Market Conditions Require Investors to Adjust Return Expectations

DALLAS-Investors of all sizes will need an attitude adjustment if they plan to continue as players in the real-life game of Monopoly. Double-digit returns and high cap rates aren't on the horizon, according to one of the top research minds in the business.

"Your job as researchers is to help people get to the right expectations," says Raymond G. Torto, principal and chief strategist for Boston-based Torto Wheaton Research. Core properties, across the board, will continue with single-digit returns in all major metros, he told 70 members of the DFW Real Estate Research Forum at yesterday's luncheon at Maggiano's Little Italy in North Dallas. "Get accustomed to that," he says.

Torto's presentation wasn't all gloom and doom, but it did put pricing into perspective. Fundamentals are improving, as is the economy, but the upticks are and will continue to be "moderate," he says. "It seems to me that the market is pricing real estate for the rebound." But not all areas, Dallas included, are on the comeback trail like the West Coast and select metros in the South, he adds.

When all the formulas are run, Torto says real estate will continue to go up in price, but the exchanges will be saddled with low cap rates. Nonetheless, he says, "the flood of capital is there. It's going to stay there, but at what price."

If there's any red flag on the horizon, Torto says it's inflation although the bond market indicates otherwise. "Our view is we have to worry about inflation," he says, predicting the 10-year Treasury will hit about 6% by the 2007 start.

Based on conditions today, the firm's research team is forecasting 10-year total returns of 5.4% for industrial property owners; 6.4%, multifamily; 6.9%, retail; 7.8%, office; and 12.1%, hotel. "That's if you buy today," Torto says, pointing to a chart that "sort of says we're in the year of disappointment if we look at 2006."

Cap rates will rise with interest rates, but it also comes with a built-in dilemma. Torto says cap rates have gone up slightly in the past four quarters after falling for five years. "I don't think lower interest rates are good for real estate," he says. "It will lead to overbuilding like we saw in the late 1980s. But, we're on this precipice when we could go into a situation where a lot of people will decide to build."

Torto says the industry's prospects are good as long as investors understand that returns will be low. "Things can move forward with a reasonable set of expectations as long as there's no random event," he concludes.