The US Real Estate Market Supply/Demand Situation

One of the most fundamental concepts that is applicable to every type of investment – stocks, bonds, commodities or real estate – is that prices are basically determined by the supply/demand relationship for that asset. There are other factors that can affect pricing from time to time, but where a true auction market exists, the relationship between supply and demand is the principal determining factor.

When the credit crisis hit the financial markets of the world in the latter half of 2007 and a severe economic recession followed, it was generally assumed that the US commercial real estate market would be devastated, as it had been 20 years earlier following the savings and loan debacle. A great many distressed assets were expected to flood the market and most of the sources of capital that had supported the extraordinary run-up in real estate prices were expected to disappear. In point of fact, this did begin to happen in 2008 and early 2009, and those who acted quickly and decisively were able to obtain some very high quality properties at very reasonable prices.

However, the situation with respect to both the supply and the demand sides of the US commercial real estate market changed rather quickly. Even though the credit markets remained frozen, within a very short time a tremendous amount of equity capital appeared from both domestic and foreign sources, all of it seeking prime properties in a few select markets. But for a variety of reasons, there was no corresponding increase in supply to meet the increased demand, and as a result prices – particularly in those few select markets including New York, Boston, Washington DC, and San Francisco – moved back up close to the levels seen prior to the onset of the recession.

As we move into the second half of 2010, Falcon Real Estate believes that factors are in place that will lead to some increase in the supply of quality properties coming to market, while demand (as measured by the amount of cash looking for investments) may have peaked. We continue to believe that investors coming into the US commercial real estate market today can find excellent investments as long as they have reasonable and fairly broad investment objectives and are able to act quickly and decisively.

The Demand Side of the Market

As a result of the credit crisis and the recession, a great deal of pressure built up on US institutional investors, such as pension funds and university endowment funds, to invest in assets that would provide higher return levels. The stock market collapse had devastated these funds and neither corporations nor state governments had sufficient income to contribute to them in order to make up for their losses. In order to fight the recession, the Federal Reserve Board had cut short-term interest rates effectively to zero and long-term rates hovered in the 2% to 4% range. Commercial real estate, with going-in capitalization rates of 7% to 8%, plus the prospect of inflation protection and some capital appreciation over time, appeared to be a very attractive alternative. Therefore, a great many institutional investors allocated increasing amounts to commercial real estate.

In addition, a large number of private equity funds were formed by groups such as Morgan Stanley and Chicago developer John Buck. Literally billions of dollars were raised from individual and institutional investors anxious to capitalize on the flood of distressed properties that were expected to hit the market. There were a wide variety of investment objectives for these funds, with some intending to buy up defaulted mortgages to gain control of good properties, others intending to buy or originate mezzanine debt and others simply looking to buy good properties at bargain prices.

The third major group that came into the market were foreign institutions and individuals. Many sovereign wealth funds, such as ADIA, the Qatar Investment Authority, the Kuwait Investment Authority and the Government of Singapore Investment Corporation made high-profile purchases of US commercial real estate and indicated that they were looking to expand their portfolios.

And finally the Real Estate Investment Trust industry made a dramatic turn around. When the credit crisis first hit, many of the REITs appeared to be on the verge of bankruptcy, with insufficient cash flow to meet their various obligations. But just as private equity funds were able to raise billions of dollars in 2008 and 2009, many REITs, such as SL Green in New York City, went to the stock market and raised very significant amounts of cash, so that instead of being forced to sell properties, they became major purchasers of quality real estate.

The combination of all these factors meant that there was an extraordinary amount of equity capital seeking high-quality commercial real estate in the US. And to compound the problem, most of these groups wanted to focus on only a small number of major US geographical markets..

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