Investors' Heyday Can't Last Forever, CREW Told

Although commercial real estate returns have outpaced the stock and bond markets over the last five years, the axiom of past performance being no indication of the future bears repeating, suggests Jones Lang LaSalle Investment Management managing director Jacques N. Gordon. According to his company's research, private real estate returned 11.8% annually over the last five years while publicly-held real estate posted a 12.7% rate over the last decade.

"I think we're not going to see those numbers again," Gordon says. "Double-digit returns are not what we can do. A lot of money is coming into real estate with unrealistic expectations. And that's my worry."

With his Equity Office Properties Trust able to secure $125 million on an Austin, TX office property at 5.1%, it is obvious to chief operating officer Richard Kincaid that financing is driving the market, with some buyers able to leverage themselves into expensive deals. However, he says the largest US office REIT plans on being a net seller this year to the tune of $600 million.

"I think it's incredibly risky," Kincaid says of the loftier purchases being closed. "Leverage doesn't create intrinsic value…I've never seen it like this."

While there may be a surplus of capital, the deals being chased tend to be concentrated in "two or three" select markets, Gordon observes. "It's almost like a funnel," he says of a herdlike mentality that has driven multifamily capitalization rates to as low as 6.25% in San Diego.

"Don't just look at what the crowd is saying," Gordon suggests. "There's plenty of great 8- and 9-cap properties out there that aren't being looked at."

According to Hyatt Classic Residences chief executive officer Penny Pritzker's math, buyers are able to acquire properties at capitalization rates in the neighborhood of 7%, and still receive yields around 8% on their 20% equity stakes as a result of the low interest rates.

"What you're doing is buying an option that when occupancy returns, current rents will go up," Pritzker adds. However, capitalization rates are likely to rise, making the value of a building's net operating income worth less to potential buyers, when interest rates rise, she notes. "You have a real exit risk."

Rising interest rates wouldn't bother Heitman Capital Management Corp. president and chief executive officer Mary Ludgin much. With current rates, she sees half-vacant buildings still generating cash flow, giving their owners little incentive to sell.

"I'm sorry to wish distress on anybody, but it creates buying opportunities," Ludgin says.

Kincaid's company's early growth was fueled by acquisition of distressed properties, and he thinks Equity Office Properties may be back in that mode in about 18 months, after interest rates rise. "You're going to see those cracks develop as the economy recovers," Kincaid says. "We're being very, very liquid."

Before exiting, property owners face new issues such as an insurance market that remains in turmoil following Sept. 11, 2001. Coverage for acts of terrorism—and policies have notable exclusions—has helped double and triple insurance premiums. "If you're a property owner, you can't pass that cost through," Pritzker says. "It's not going to go away."

Debra Cafaro, president and chief executive officer of health care REIT Ventas, Inc., says her company is faring well in the downturn. "People go to a nursing home, they go to a hospital, despite the economic environment," she says. However, federal and state budget cuts could result in "tremendous amount of pressure" for operators.