Is There a Real Estate "Bubble"?

Some analysts have suggested that a "bubble" has developed in the U.S. commercial real estate market, similar to the "bubble" that developed in the U.S. stock market in the mid- to late 1990's. That stock market "bubble", of course, collapsed in a spectacular fashion, and the concern is expressed that a similar collapse could occur in real estate. As we have noted in previous newsletters, real estate has been the preferred asset class among knowledgeable investors for the past three or four years and, as a result, has attracted many new investors and a great amount of new investment. But commercial real estate investors differ from stock market investors in many important respects, and the real estate market itself is very different from the stock market. Because of these differences it is almost impossible, in Falcon Real Estate's opinion, for the same degree of overpricing to develop in the commercial real estate market as developed in the stock market.

Some of the constraints on overpricing include the fact that investments in real estate follow what is inherently a much more disciplined investment process than do investments in common stocks. There are no “hot stocks” in real estate; there are no “concept stocks"; there are no theories or chartists or technical analysts, as there are in the stock market. In addition, real estate investors generally have a longer term time horizon than do the majority of investors in the stock market and this causes them to be more cautious in their decision-making. Finally, an investment in real estate is an investment in a real asset, and the cost of that real asset serves as a check on excessive market prices. Therefore in our view, while some segments of the market appear to be fully priced, and while there will be some downward pressure on real estate prices as interest rates move higher, we do not believe that a "bubble" has developed and do not foresee a collapse in commercial real estate prices such as occurred in the stock market.

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The Real Estate Investment Process

Most professional investors in commercial real estate adhere to a very disciplined approach to the entire investment process. The value of a piece of real estate is primarily determined by the income that a given property can produce currently or can reasonably be expected to produce in the foreseeable future. Each potential property investment is analyzed on that basis, with detailed analyses being prepared of the rents produced by each lease on a property and the potential future rental income that might be realized, taking into consideration market conditions. When the income stream has been determined, either a capitalization rate is applied to the current net operating income or a discounted present value of the future income stream is calculated. One of the primary reasons that a "bubble" developed in the stock market was that investors had completely lost touch with the real cash flow - earnings and dividends - that might be generated by many companies, particularly those in the technology and telecommunications fields. The real estate investment process, by contrast, is firmly tied to the actual cash being generated by the investment.

In addition, the real estate investment process demands an exit strategy. It is necessary to make a decision based upon existing and prospective leases as to an appropriate holding period for an asset. This will, in turn, determine the type and maturity of the mortgage financing that is obtained. An exit strategy is implicit in the length of mortgage chosen for a property. Every property is rigorously analyzed and investment decisions are based upon this type of objective analysis. All too frequently the discipline of having a defined exit strategy is lacking when a common stock investment decision is being made.

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