Since the technology market bubble burst in 2000, real estate has been one of our most secure and successful assets. But before we make new investments—and when we consider how to manage our existing exposures—we should take heed of the growing chorus of concern over the state of the market, and whether it can maintain its upward trajectory.

Home sales reached all-time highs in 2003, and the price of commercial real estate in many markets continues to catapult upward. Publicly traded real estate investment trust (REIT) stocks, which are backed by pools of real estate assets, enjoyed a compounded annual return of 38.5 percent last year, trouncing the S&P 500, while providing a comfortable level of liquidity. “Everybody has decided real estate is the investment vehicle of choice,” says Mark Godsey, director of the institutional REITs trading program at Connecticut-based financial services provider Advest.

But a growing number of analysts worry that this poster child for post-dotcom investing has, in fact, emerged as an obese adolescent. Certainly, sales and construction data suggest the real estate boom is still going strong. Driven by mortgage rates running at 40-year lows, demand for single-family homes has been on the rise for several years. According to the National Association of Realtors (NAR), a record 6.1 million homes sold last year, compared to 3.8 million a decade earlier. The average price of single-family homes has soared over the last 10 years, from $97,000 to $170,000, consistently outpacing inflation. The construction industry broke ground on 1.85 million new homes in 2003, up from 1.7 million in 2002.

“Currently, we are projecting that home sales this year will decline slightly, but they remain at exceptionally high levels,” says David Lereah, chief economist for NAR. “With a strong demand for housing from a growing population, and in a recovering economy, we could be flirting with another record this year.”

House Poor
But as investors who suffered through the 1988 to 1993 real estate downturn can attest, this is not a market without its risks. Indeed, the fundamentals of the real estate market today—the rate of growth of commercial properties’ net operating income, the occupancy rates of retail store properties, and so on—are sending increasingly mixed signals. Residential property, with its outsized effect on retail spending and, consequently, the economy at large, is also showing signs of susceptibility to gravity’s downward pull. Jack C. Harris, research economist at the Real Estate Research Center at Texas A&M University, cautions that he has seen some softness recently in segments of residential housing in his local Texas market. “I don’t think there’ll be a steep downward trend,” he says, “but it could be coming to the top of its cycle. Right now, most residential segments are in neutral range, somewhere between over- and undersupplied. But the high end of residential is looking a little soft.”

One of the pillars supporting the real estate boom in recent years—and potentially a contributor to its undoing—is the ever-closer tie between mortgage rates and the global capital markets. In a recent editorial in the Los Angeles Times, Susan M. Wachter, professor of real estate and finance at the Wharton School of Business, University of Pennsylvania, wrote: “Housing and mortgage markets have been the cornerstone of the U.S. economy’s recovery. The low mortgage rates have driven refinancing to record levels, reaching a peak of $3 trillion in 2003. It’s been an unprecedented time in our history.” According to Wachter, the difference in recent years has been the rapid growth of the mortgage-backed securities market, which repackages home buyers’ mortgages and sells them to investors worldwide.

In a subsequent interview with Worth, Wachter explained that because of the exponential growth of this secondary market, U.S. mortgage markets are now fully integrated into overall global capital markets. “This means that interest-rate declines translate almost literally overnight into lower mortgage rates for homeowners. In the past, it would’ve taken weeks, or even months, for this to happen.”

TOP VIEW Our real estate portfolios have consistently outperformed most other types of investments in the years since the technology bubble burst. Caution, however, is warranted; some economists argue that many parts of the market are now overpriced, and values may fall if interest rates rise. There are useful indicators we can monitor to judge the health of the market, and how to best position our investments in it.

This integration could work in reverse—with rises in interest rates moving more quickly from the capital markets to the mortgage markets. “Mortgage rates will eventually rise with an improving economy, and the housing markets will cool,” says Wachter. Still, she is sanguine: “They won’t collapse. There are no signs of a housing bubble on a national basis.”

Regional markets may be a different matter. Real estate prices in America’s urban centers have reached record highs, causing some analysts to nervously speak of the potential for, and consequences of, the bursting of a real estate bubble. In markets like Atlanta, Los Angeles and New York, buyers now pay princely sums for properties that only a few years ago were considered unattractive. “There may be some local markets that have issues,” Wachter agrees. “After all, high prices supported by nothing more than the expectation of even higher prices is the definition of a bubble.”

Fundamental Issues
Craig Hall, chairman of the Hall Financial Group and author of the just-published book, Timing the Real Estate Market, has invested in Dallas real estate for 36 years. In 1995, he bucked conventional wisdom and bought a pair of downtown office buildings for $60 million. “Dallas was so down and out, most people thought it was the dumbest thing we could’ve done,” he says. “But we felt the timing for this market was ripe for a turnaround. We often make our money by taking a contrarian position, and going against the grain.” Hall’s gut feeling to buy was right. “We held it for three years, and made capital improvements, but the turnaround wasn’t going as I had hoped,” he says. “But other people were more excited about the future, and there were more buyers than the market justified.” In the end, Hall sold the two buildings in 1998 for $110 million.

Hall, whose holdings range from Texas office parks to Napa Valley wineries, explains that three national trends—inflation, interest rates and capital flow—affect the market. Despite the bullish climate in commercial real estate, he says he does not have a clear handle on the future. “It’s a very confused time right now,” he says. “This is the only time that I can recall when fundamentals in commercial real estate have deteriorated, but property values have remained steady or gone up.”

With this stream of willing buyers, the values of both residential and commercial properties continue to rise, despite languishing vacancy rates in many markets and other signs that fundamentals are not robust. “There’s a tremendous amount of capital looking for product,” says Charles Lowrey, CEO of Parsippany, N.J.-based Prudential Real Estate Investors, which provides financial services to institutional investors and affluent individuals. “The question is whether capital flows will continue to overwhelm the fundamentals, as they have over the past few years.”

The number of commercial sales rose about 10 percent last year over 2002. The buying frenzy is such that some otherwise intelligent investors are abandoning reason: Lowrey says that in some markets, buyers are waiving due diligence before their purchase. “That isn’t the norm, but it’s an indication of how aggressive it has become.”

Individual investors are becoming increasingly innovative in their attempts to tap this market, and to compete for properties with institutional investors. “Our parent company, CB Richard Ellis, did $16 billion worth of commercial real estate transactions last year,” says Raymond G. Torto, chief strategist of Torto-Wheaton Research in Boston. “They’re finding that small syndicates and individuals are buying big chunks—up to a half—of what they’re selling. High-net-worth individuals are moving into real estate because of what’s happening with other investments.” Whether the investors rushing into the real estate market now are akin to those who bought Nasdaq stocks in the first quarter of 2000 will only become apparent with time.

Bubble-Like
Torto, who follows the U.S. commercial market closely, says he does not see any bubbles, but rather bubble-like phenomena in some property types, such as condos and other multihousing properties. Capitalization rates (a ratio used to estimate the value of income-producing properties calculated by dividing their net operating income by their price) in many markets are at historic lows, meaning the same amount of income is supporting ever-higher prices—a phenomenon that gives many investors pause.

Craig Hall is cautious about the current market and suggests that it could be a good time to sell. “The risk—and I think it is very real—is that if you pay a high price based on today’s values, interest rates could go up and, in turn, cap rates might follow,” he says. “That means a lower value five years from now.”

Hall believes that a slow rise in interest rates, perhaps 1 to 1.5 percentage points over 12 to 24 months, will not cause the market any severe problems. But, he says, if they go up 3 percentage points over the next six to 12 months, cap rates could increase and prices could fall.

“We expect long-term, risk-free rates to rise by about 100 basis points over the next 12 months,” says Peter Linneman, professor of real estate at the Wharton School of Business, and author of Real Estate Finance & Investments: Risks and Opportunities. Linneman says that as real estate begins its slow move through the upside of the cycle, the long-term rate of net operating-income growth will decline modestly.

Linneman also sees a slowdown of capital flows into the market. He predicts that as other sectors of the economy improve, there will be a rotation out of relatively safe investments—including real estate—into riskier assets. This, he says, is the “price real estate pays for being connected to broader capital flows.”

Ultimately, these flows determine investment performance, Lowrey argues. “If interest rates increase or investor sentiment shifts strongly toward growth [investments], real estate performance could suffer. However, with the presidential election looming in the fall, we do not expect interest rates to rise sharply in 2004.”

REITs
Perhaps the most popular—or at least most publicized—form of securitized real estate investment is the REIT. REITs own and usually operate income-producing real estate; some also provide mortgages. They can be privately held, non-exchange traded or publicly traded. (There are about 180 publicly traded REITs, typically called real estate stocks.)

According to the National Association of Real Estate Investment Trusts (NAREIT), publicly traded equity REITs outperformed both the S&P 500 and Nasdaq from 1972 to 2002, and last year, had a compounded annual return of 38.5 percent.

Most analysts expect REIT returns this year to be substantially lower. “Forecasts are all over the lot,” says Jay Hyde, NAREIT vice president. “The most optimistic is 15 percent, the most pessimistic is a double-digit decline.”

But all REITS are not created—or valued—equally. Divided into property types, retail REITs last year saw average returns of 47 percent, while apartment REITs returned 25 percent. Still, values remain high—some think too high. “Investors moved to REITs in the last few years for the safety of holding a security backed by hard assets and an attractive dividend yield,” says Brent Fykes, a financial advisor at Asset Management Advisors. “We think REITs have become fully valued, and it’s increasingly difficult to find attractive valuations in the industry.”

Fykes says his company actively picks REIT stocks based on growth sectors like health care, as well as including many REIT preferred securities. This cherry-picking approach has helped the company outperform the index.

Michael Schatt, portfolio manager of the Phoenix-Duff & Phelps Real Estate Securities Fund, has also consistently beaten the NAREIT Index. He says that REITs, given their low correlation to many other assets, are not a “hot sector play, but a stable part of a diversified portfolio.”

But will REIT stocks stay strong? “As long as interest rates stay low, yields on REIT stocks will be extraordinarily attractive,” says Samuel Zell, chairman of Equity Office Properties in Chicago, the country’s largest REIT, with 700 properties. “I see nothing on the horizon to change that.” Zell predicts that, within 10 years, publicly traded REITs will own 60 percent of all investment-grade real estate.

Direct Investments
While REITs aggressively acquire property, many individual investors and small syndicates are pursuing higher potential returns by investing directly. The downside to direct investment, of course, is the liquidity issue. Unlike a REIT, once you are in, getting out is not always easy.

Despite this risk, many prefer direct investment. Fykes, for example, uses limited partnership structures to create investment opportunities in development projects for his clients. “We work with a developer in Florida who typically puts together two or three projects each year,” he says.

The latest success, reports Fykes, was a mall located at one of the five busiest intersections of a city in Florida. “The total project cost is about $32 million. Our investors expect to be in this deal for about 10 years while earning a preferred return of 7.5 percent from the cash flow of the project.” The strategy, says Fykes, should produce an average annual return of 25 percent.

Direct investors may take a more passive approach without losing revenue stream by taking advantage of the U.S. tax code’s 1031 Exchange, notes Tom Jahncke, senior vice president of Passco Real Estate Enterprises in Santa Ana, Calif. Utilizing a 1921 IRS rule that allows an owner to sell one property and buy another of similar value while deferring the payment of capital gains, Jahncke’s firm has structured a tenant-in-common program that gives an investor a common ownership in a retail commercial property. “This would allow someone with $1 million to acquire a 10 percent ownership in a shopping center worth $10 million,” he says. “The owner gets a deed saying he is a tenant-in-common owner of an undivided shopping center. It’s ideal for someone who is tired of managing his own property, since we now do it for him.”  

Additional Information
Investment Vehicles
Strength Through Diversity