The heights of uncertain optimism in the current commercial real estate environment - by Bill Pastuszek

Bill Pastuszek, Shepherd Associates

In the current commercial real estate (CRE) environment, hope springs eternal as the stock market is in a losing streak and the prospect of rising rates keeps almost anyone but the least fainthearted away from bonds.  Keeping your money in a sock is a great way to erode value – almost as good as buying a CD.

So the real estate market gets a little more crowded as more local, regional, national and international investors decide that they must have hands in some real estate investments. Are the pros wise enough to stay on the sidelines at this point?

Even homeowners and their lenders are getting smug, now that most residential markets near major urban centers are showing some appreciation and some sustained activity. Equity lines, anyone? Remember the 2000’s and your house as piggybank? Watch, it might happen again.

Housing development markets, particularly in urbanized, high value areas, show very strong pricing as developers and builders fall all over each other to acquire development sites at exorbitant prices and what appear to be squashed yield rates. A local survey (Boston) showed strong downward movements in discount and profit rates for development sites. Of course, with such strong pricing for retail units, developers can afford to overpay, even if slightly, going in. Smart? Kind of risky? Watch the pros? Are they buying?

Most CRE markets continue to see cap rates still compressing. The rate of compression is less frothy than in previous years but still indicates there are sellers who want top dollar for their properties and plenty of buyers out there willing to pay for them.

A major, respected investor survey in their 4^th quarter findings note that average overall capitalization rates decreased in the majority of their markets. Not all sectors experienced notable declines and some experienced modest increases.

Many observers note concerns about retail with the exception of neighborhood shopping centers. Investors love triple net investments of almost any kind; some of the net lease deals may come to a less than satisfactory end on the long horizon.

With respect to cash flow assumptions, there are predictably two extremes: at one end, those investors that want to “complete” and to “place funds” have to be aggressive. A stomach for some (or a lot of) risk and looking below the first tier of the table is necessary. The other extreme shows a more measured approach given uncertain interest rate and stock market environments, and the general global volatility that prevails.

There’s a lot of “chasing the deal” behavior going on with aggressive investors manufacturing reasons to pay too much and lenders justifying lending too much. On the end, it’s hard work to keeping saying “pass.” Both strategies require discipline

Bear in mind, markets don’t move in lock step. Aggressive behavior in warehouse sectors, for example, may be merited, whereas aggressive behavior in retail sectors, may not.

In terms of the multifamily arenas, far greater micro scrutiny of cash flow assumptions is necessary as the quality “value add” deals have mostly disappeared or are really hard to come by. Investors have to go trolling in less robust markets for lower tier, less attractive, and thus more risky, properties. In some parts of the country, hit particularly hard from the fall-out from low oil prices, investors are showing much greater modesty in terms of assumptions regarding future multi-family behavior. On the other hand, in Boston, observers keep asking, “are we over built yet?” 

Real estate is a complex investment vehicle. Real estate has the unique characteristic of a fixed location and a resulting lower level of liquidity. One of its maddening aspects is its “cyclicality” where real estate markets are not always in sync with investor expectations or other investments. Property types tend to operate independently of each other (but not totally in a vacuum) and market participants are often mightily tempted to lump them all together. That would be wrong.

While it’s tempting to paint everything with the same bright colors, real estate markets are still not very transparent and small sample sizes can result in misleading insights. Enough research is required so that in the end it may just be possible to understand how investors operate in specific markets and property sectors. Only then, can rental, sales, construction, and marketing activity be understood in specific contexts. With that understanding, an analyst can understand the herd behavior that overheated real estate markets exhibit.

Bill Pastuszek, MAI, ASA, SRA, heads Shepherd Associates, Newton Mass.