Is There a New Paradigm for Real Estate Investment?

By Boyd Stofer, President/Chief Executive Officer, United Properties

Commercial real estate pricing has soared in recent years, leaving some to refer to a “paradigm shift” in real estate asset valuation. Investors have plowed capital into the market in unprecedented fashion, resulting in the hottest property sale market in history. Many observers believe we are far from satisfying the seemingly insatiable demand for income-producing property and that a complete market change is at hand.

Cap rates have declined to unheard-of lows for nearly every type of commercial property, falling another 100-150 basis points in the past 12-18 months. Twin Cities retail centers that sold for (already low) 8% cap rates two years ago are now trading below 6.5%. One major apartment complex in the Twin Cities is trading for a cap rate around 5%. Several significant office properties have traded at cap rates well below 8%, with multiple bidders for every property. And bulk warehouse, if you can find it, can trade for cap rates as low as 6%.

Calling into Account Basic Fundamentals
Recent experience is enough to make some question the basic techniques for valuing commercial real estate. Along with the optimistic underwriting assumptions made by investors, rental rates, absorption, tenant retention, and capital costs will need to pan out simultaneously to meet cap rate expectations. Many investors are purchasing properties assuming that residual (back-end) cap rates will remain at current levels—implying that today’s circumstances will persist indefinitely. Do these investors really believe this, or are they making whatever assumptions are necessary to place capital in this investment class?

At the core of this debate are different views on what the risk-adjusted spread should be for ownership of real estate versus a “risk free” investment. Buyers historically have demanded 300-400 basis points above a 10-year Treasury note for real estate. Today, the spread is more like 100 to 150 basis points. This remarkable pricing places real estate more in the class of a bond than an equity, a status that defies historical risk-adjusted pricing for real estate.

The argument in favor of a paradigm shift is supported by the supply of capital from multiple sources—all looking for decent real estate deals. If this capital supply is permanent, then perhaps investors will simply forever accept lower yields for investments with greater risk. Institutional investors have dramatically increased their allocations to real estate, and the persistent low interest rates remain attractive for private investors. But is there any sense to cap rates that are lower than the debt service constant or to investors paying prices that exceed replacement cost?

Higher Construction Costs May Constrain New Development
The cost of new development is likely to be much higher in years to come, which supports the current buying activity and high prices. This is particularly true in the Twin Cities where soaring land and construction costs may boost the price of new office and industrial development by 25% over costs in the previous development phase (1995-2001). These higher costs may retard new development activity, thereby allowing owners of existing properties to increase rental rates as vacancy levels slowly decline. Today’s investors have already forecasted such rental increases to get to the value for recent deals.

Will cap rates for real estate stay low indefinitely due to ongoing investor demand and scarcity of good deals? Is this a “paradigm shift” or simply another cycle that will be followed by traditional cap rate spreads over the long term?

The Future is Somewhere in Between
Investor expectations for all asset classes have declined during the past several years. Capital will always seek the best risk-adjusted yields and perhaps also diversification. Real estate has become a mainstream investment class rather than an “alternative.” Although I believe it is foolish to use residual cap rates nearing the current historical lows, it’s possible cap rates have permanently declined by as much as 100 basis points. Land scarcity and rising prices will positively affect rental rates. This combination will likely result in average cap rates of 9% for office (traditionally 10%), 8% for industrial (9%), and 8% for retail (9%). Well-located apartments will still command the lowest cap rates, averaging approximately 7%. Real estate is inherently cyclical due to basic supply/demand characteristics, and accordingly, cap rates will always fluctuate.

All this focus on cap rates, capital flows and investor underwriting leaves me a little cold. I suppose we could debate forever such notions, but the future of space demand will impact all investors. In other words, net job growth and demographic trends that impact space absorption will undoubtedly have greater effect on investors’ future success than the direction of cap rates.