Wednesday, April 22, 2009

Capital Bribery

Posted by: Scott Beggs
Investment Specialist
775 336 4644

Scott joined NAI Alliance in March 2008 to assist the company with investment sales. Previously, Beggs spent over seven years with Dermody Properties as Vice President of Acquisitions and Port Management.

NAI Global recently offered a webinar to their affiliate offices featuring a presentation by Dr. Peter Linneman, one of the leading real estate economists in the nation. During that presentation, Dr. Linneman described the current investment situation in which investors must be “bribed” into moving out of cash and into higher returning investments. The “bribe” comes in the form of a huge required risk premium on any non-cash investment opportunity. Basically, those entities with capital available for investment are choosing between two extreme investment alternatives: (1) a 0% real-return from cash equivalent investments, or (2) a requirement of 25%+ unleveraged returns over a three to five year holding period on equity investments in commercial real estate (regardless of the asset’s risk profile, which is highly problematic in my mind).

If an investment is not priced at a level that offers an investor these types of returns, those investors are staying away in droves. Investors justify this stance by pointing to all of the uncertainties inherent in commercial real estate at this point in the cycle. The most obvious risk being continued weakness in tenant demand which could lead to prolonged vacancies and/or deterioration in market rental rates. My first response to this view is that high-quality real estate investors should be able to underwrite and more importantly mitigate the risks of reduced demand in the space markets and should be able to weed-out those assets that possess undue demand risks. Secondly, this view suggests that the investor has a negative view of the resilience of the U.S. economy and a short-term perspective on investing. In that sense, these investors should maintain their cash positions because their view of real estate is too clouded by the anomalies of the last 4 years.

Another commonly noted risk of real estate investment is the fear of continued deterioration in the capital markets resulting in a prolonged (or worse, permanent) increase in cap rates. As for the risk of prolonged softness in the capital markets, those investors would seem to poses a fairly myopic perception of the long-term value of commercial real estate. (my·o·pic \ mi-ō-pik \ adjective: “a lack of foresight or discernment : a narrow view of something.”) At some point, the supply/demand fundamentals for commercial will moderate and eventually improve. Capital markets will begin to stabilize and the required risk premium on commercial real estate will decline. At that point competition amongst investors will grow and downward pressure on cap rates will build. And some investors will still have “dry powder” but they will have missed the opportunity created by this upheaval.

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