The following article was written by Professor Riddiough for the Pension Real Estate Association last July. “Most of what I said still holds today,” according to Professor Riddiough. “However, we are now much more precariously situated. Long-term interest rates are finally beginning to move up, the budget deficit has grown and price increases have become particularly steep in certain parts of the country. All of this bodes badly for real estate. Moreover, real estate lenders continue to be extremely aggressive, facilitating price increases and additions to supply. In other words, I would recommend thinking twice about buying into this market right now, as there are significant downside risks.”

As the “Saturday Night Live” character, Roseanne Rosannadanna, was fond of saying, “It’s always something.” This is why, as an economist, I find commercial real estate so fascinating—that and the personalities of those who buy, sell, build and finance the stuff.

The “something” right now is how commercial real estate prices, which one can safely characterize as frothy, will react to upticks in inflation and short-term interest rates.

This is a critical and confusing question, as much of our conventional wisdom is based on the following two “facts”:

• Commercial real estate is an inflation hedge, and
• Supply (as opposed to demand) is the wildcard in space markets

Based on recent experience, we can toss those two pieces of conventional wisdom out the window. Commercial real estate has done just fine, thank you very much, in a non-inflationary environment. This would suggest that real estate is more of a stagnation hedge than an inflation hedge. Furthermore, as we all know, the recent weakness in fundamentals has been driven by demand—not supply. Supply has been extremely well behaved in aggregate for the last decade, even as funds have flowed at high rates from old and new capital sources. Toss in capital market integration—a butterfly flaps its wings in Russia and U.S. real estate debt markets come to a screeching halt—and you have a recipe for bewilderment.

Consequently, we cannot fall back on the conventional logic that inflation chokes off supply and is bad for “paper assets” like equities, thereby causing real estate price increases. This time around, moderate inflation could very well mean a healthier macro economy, a stronger equities market and higher-cost mortgage debt—probably not a good-news scenario for real estate prices.

Where do the industry gurus come out on this subject? Property sector experts are remarkably uniform in their assessments. Upticks in inflation and short rates will likely cause capitalization rates to increase a bit, a negative effect that will be more or less offset by better fundamentals and therefore higher cash flows. The net expected effect? Prices will hold firm in the short run and even increase in certain sectors, such as hotel and industrial.

I generally agree with our experts’ assessments but with some slight differences. In the immediate term, I expect cap rates to decrease somewhat below their already aggressive levels, causing prices to continue their march upward. Then, perhaps six months from now, I am hopeful that reality sets in and there is a correction—a controlled burn, if you will—in commercial real estate markets as investors take stock of what has gone on during the past few years. However, I am far from confident that sanity will prevail, as the psychology of disappointment and desperation hangs over the market. Thus, I have some serious concerns about the medium term. The stars are aligning for a real-life boom-and-bust in commercial real estate—an out-of-control wildfire, if you will—that threatens the long-run health of the market.

Thus, with the usual economist’s “on the one hand, but on the other hand ...” approach to things, I will now provide you with seven reasons why commercial real estate prices will hold for now, and five reasons why you should sit up straight and pay close attention to the market.

Reasons to Be Optimistic

Reason #1—A Fed Tilt Toward Tightening Is Already Priced into Long-Term Rates: When the Federal Reserve first raised short-term rates in June 2004, the 10-year Treasury yield actually fell. Since then, long-term rates have held relatively steady. Why? The bond market had expected the possibility of steeper rate increases as a signal of wider-spread impending inflation. A quarter-point increase had been fully priced and actually calmed folks down. The result? Fixed-rate mortgage debt remains reasonably priced. In fact, when since 1985 has it been a better time to be a borrower, with low rates, slim spreads and high loan-to-value (LTV) ratios? I don’t see this changing in the immediate term.

Reason #2—The Budget Deficit Is Not a Problem—Yet: Yes, OK, we are running a deficit again. In fact, at close to $500 billion, it’s bigger than any in history. But as a percentage of GDP (3 percent), the deficit is not out of line with historic norms. The general consensus is that bond markets can handle a deficit of this magnitude without much trouble, and increases in interest rates will in all likelihood be due to economy firming up, not because of 1970s-style stagflation. This, in turn, suggests improving real estate fundamentals with moderate increases in interest rates and inflation.

Reason #3—Globalization and the Inflow of Capital from Abroad: Although globalization certainly has its critics, the good news is that economic development and open trade have helped keep the lid on inflation. Moreover, the United States continues to attract capital from abroad. Why? Although we are the world’s 800-pound economic gorilla, we continue to be productive, innovative, flexible and stable. We look especially vibrant when compared to Western Europe.

Reason #4—Uncertainty Overhang in the Equities Market: The broader equities market has been in a funk. Corporate profits are up and governance is better. However, price-earnings (P/E) ratios have fallen and the market is basically going sideways. Why? A whole lot of uncertainty originating from three major sources: commodities prices, terrorism and politics.

Reason #5—The Supply Side Has Been Well Behaved: Remember supply ...? We used to obsess over it and with good reason. It has blown us out of the water more than once, and the pain it caused in the early 1990s still resonates. However, with localized exceptions, supply is well-behaved today and looks good going forward.

Reason #6—Momentum in Funds Flow: Did I say that capital is flowing to commercial real estate? Oh—my—God (intonation like that of my 16-year-old daughter), it’s really a bit frightening. Capital is flowing from everywhere: from other countries, mom-and-pop as well as sophisticated retail investors, the Commercial Mortgage-Backed Securities (CMBS) market, pension funds. Much of this capital, especially the institutional capital, has significant momentum. Absolute return and real cash flow are highly valued today, as investors are starved for yield. Under-funded pension liabilities are a particular concern for some institutional investors, resulting in a move up the risk curve. Allocations of more than 10 percent to commercial real estate? Considered reckless yesterday, they are becoming the norm today. Leverage? Almost unheard of yesterday, it’s commonplace today. The result: No way around it—cap rate compression will continue in the immediate term.

Reason #7—Capital Market Integration and Improved Risk Management: I’ve been arguing for years that cap rate compression was coming to commercial real estate. It came in the form of higher P/E ratios to the broader equities market in the 1990s; so why not real estate? Actually, there are very good financial economic reasons for lower long-run cap rates (and they are not just related to lower interest rates). First, capital market integration has resulted in real sustained discipline, which investors have finally bought into. Discipline implies less boom-and-bust and therefore a lower risk premium. Second, we are now more than two generations removed from the traumatic effects of the Great Depression, with vast numbers of baby boomers headed for retirement. Translation: Less risk aversion and therefore a tolerance for lower returns (backed by real cash flow). Third, investment and hedging opportunities continue to expand through globalization and financial innovation. This implies better risk sharing and risk management, and therefore increased tolerance for “alternative” investment risks such as commercial real estate.

The downside of course is that everything is increasingly interconnected,
so when that butterfly flaps its wings again ...

Reasons to Be Pesimistic

Reason #1—Private Equity REITs: Private equity REITs (Real Estate Investment Trusts) are growing, largely by attracting unsophisticated (aka dumb) retail money. They are taking huge up-front fees and moving up the risk curve to generate promised returns. A syndication-like structure, no investor control, a pyramiding investment approach ... it’s beginning to look a lot like 1985.

Reason #2—Mortgage Loan Underwriting Standards Have Softened Considerably: It’s a bit shocking—yes, shocking—how much mortgage-underwriting standards have softened in the last year or so. Loan-to-value ratios are up considerably with fewer questions asked, and spreads continue to compress. A great time to be a borrower, but at what longer-term cost?

Reason #3—The Rating Agencies Have Wimped Out: That’s a bit harsh, but hear me out. Subordination levels on CMBS are controlled, or at least influenced, by the rating agencies. Since the early 1990s the rating agencies have taken a relatively conservative approach and investment banks have argued that default rates on CMBS are significantly lower than similarly rated corporate debt. The implication? Lower mortgage rates for borrowers and greater risk to the system as a whole.

Reason #4—New Entry: A wonderful source of discipline (at least since late 1998) in commercial real estate has been the B-piece (the unrated class of securities) in the Commercial Mortgage-Backed Securities market. Because there had been only a small number of players, these buyers have been able to exert big-time discipline by kicking out risky loans and otherwise pounding on conduit lenders to behave properly. Now it’s the revenge of the conduit lender, as aggressive, new b-piece-buyers have entered the market.

Reason #5—The Psychology of Desperation: Not so long ago, commercial real estate pros surveyed the market and shook their heads. Bad fundamentals together with rising prices set off alarm bells. “I remember the 1980s and early 1990s,” they said, “and I vow not to repeat it.” They held their ground on cap rates and lost deal after deal. It was disappointing, especially when due-diligence costs could not be recouped and cap rates continued their downward trend. Then pressure mounted to do deals as capital flowed in—have to deploy the capital for yield-hungry investors—lost a few more deals—desperation sets in—then analysis fatigue hit as the numbers didn’t seem to matter anymore. The eyes glaze over and you say, “Well, everyone else is doing it, I’d better do it too.”

That’s it, my best shot at the “something” in “it’s always something.” My read is that a moderate uptick in inflation and interest rates is not bad news for commercial real estate. The bad news is that eroding discipline within the sector has taken on a life of its own.

Professor Tim Riddiough holds the E.J. Plesko Chair of Real Estate and Urban Land Economics and is the academic director of the Center for Real Estate at the UW-Madison School of Business.