Real Estate Capital Flows

Just when it seemed that the commercial real estate industry was overflowing with capital, there appears to be even more money entering the investment arena seeking increasingly conservative returns in what is viewed as a safe asset class. When measured against other investment alternatives, real estate continues to outperform its counterparts and has done so for quite some time, especially when analyzing historical returns over a five-, 10- and 20-year period.

The additional investment capital is coming from several areas, but one specific sector that has a significant impact on our industry and appears to be very bullish on real estate is the pension fund sector. We are seeing a number of trends occurring from this important industry segment. One is that pension funds that have consistently invested in real estate are increasing their allocations and using increased leverage. Funds that have not used leverage in the past are now beginning to place 20% to 25% leverage on their acquisitions. Similarly other funds appear to be moving up the leverage spectrum as well, and those that placed 20% to 25% are now placing 50%, If before it was 50%, now it's 70%. And if before it was 70%, now it's 80% with the utilization of mezzanine financing. In addition, several pension funds that have elected not to participate in the real estate area within their portfolio are now beginning to create allocations for real estate.

All of these trends create additional downward pressure on return expectations for all categories of fund dynamics including core, core-plus, value-added and opportunistic due to the increased capital flowing to our industry. The question is, are we experiencing a paradigm shift to a more fluid, transparent market that will experience lower risk-adjusted return rates similar to return expectations experienced by investors in Europe . Or is it just a short-term phenomenon that will likely revert back to historical rates of return for the domestic commercial real estate market. Many believe we are experiencing a paradigm shift.

The combination of lack of deal flow and the pursuit of above-market returns are creating a variety of interesting strategies within the investment community. Many institutions are focused on niche development programs using in-fill locations for mixed-use and residential product, as well as designing select programs for industrial development in the five to 10 major industrial markets. Additional strategies gaining momentum include institutional investors partnering with real estate investment trusts similar to what we have seen occur recently with JP Morgan and Crescent. I fully expect this trend to increase over the next two to three years. Institutional investors are also seeking operating partners locally, regionally or nationally to increase deal flow within certain product segments. Unlike the REIT partnerships, usually operating partners are required to have significantly less equity in the joint venture, as long as it is meaningful and creates an alignment of interests between the two parties.

The increasing flow of capital to our industry has also created some interesting strategies with regard to holding periods. We had become accustomed to working with our institutional clients who were targeting three-to-five year holding periods for their core-plus and value-added portfolios. Now however, we have seen an increasing willingness on the part of these institutions to accept historically aggressive pricing and accelerate their investment cycle by selling assets that they have held for as little as 12 to 24 months. One note is that in these situations the pricing has to be extremely compelling due to the difficulty in redeploying capital back into the market in an acceptable manner to achieve targeted rates of return.

It appears that cap rates may finally see modest upward pressure due to the impact of higher interest rates in 2005. However, pricing should hold up as the overall fundamentals of the market enhance performance.

In all, 2005 should provide a great deal of additional capital to the real estate industry and as a result it will continue to fuel investment sales activity at a very high level.