Recent articles have suggested that a commercial/investment real estate recovery may be underway but, is that really the case or is it wishful thinking?

Much has been written about the potential value recovery of the rental apartment sector with that recovery tied to four things: 1. Increased demand from dispossessed, former homeowners. 2. The availability of relatively cheap financing. 3. The lack of new, competitive construction in the last three years. The increased demand is touted as the engine that will cause rents to rise causing yields to increase. 4. The perception that existing properties can be purchased at prices substantially below their replacement cost new. Cheap financing will obviously serve to increase yield and the lack of new product eliminates alternatives for the renter. Taken all together, these factors suggest that apartment investments may be warranted but, there are downside arguments. In the short term, everything could work out well. But, real estate, unlike shares of stock, is not highly liquid and the real profit doesn’t emerge until the property is sold. Overall changes are not instantaneous and timing is everything. It is easy to get caught in the euphoria of a rising market and miss the opportunity to exit before conditions turn negative.

On the negative side, not necessarily in any order of importance, are the following”
As soon as vacancies begin to disappear, with the consequent increase in rentals, the apartment developers will leave the “sidelines” and begin to build again to satisfy the demand perceived to exist. This new building cycle, will increase supply and bring about an eventual decline in effective rentals forced by increases competition.
There are millions of unsold homes hanging over the market at bargain prices by comparison to the past. As the economy recovers, the ability of former homeowners, who are now renters, to move back into ownership, will take place. And, the lenders holding the distressed housing inventory will be anxious to reduce their exposure and will be helpful in facilitating sales. This will reduce rental demand.
Unemployed people, despite their need for shelter and despite their numbers, will not add to any real demand for rental housing. So, until employment picks up materially, real demand for housing should not be expected to increase.

The ability to purchase at prices below replacement cost new is not necessarily a good economic justification for purchasing. If the property is not producing adequate net income or will not produce adequate net income in the immediately foreseeable future, to economically support the purchase price, then purchase may be a bad idea.

Most importantly, interest rates are being kept artificially low as a strategy for increasing economic growth. Once growth is clearly established interest rates will begin to increase and, if inflation becomes a danger, pressure to increase rates will accelerate. Thus, when it is time to exit an investment, the value may become depressed for no reason other than higher financing costs that will cause yields to drop.

In the office sector, in spite of arguments to the contrary, occupancies should not be expected to increase absent demand caused by a substantial improvement in the job market, particularly in the service sector. Increased blue collar employment does not translate directly into service job increases. The office market is location specific and, obviously, some markets are currently behaving much better than others but, isolated improvements in specific markets do not spell improvement in all markets. The fact is that the service sector in most markets is still depressed.

The retail property market remains in a danger zone and faces continued contraction as chains reduce their exposure by closing underperforming stores and as other large retailers like Office Depot, Circuit City, Mervyns etc encounter depressed sales. And, the impact of on-line purchasing is expanding and becoming a major competitive factor for all traditional retailers, many of whom have their own on-line sales programs. On-line merchants do not need expensive store space to survive. Catalog sales both via the mail and via the internet reduce sales available to the traditional merchant. All of these observations suggest that a recovery in the retail sector may be a long way off with demand and rents continuing to decline.

Reportedly, the hotel sector is beginning to recover but the recovery signals may be false signals. Highly discounted room rates are still available in most markets save at times when a major convention or conventions hit town. Resort properties are still experiencing difficulty and foreclosures are still worrisome. Business, and government, in particular, is still in a mode of cost cutting and most well run companies are carefully watching their travel and entertainment expenditures. The vast improvement in video-conferencing and computer cameras has provided the ability to have “face” meetings without leaving home. And, during the boom years, a substantial over-supply of hotel rooms and resort properties destabilized the market. On the other side of the equation, operating expenses and labor costs appear to have continued to escalate as ADR’s and occupancies declined. Any material improvement in hotel economics will probably have to wait for a very significant improvement in the job market and economy. Vacation travel away from home is very low on the list of spending priorities and probably at the bottom of discretionary spending items after dining out, local entertainment, gifts etc.

Real Estate for the vast majority of the public means a home or a condominium. And, that residential market is completely different, with a different set of dynamics, from the commercial market. The purchase of a home or condo is probably the last bastion of individual decision making, where the wrong decision has an immediate adverse impact on the purchaser. The commercial real estate market is no longer dominated by individual purchasers. Rather it is dominated by REITs, institutional investors, investment bankers and pension funds. The individual investor participates indirectly as a shareholder, pensioner, or investor in a pool. The investment decisions are made by money managers. Money managers usually do not have a substantial amount of their own money invested in any acquisition (no real skin in the game) and may be motivated by competitive pressures (a herd mentality) rather than sound economic analysis. In the current market environment, it has been relatively easy to raise substantial amounts of money to invest in “distressed” real estate at bargain prices. However, with the money raised the job of investing it places pressure on the manager. So far, the anticipation of abundant opportunities has not come to fruition as evidenced by a recent article suggesting that the money was beginning to look off shore for opportunities. The reason for a lack of product is two-fold. First, those with good assets and no debt problems are unwilling to sell in an adverse market even though their values have been eroded. Secondly, the institutions foreclosing properties will generally try to re-position the property before selling and are usually unwilling “fire sale” sellers.

Given the foregoing backdrop, it should be expected that money managers have a vested interest in creating the illusion of improving market conditions in order to justify their purchase activity and decisions. Also, with vast pools of newly raised money, the investors want “action” so, for the money manager, sitting on the sidelines patiently awaiting a really good opportunity, is not an option. All of this means that the investor should be skeptical of pronouncements indicating improvements and should focus on real signals of a market turn through vastly improved employment statistics as a main driver coupled with material increases in corporate earnings as the engines of economic growth. Programs like the home buyer tax credits artificially improved sales but did not serve to provide lasting stimulus despite the publication of statistics indicating improvement in the residential sector. Investors should be mindful that many major investment banks, REITs and institutional investors (managed money) made some very cataclysmically terrible judgment errors that ended up costing them billions. Thus, there should be no confidence that the same errors will not be repeated. It is predictable that under competitive pressure to invest, money managers will again get caught in market euphoria and over pay to be a player.

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