U.S. Real Estate: Alternate Strategies for 2006

Prices in the commercial real estate market in the United States have been in a persistent uptrend ever since the last major real estate recession of the early 1990’s. Until about 1995, the uptrend represented a recovery from the depressed prices that had developed during the recession. In recent years, however, this uptrend has brought prices for institutional quality real estate to levels that have rarely been reached for any sustained period of time in the past. With capitalization rates continuing to fall to the 6% level and even below, and with mortgage interest rates frequently exceeding 6%, the market has reached a point where the cost of carrying debt will frequently reduce the yield from a property below the going-in capitalization rate. Under these circumstances, Falcon Real Estate believes that the prudent investor should be very careful about purchasing those properties that are now so much in demand (primarily well located properties leased to credit quality tenants on long-term leases) but instead should be willing to consider alternate investment strategies.

In addition to the traditional approach of buying fully completed and fully leased properties, Falcon believes that there are several other strategies that can be followed in the U.S. real estate market today that will provide excellent returns to the investor. Such strategies include buying apartment complexes and converting them to condominiums, engaging in new development and purchasing raw land. It is frequently preferable to select an experienced development company or condo converter company to act as one of the investor's joint venture partners when adopting one of these alternate strategies. Falcon Real Estate would also serve as a joint venture partner, and would continue as advisor to the investor.

Each of these strategies would involve somewhat greater risk than would have been involved in the purchase of a fully leased office building in the past. But we believe that the risk of over-pricing is the principal risk that needs to be avoided in the U.S real estate market today, and that risk seems to us to be most evident in the purchase of traditional fully leased properties..

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Condominium Conversions

We believe that the condominium conversion market continues to be one of the more attractive areas in the U.S. real estate market today. Many studies have indicated that the housing market in the United States has been slowing from the extraordinary levels that were reached during the last few years. In our view, this slowing has taken place primarily in some of the markets where prices had risen the most rapidly. It has also taken place in the highest priced segments of housing markets around the country. But it is our belief that housing demand remains strong in those markets in which population growth is continuing, and we particularly favor the lower priced part of the condo market where competition has been less intense. In deciding to recommend a particular conversion project, Falcon carries out a significant amount of detailed study in the local residential real estate market to determine how much competing product there is in that market, since we believe that it is important to be well positioned competitively in each case. We also tend to favor projects having approximately 150 to 200 units, since selling out the individual units quickly will reduce the risks involved in this type of investment and will also improve the total internal rate of return. We believe that 20% internal rates of return are still achievable in well-selected condo conversion investments.

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Development

The generally high level of prices in the U.S. real estate market is at least partially due to the improving fundamentals in that market. Vacancy rates in most geographic markets and in most types of real estate have been slowly declining, and rental rates have been moving upward. However, at the present time conditions in the market do not appear to call for a great deal of new construction. Nevertheless, good development opportunities can still be found in many locations around the country.

With an expanding economy, many companies require an expansion of their existing facilities, either by adding a new office or an industrial warehouse. These so-called "build-to-suit" opportunities have relatively little risk since a tenant is in place when construction is completed. The investor will enter into an agreement with the developer, usually providing the equity for the transaction and earning a share of the profits upon sale of the developed property. Since the property will almost always be on a long-term lease, there can usually be a significant profit at the time of sale. Falcon would not recommend the development of purely speculative office, industrial or retail properties.

Engaging in development projects in the housing market can usually be somewhat more venturesome, but also more rewarding. Going into partnership with a developer or construction company to build single-family homes, apartments or condominiums can be quite profitable. In this case, it is of primary importance that extensive studies be carried out to determine the extent of the demand for housing in that particular area, and that the type of housing that might be attractive to potential purchasers be carefully analyzed. Falcon has been involved in a major development project outside of Washington, D.C. and is studying several similar projects in that market.

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