, Fixed Income, Commodities, Private Equity (i.e. your own business or profession), and both residential and investment real estate. The most accurate pricing on residential real estate is found on the auction market now, with homes clearing at prices nearly half off from the recent market peak.
The national listing inventory continues to grow, as individual sellers are reluctant to realize the full extent of price erosion. If you want to benefit from the new market pricing, check out auctions of unsold new housing from builder/developers, who have a much greater appreciation of reality than private sellers.
My focus today is on investment real estate: retail, office, industrial and apartments. Existing properties that will generate positive cash flow with the traditional 25% cash down payment.
Cap Rates Are Declining
I just looked over the 2007 year in review data from Real Capital Analytics, a firm that provides data to the commercial real estate industry, and what was most obvious was the steady decline in Cap Rates from 2002 through 2007. In all four categories, cap rates declined from at or near 10% in 2002 to the 6.0-6.5 range in 2007.
Quick Definition: Cap rates are the inverse of price-earnings ratios used to compare stock valuations. It is the net operating income of a property divided by it selling price. As a crude measure, think of it as a property’s “yield” assuming no debt on the property. If the “yield” (i.e. cap rate) is going down, the property is producing less income as a percentage of its selling price. In plain english, the lower the cap rate the more expensive the property, and vice versa.
This trend will not continue. The market peak was early 2007 when Sam Zell (aka “the gravedancer” for his ability to buy properties at market bottoms) sold his real estate empire to Blackstone, the hedge fund de jour. Blackstone promptly put into play the “greater fool” theory, that no matter how much you overpay, there is always some greater fool who will pay even more. The designee for that title is the prominent real estate family that bought and overpaid for seven Manhattan highrises that Blackstone immediately flipped after they bought and overpaid from Zell.
And now here they are, one year later, handing the keys over to the banks in lieu of foreclosure.
Reality Check
You will not hear this story from your friendly real estate broker. They always deal with the data in front of them, and that data says that cap rates are currently rising, but only a half point or so from the market bottom reached last year. Brokers need to earn commissions. Sellers want to sell at prices that no longer exist. Your job as a buyer is to ignore the pressure from both of them.
The onslaught of carnage from the excesses in the credit markets has spread and compounded into credit card loans, auto loans, home equity loans, junk bonds, leveraged bank loans….you name it. It begs credulity to think that commercial real estate is immune from this contagion.
Just as individual home owners must adjust to market reality, to have any hope of selling in this market, the owners and brokers of commercial/investment/income properties must do likewise.
Opportunities for Buyers
So what can potential buyers do to take advantage of this asset re-pricing? First, get your house in order. Raise a cash hoard, and make sure your credit is impeccable. There is a darwinian selection process now underway, whereby lenders are winnowing out the weak borrowers. Make sure you are not one of them.
Then, start scouting the auction market, where the re-pricing will first become evident. Your goal is to buy a good property from a motivated and/or distressed owner, not a distressed property being bled dry by weak ownership.
Much more on this topic in future postings. For now, keep your powder dry and your eyes wide open for what is inevitably coming down the pike. We last saw a buyer’s market like this after the Savings and Loan Crisis in the late eighties and early nineties. Extreme market reversals such as these are like waiting for the mini-skirt to come back in fashion. Not likely, but worth the long wait.
