Is There a New Bubble?

While the volume of distressed property and loan sales continues to disappoint many potential buyers and the "new normal" market-pricing level continues to evade easy analysis, one surprising market trend is the re-emergence of some high-price/ low-capitalization rate transactions. Many commentators have noted that certain high-profile transactions have attracted multiple bidders and closed at prices that were higher than expected. This anomaly has several causes and a few caveats.

Let's start with the caveats. First of all, there have been very few such transactions. Also, many of the transactions are not exactly typical. Although the prices may have been higher than expected, most are well below the high-water marks set at the top of the bubble two or three years ago.

Trophy office buildings filled with creditworthy tenants, located in cities with high barriers to entry, are cited as examples of the new enthusiasm.

The buyers include a REIT, private equity firms, an insurance company and a pension fund. While the sticker prices are high, ranging from a quarter of a million to almost a billion dollars each, the prices per square foot do not begin to reach the stratospheric levels that existed from 2006 to 2008. The buyers are interested primarily in reliable long-term income with the chance for a meaningful increase in price over the medium term.

What motivates buyers like these to bid up the prices for trophy properties? In a market where safe investments carry returns in the 1%-to-2% range, the 5% or 6% return offered by a well tenanted, high-profile office building is more attractive than it would have been in a high-interest rate environment. REITs, in general, have fared well in the past 12 to 18 months, gaining new equity investors and refinancing existing debt or acquiring new debt at advantageous rates. So they are well-positioned to make new investments. REITs have traditionally been more of an income oriented investment than a growth play, although some investors may have lost sight of that when prices were skyrocketing. Similarly, many insurance companies and pension funds are looking to allocate investments among various asset classes and, after sitting out for a year or two, they are back with funds and an appetite for moderate, reliable rates of return.

Private equity investors, in some cases, are sitting on large amounts of cash and are facing a use-it-or-lose-it situation that may spur investments before they can redeem their pledges. Unlike REITs and insurance companies, the rates of return from trophy investments are, by historic standards, not attractive to private equity investors. However, when distressed assets are difficult to acquire, some return is arguably better than no return at all.

But how does one define trophy properties? Some investors claim that any building constructed in the CBD of any large city in the past 20 years qualifies. Attributes of trophy properties include location in gateway cities such as New York; Washington, DC; Boston; and San Francisco, and strong creditworthy tenants whose leases are at market and do not expire in the near, or even medium, term.

Where does the risk lie in this potential new bubble? In a word: leverage. Buyers who transact using all cash or low-leverage ratios are oft en protected against possible downturns in the market. However, lenders offering 50% LTV loans at the beginning of 2010 appear to be increasing their appetite for risk and may soon be back to the traditional 75% level. The new bubble is not yet fully developed, but it is growing as we speak. If this phenomenon leads to euphoric price levels before real estate fundamentals recover, the inevitable bust will follow quickly.

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