December 8, 2009
The following is the sixth in a series of newsletters designed to foster a healthy dialog. I hope you enjoy it and encourage your feedback and discussion.
Take a look on http://www.caswell.org for prior articles, access to resources and information on what I can do for you. If you know someone who would benefit from this piece, feel free to forward it.
Please let me know your thoughts on this piece and other subjects you would like explored.
Ward S Caswell
Who Controls Pricing?
The stock market is up, unemployment is down and shopping baskets are filling up for the holidays. We are experiencing signs of a tepid recovery as confidence slowly returns. With the prospect of a long, slow improvement in the economy, investors are looking for opportunities to profit. In this environment, it is critical to place your bets with a clear strategy. Leading indicators for different asset classes provide mixed signals, clouding decision-making. The movements of the stock market are fluid and somewhat unpredictable as it reacts instantly to news, statistics, and perception. It can be a gut wrenching experience for anyone with a vested interest in performance. Commercial real estate (CRE) however is much slower moving, with fewer visible indicators, and yet, it is far more predictable. In this edition we will explore the major forces that influence commercial real estate pricing, helping you make more informed investment decisions.
If you had a crystal ball that allowed you to predict the stock market, you could get rich quickly. The degree to which you could accumulate wealth would depend upon the accuracy and level of detail of your predictions. You could place bets as aggressively as possible, tempered by your faith in the reliability of the forecast. The problem with crystal balls in the stock market is that they only work for a short time. If your crystal ball provides longer-term trends, then the marketplace has time to observe your tactics and react, thus canceling out your strategy through adjustments in pricing. The stock markets are efficient and eliminate the creation of money machines. If you find a winning pattern, the market adjusts to cancel it.
To profit from a forecast you need an inefficient market.
Is it time to get back in the water? With depressed pricing and so many distressed properties there are many emerging opportunity funds. Starting a successful fund requires careful preparation. Acquisition targeting strategies, diversification guidelines, and expected returns all require a careful blend of data, opinion, and above all, a detailed understanding of risk. The timing for raising investment capital is important. If you have the cash in hand too early, you risk making purchases prematurely, as values for commercial properties are still falling. It is difficult to raise additional capital when your initial fund returns are negative! At the same time, waiting for the market to clearly turn may be too late as the best opportunities for large positive returns come from buying at, or at least near, the bottom. Once the market has clearly turned, those low-price buying opportunities will dry up quickly. The time to buy into the market is in the next twelve months at the confluence of distress, cap rate decompression, income decline, and bank deleveraging. When any of these forces flatten or turn, price declines will slow. When two or three of these issues turn, prices will begin to rise.
What are the main influences of CRE pricing? The March Newsletter discussed a few of these including the impact of declining rent and occupancy rates. A study of historic commercial real estate pricing shows that cap rates have a greater impact on pricing than rents and occupancies [see sidebar "What's a cap rate"]. So what moves cap rates? It is commonly believed that cap rates vary with the ten-year U.S. Treasury Note. The relative ease of buying and selling U.S. Treasuries compared with that of real estate mean that real estate is required to offer a higher rate of return to the investor to compensate for the lack of liquidity. The difference between cap rates and Treasury yields can be referred to as the spread. Over time, the spread can expand or contract due to different factors. The largest effect on the spread is the volume of real estate sales transactions. In high transaction periods such as that from 2004 through 2007, investors were more able to find a buyer at a reasonable price in a short time, thus the premium investors required from real estate compared to Treasuries was reduced, and cap rate spreads were compressed. Current conditions make it very difficult for a property owner to sell quickly at a reasonable price, thus the risk premium for real estate is high, and the spread is large. Luckily for current owners, Treasury rates are now low, so even with the large spread, the cap rates are within historical boundaries.