In 2002 Real Estate was “King”.
Will it Continue in 2003?

A leading investment advisor recently said that, of all the many investment asset classes, real estate was the “king” in 2002. As we enter 2003, the question is “Can real estate continue to be the best performing asset class in the United States?”

The case for the relative attraction of real estate is not difficult to make. With interest rates at historically low levels, fixed income investments have very little attraction. Current interest rates are quite low and, assuming that the economic recovery in the United States continues or perhaps accelerates, interest rates are almost certain to rise, thereby depressing the price of existing fixed income investments.

A recovery in the stock market should accompany the improving economy. However, price/earnings multiples on stocks are still well above historic norms and dividend yields remain below 2% on average. Therefore, the recovery potential in the stock market appears limited.

Real estate, however, clearly benefits from the low level of mortgage interest rates, since cash-on cash yields in the 9% to 10% range are now easily attainable. In addition, many of the excesses that began to develop in the real estate market in the late 1990’s have been corrected during the recent business slowdown. As the economic recovery progresses, demand for all types of space will accelerate. But investors going into the market today should be aware of the following factors:

1. 1. The continued divergence within the real estate market.
2. 2. The effect of historically low mortgage interest rates.
3. 3. The need for a clear exit strategy.

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Divergence within the Market:

The U.S. real estate market has effectively divided into two markets — one a substitute bond market and the other the true real estate market. As investors fled the declining stock market, which has suffered its most serious and prolonged decline since the depression of the 1930’s, their primary concern was to look for security, and this could be found in the first instance in the bond market. However, with interest rates plunging to 40-year lows, bonds quickly became unattractive and investors began to turn to real estate. Since security was the prime objective, investors concentrated on quality properties in prime locations that were leased to credit worthy tenants on long-term leases. And this category of real estate, the safest and most secure category, became, in effect, a bond substitute. The credit of the tenant was all-important, as was the yield on equity after providing for debt service. As a result, prices in this segment of the market have risen, and capitalization rates have dropped. Investors are still able to get good cash-on-cash yields in the 9% to 10% range from this type of investment since mortgage rates have fallen to the 6% level or even below. But investors should be aware that in many cases this part of the market has become overheated.

In contrast, virtually everything else in the real estate market remains reasonably priced or even under-priced. This is due to the fact that both leasing risk and credit risk are anathema to most investors today. Only the true real estate investor is willing to consider assuming such risks. Many properties that are leased to very fine companies still trade at relatively high capitalization rates and low prices because the tenant’s debt is either unrated or is one notch below investment grade. In Falcon Real Estate’s view, the price discount associated with this type of credit risk is much greater than is warranted by the actual risk of default by the tenant. Similarly, any property that has any significant lease rollover in the next few years will also trade at a depressed price. Again, with a proper understanding of the local real estate market, the assumption of some leasing risk can be profitable in the long run and can represent an excellent purchase today.

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