Someone Has Already Caught the Falling Knife as Smart Money Moves Into Commercial Real Estate, Says UCF Economist

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(MIAMI, FL) -- "Don't bet against real estate" was one of the themes at a recent Realtors Commercial Alliance (RCA) conference this past week at the Biltmore Resort in Miami, a day-long event sponsored by the Miami Association of Realtors that focused on the current conditions of the U.S. commercial real estate investment and development marketplace.

According to the keynote speaker, Dr. Randy Anderson, the Howard Phillips Eminent Scholar Chair and Professor of Real Estate at the University of Central Florida, "many real estate market segments have started to strengthen; meaning that someone has already caught the 'Falling Knife' and investors should now be taking a hard look at making real estate allocations."

Anderson showed long-term relative strength of investing in commercial real estate as part of a mixed asset portfolio.  Anderson noted that "the smart money has already started to move strategically into the commercial real estate space," and he stated that some of the current investment opportunities are "in places and products that may surprise you."

Dr. Anderson told the World Property Channel in an exclusive one-on-one interview that "the reason smart money has already moved in is because one of the keys to investing in real estate is to buy when prices are below replacement cost and sell early before the market corrects and liquidity wanes.  The timing today seems good as pricing, in most cases, is below replacement costs and we have seen several quarters of pricing strength and well as improved fundamentals, suggesting that markets are improving."

Dr. Anderson also commented that "there is a false premise in the marketplace that the best growth opportunities always come from buying 'trophy assets' in the largest of markets.  Contrary to conventional wisdom, the data shows that quality rent growth and asset appreciation can and in fact does occur in secondary markets with B assets.  Add to this that the pricing spread between trophy assets in the largest markets relative to the B assets in secondary markets is much higher than historical norms, suggesting that there are quality risk-adjusted returns in places where some investors are not currently looking." Anderson adds that some investors are now "buying trophy buildings in top tier markets on a 4% to 5% cap rate, which is extremely rich pricing, while others are buying stabilized assets outside the top 20 markets at 7%-8% cap rates."

Anderson cited an example  of how, statistically speaking, a commercial real estate investor may actually enjoy higher returns by buying "B" class buildings in secondary markets at a 7% to an 8% cap-rate, than someone buying "A" buildings in "A" cities at a 4 or a 5.  In this example, Anderson showed that if cap rates expand by just 100 basis points, the increase in rents that "A" buildings needed to make any money is quite high, and that there is simply no room for error when buying at 4% cap-rates.

Dr. Anderson's 2011/2012 commercial sector highlights included the following points:

Retail Sector

• Overall retail spending is higher now than before the 2008 crash.

• Retail is enjoying a big boost in spending from long-term pent-up demand.

• Spending will plateau shortly unless consumer confidence improves.

Office Sector

• Office buildings, over long time periods, have had high risk levels for the realized returns.

• One of the reasons for this poor risk-adjusted performance is that investors typically underwrite offices with vacancy in the 5% to 10% range, when vacancy is, on average, higher than this.  Another major reason for underperformance is that investors tend to underestimate capital expenditures, which can be exceptionally high during soft markets.  Combining these two issues, we have seen, on many occasions, office investments falling short of expectations.

• Office is, nevertheless, a great 'cyclical play' and investors can experience exceptional   absolute returns during market upswings.

Industrial Sector

• To successfully invest in industrial properties, you must be an expert in the global economy and have a detailed understanding of how goods are moved around the globe.

• One of the major changes that will impact the industrial markets is the widening of the Panama Canal, as it will change how goods are transported to the East Coast.

• While the fundamentals are improving in this space, there is quite a bit of capital chasing quality deals that have made it hard to buy "right" as cap rates have compressed and price per foot has risen substantially since the bottom.

Multi-Family

• 'Simple math' shows how fundamentals in this market have been improving and are likely to continue to improve.

• The reasons for improvement include growth of the population in the most likely to rent age cohort (the echo boomers), increased growth from immigration, growth in non-traditional households, declining homeownership rates (now at 65.1% which is the lowest rate in 13 years - and for every 1% decrease in homeownership we see about 1.2 to 1.3 million new renters), and other factors combined with limited new supply.

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