The Changing U.S. Real Estate Market

One of the local offices of CB Richard Ellis recently sent out a mass mailing that was headlined, “We need your help!” It went on to say, “Investment demand for properties . . . significantly exceeds supply and we need additional properties or portfolios to sell.” That the largest real estate brokerage firm in the United States is unable to find enough properties to meet current demand speaks volumes as to the situation in the U.S. real estate market today. There are more buyers than sellers, at least for certain classes of properties, and prices for premier properties continue to move higher.

As we have pointed out in previous newsletters, however, a wide divergence exists within the real estate market. Demand remains intense for properties on long-term leases to credit-quality tenants, while properties that appear to have any credit or leasing risk trade at much lower prices and much higher capitalization rates. The extraordinarily low level of U.S. interest rates is the primary factor that has caused this distortion to persist in the real estate market. As long as the war continues in Iraq, uncertainty will plague the investment markets, keeping interest rates at or near historic lows. This same uncertainty has depressed both the economy and the stock market, causing secure, income-producing real estate to be considered the most attractive investment alternative today.

However, investors need to be aware that when the war is over and the economic growth rate begins to accelerate again, many of the present trends in the U.S. real estate market will begin to reverse. Falcon anticipates that over the next few years the most secure section of the market will experience rising capitalization rates, while what today seems to be the riskier part of the market will move higher in price and will experience lower capitalization rates.

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A Shortage of Quality Product:

As the mailing from CB Richard Ellis indicates, demand significantly exceeds supply for investment grade properties in the U.S. real estate market today, and there are really three reasons for this situation. The first of these is the increasing demand for high quality, secure investments. Since the collapse of the technology bubble in the stock market three years ago, literally hundreds of billions of dollars have been withdrawn from the stock market, and today this money sits temporarily in short term credit instruments or in money market funds. With the interest rate on such investments being less than 1%, many investors, particularly institutions, have been funneling some portion of that money into the real estate market. As many of these investors are new to real estate, they are unwilling to assume the risks normally associated with real estate, and opt, instead, to buy properties that are on long-term leases to credit quality tenants, and therefore appear to have little or no risk associated with them. These are the so-called “bond-substitute” buyers.

A second factor contributing to the shortage of quality properties is the growing frequency of developers and owners of such properties to continue to hold them, rather than to sell them. This is another result of the very low level of current interest rates. Many developers have concluded that it is preferable for them to continue to hold a property, rather than to sell it and incur a large capital gains tax. Since they are able to obtain financing on very attractive terms, they can realize an excellent income return at the same time.

And the third reason for the shortage is the fact that there has been a significant decline in the amount of new product being created. Business investment in new plant and equipment has been one of the principal weaknesses in the U.S. economy and this has been reflected in a slowdown in the construction of new buildings. The demand for office and industrial space by corporations declined sharply during last year’s recession and has only just begun to recover. Even those corporations that need additional space at this time find that it can be obtained more cheaply by leasing space in existing buildings, rather than arranging for a new build-to-suit property.

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