Values: Has Market Peaked?
By Tom Wooten
Frederick Ross Company
The news over the last year has been full of stories about the increasing levels of capital flowing into the real estate market. These capital flows have contributed to extraordinarily low cap rates on stabilized properties, creating tremendous real estate value for some astute (and lucky) investors. For those looking to buy income property, these cap rates (and corresponding values) are generating significant heartburn. Brokers, as always, are stuck in the middle trying to keep "market priced" deals together when even the slightest hiccup can cause deals to blow up. At these valuation levels, there is little room for error.
Will it last? When will the music stop? Are we near the end? Are these cap rates here to stay? What should we buy? What should we sell? Is it a bubble or a new baseline?
Bubble or Baseline?
This question, and numerous variations, is being whispered by many real estate investors and service providers across the country. When we begin hearing signs of "peaking", another mega-deal gets announced to drive investor return expectations to even new lows. The announcement last year of Blackstone's offer to purchase Equity Office Properties was just such an occurrence. Not coincidently, Blackstone's announcement is coming at a time when institutional investors are increasing their real estate allocation within their portfolios.
Institutional investors (pension funds, insurance companies, etc.) have always been significant participants in ownership of significant real property assets. Their allocations tend to fluctuate over time, in response to return trends on various asset classes. Because real estate has provided outsized returns over the last five years (as cap rates have fallen) when compared to many asset classes, institutional investors have responded with increased real estate allocations. The net effect of these changes, as the asset base of the various institutional investors continues to grow, is that more money is chasing income property. On a continued basis, this pressure helps keep cap rates low. With regard to institutional investors, we can surmise the following:
- Institutional appetite for stabilized income properties will continue at or above current levels
- Investors will chase yield into higher risk property investments, compressing the risk premium significantly below historic levels
- Investors will be drawn to new development opportunities in their effort to find yield, compressing the equity risk premium typically demanded in new development.
While private equity is not new to real estate investing, a private equity purchase of a stabilized income portfolio certainly raises some eyebrows. Little public justification has been provided, or will likely be forthcoming, from Blackstone on their purchase. Such is the nature of "private" equity. We can, however, make the following prognostications:
- Blackstone is not likely to be a long-term holder of the bulk of the EOP Portfolio
- Their purchase will unlock significant opportunities for institutional investment of individual EOP properties (in other words, they will be a seller)
- With the pressure on Blackstone and other private equity firms to deliver financial returns, this purchase provides immediate income and depreciation benefit (tax shelter) while also providing some capital appreciation potential. As a consequence, it relieves some pressure on return requirements from other equity investments.
- Other REITS will become targets of private equity, both to unlock potential value through individual sales as well as providing immediate income with some long- term capital appreciation.
- Private equity will get cozy with institutional investors, as a prime conduit for selling individual properties acquired through bulk REIT purchase
What do these tremendous capital flows and liquidity mean for smaller properties and private real estate investors?
- Bargains will continue to be tough to find
- 1031 buyers will continue under-pricing risk in trade properties, in an effort to avoid paying capital gains taxes
- Land prices for parcels that justify immediate development will increase
- Speculative land (without near-term market development potential) will struggle
- Equity partners will continue looking for operating partners, with some compression on return requirements because of the demand from other equity sources
For institutional investors and smaller individual investors, caution is prudent. Current income property valuations are high, and leave little room for error. While office and apartment vacancy rates have been declining significantly over the last few years, investors need to be reminded about the inherent illiquidity of the real estate market combined with a market that, by definition, is cyclical. This is not to warn of an impending "bubble", but instead growing awareness to the foundation on which the new baseline is being constructed. Is the baseline sustainable? Stay tuned to economic conditions, and we'll revisit that question this time next year.