Commercial Real Estate - Not Lost in Translation - Steadyhand ...

Commercial Real Estate - Not Lost in TranslationPrint

Posted on March 7, 2013

By Tom Bradley

I?ve been highlighting a number of asset classes where the risk premiums - the opportunity to achieve returns above government bonds - have narrowed. My focus has been on income securities, but I?ve poked my nose in on residential real estate as well. From my research and discussions with other investment managers, however, it seems that near-zero interest rates have pushed risk premiums down almost everywhere, including most areas of the hedge fund universe. (Note: I think stock valuations are still close to normal and offer potential returns that are similar to historical levels, but that?s for another post coming soon)

Lately I?ve found myself in front of a number of commercial real estate managers, another area that is all about income and is highly sensitive to changes in interest rates. I don?t know nearly as much about this asset class, but thought I?d try to apply some of the tricks of the trade I?ve learned from almost 30 years of interpreting bond and stock presentations.

The format below takes some of the phrases I?ve heard in formal real estate presentations and translates them into what I imagine might be discussed around the water cooler or over beers.

Pricing is good.
Coors Light: Things are expensive right now. I can?t believe what people are willing to pay us for our buildings.

It?s competitive.
Moosehead: But if we sell, we?ll find ourselves in a bidding war with pension funds and REITs to buy something else.

We?re looking to build some multi-residential buildings [apartments].
Molson Canadian: Apartment buildings are in such demand that transaction prices have risen above replacement cost. In some areas, it now makes more sense to build than to buy.

Pension plans are increasing their weighting in real estate.
Budweiser: This is not an undiscovered asset class. The returns have been terrific ? and steady. It happens every time - returns are good and everybody wants more. Maybe it?s time to feed the hungry wolves.

We?re finding opportunities to upgrade the quality of our portfolio without sacrificing much on valuation.
Moosehead: The market isn?t discriminating between high quality and lesser quality to the degree it usually does. It?s a great opportunity for us, but it?s also a little worrisome. This usually signals the peak of the cycle.

Financing is not a problem. Spreads are reasonable and we?re able to get 10-year loans.
Coors Light: If we can get 8-10 year money at 3%, then we can afford to buy at 6% cap rates, or even less. As long as the banks and insurance companies are there for us, we can keep buying, even if it feels expensive.

The capital appreciation will vary from year to year, but the rental income provides a nice cushion.
Budweiser: Rental income has provided about half the return over the last few years. It?s coming down a little, but should hold up. But when rates go up and the spread narrows [between cap rates and interest rates], rents aren?t going to matter much. Prices are coming down. I?m not sure our investors are ready for lower property valuations.

As I said earlier, I?m not an expert in commercial real estate, but reading between the lines, it sounds like investors need to adjust their return expectations just like other asset classes. It?s never an easy conversation to have, so maybe more than beer is required. Scotch anyone?

Source: http://www.steadyhand.com/industry/2013/03/07/commercial_real_estate_not_lost_in_translation/

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