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GRAND RAPIDS, MI-Real estate capital flows as yet have shown no signs of abatement and have already broken record annual levels. Given the competition, both debt and equity capital have become inceasingly aggressive, supporting further cap rate compression and lowering yields. Eventually, this likely will lead to a moderation of capital flows to real estate, which will be positive for real estate over the long term but will be limiting in the short term.

That is the present and future real estate, according to “Expectations & Market Realties in Real Estate 2006,” a new 113-page report by Principal Real Estate Investors, Real Estate Research Corporation, and Torto Wheaton Research. GlobeSt.com was given an early look at the report online; the hardcopy will be out later this month.

As of the end of September, real estate capital flow has already broken record annual levels of sales transactions and CMBS issuance levels, according to the report, which is compressing capitalization rates. As a result, investment strategies have broadened, but debt and equity real estate capital markets also have become increasingly aggressive, resulting in high prices relative to reproduction costs, a proliferation of interest-only loans, and increasing financial leverage. The aggregate outstanding balance of US commercial mortgage debt has doubled over the past 7 years, according to the report.

The cap rate compression is eating away at the real estate’s historical yield advantage over other asset classes, according to the report. “Eventually, this will lead to a slight moderation of capital flows as momentum-driven and tactical investors rotate away from real estate,” states the report. “However, such forces of moderation will be positive for real estate over the long term, as they will tend to even out excess capital flows.

As a result, the report predicts that future real estate investment performance is unlikely to be facilitated by further cap rate compression; rather, real estate upside will be largely limited to investor success in increasing property NOI, “which ties back to the health of space market fundamentals, the sustainability of increases in landlord pricing power, and effective downside risk identification and management.”

Given numerous institutional and retail investor segments that are underinvested in real estate relative to investment targets, the report’s predicts that high levels of sales transactions will continue well into 2006, which could serve as an underpinning for real estate valuation and price level stability.

“However, a key issue is whether new supply will remain in check until space market fundamentals improve further,” states the report. “Current new construction levels are reasonably low, but there has been a rapid build-up of new supply in the planning stages, as investors have allocated more capital to higher-risk strategies.”

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