Wall Street Bears Propel Real Estate Bullishness

In a cross section of metro areas, office building sales are tracking 36% ahead of last year's volume. This is unprecedented in the last five real estate cycles. There are several reasons for this pattern-shift:

Since 1996, institutions in general have been reallocating assets to a higher fraction of real estate. In part this has been driven by superior performance of portfolio real estate and in part by reallocation within real estate to apartment assets, which in turn have out-performed office and industrial assets. As corporate memory of 1989 faded, managers were increasingly willing to invest in real estate.

Interest rates have been at record low levels since the mid-1990s, so bond yields have been low. Portfolio balance has suggested a reduced allocation to bonds. Real estate has benefited in two ways: First, with lower borrowing rates, project yields are up. Second, institutional funds otherwise earmarked for bonds have been diverted to real estate, where yields have been substantially higher.

Until 1999, the stock market was the darling of institutional investors. They made so much money in the market that allocations got distorted--too much in equities. Up to that point, institutions were buying real estate deals to help keep portfolios in balance. Since 1999, and especially acute so far in 2002, institutions have decided to buy real estate as a shelter from the down stock market. Surprising to most of us is that this occurred in spite of a decline in property performance that began in late 2000. It is this phenomena that broke from the traditional pattern of prior cycles.

Even more surprising has been the pricing of deals so far this year. Prices are holding up in many markets nationwide--also a break from the traditional pattern. Why?

A declining stock market has meant a flight of capital from Wall Street to real estate, putting upward pressure on commercial real estate prices. This in turn has eased cap rates since more investors are willing to take lower returns to be in the market.

Lower interest rates have meant prices can hold up while cap rates ease. More post-debt return is available to investors, thanks to reduced borrowing costs. Borrowing has meant real leverage in this cycle in contrast to the last cycle. Lower interest rates in the yield formula have meant reduced cap rates.

This is a surprise at this point in the real estate cycle, especially in light of rising operating costs due to a rise in insurance premiums and marketing costs.

So what's the outlook? We believe we are into a sustained period of declining cap rates. This in turn will help commercial real estate prices hold up even in the face of rising operating costs and declining income performance. If the production of new product remains at current low levels for another two years, prices will hold relatively stable through 2003 and then begin to move up again in 2004 and beyond.

Steven Pumper is president of Owner Advisory Services for Transwestern Commercial Services. Gregory Leisch is founder and chief executive of Delta Associates, the Alexandria, VA-based national research affiliate of TCS.