Jan Brzeski is a contributor to Seeking Alpha. The article below is a copy of what he posted on August 30, 2011. To access his article on Seeking Alpha, please click here.
Real estate investors know that generalizations are of little value when describing the real estate investment market. Some markets see rising rents while others see the opposite. Results vary by asset class as well.
Today we are seeing an unusual divergence in values as indicated by the two charts below.
The Broad Commercial Real Estate Market: Still on the Floor
The first chart is the Moody's/REAL All Properties commercial real estate index:
The index from which the chart above was made tracks repeat sales of all properties across the U.S. where the sales price was $2.5 million or above.
The Institutional-Quality Commercial Property Market: Bubbly
Now let's look at the Green Street Advisors Commercial Price Property Index (CPPI). This index tracks the price at which public REITs are buying and selling real estate. This index also gives higher weight to higher dollar volume transactions, whereas the first index gives equal weight to every transaction (only repeat sales of the same property are tracked in the Moody's/REAL index; the CPPI tracks all large transactions by REITs, including those that are not repeat sales).
The index of REIT-quality properties is up almost 50% since it hit bottom in early 2009. Meanwhile the broader index that includes many smaller, lower quality properties has actually gone down since 2009.
Consider for a moment that the broader index, which is still near its bottom, includes some large transactions where the price is presumably up 50% from where it was two years ago. This must mean that the prices of all non-large properties are down substantially since two years ago, in order for the broader index to be flat.
Imagine if the Dow Jones Industrial Average were up 50% in the past two years while the Wilshire 5000 Index was flat in the past two years. That is more or less what this data says.
Let's examine some possible explanations of this dramatic divergence. Note that I am not advocating for the superiority of one or another explanation below, only trying to draw out arguments that could explain what we are seeing.
Explanation #1. The income of Class A buildings has gone up 50% in the past two years, while the income of all commercial property as a whole is flat. This explanation, if true, would be satisfying. It would suggest that the indexes are diverging for sensible reasons. However, that is not the case. On page 4 of the 2010 Annual Report of Vornado Realty Trust, "same store sales" EBITDA for Vornado's office properties rose 3.2%. And that includes more than a 5% increase from Vornado's big investment in the government bubble market of Washington D.C. which benefitted from stimulus spending during the period.
Explanation #2. Large, institutional quality assets are experiencing a bubble and are over-bought. Interest rates for both individual savers and institutional investors such as pension funds are near all-time lows. As investors look for yield, they are buying high quality REIT stocks, driving the dividend yields on those companies to very low levels. In turn, the REITs have issued huge quantities of equity on favorable term. If they only need to pay investors 2-4% dividend yields, they can afford to pay very low capitalization rates (very high prices) when they go shopping to invest the cash they raised. Of course if they are going to pay top dollar, they want to buy only the highest quality properties.
Explanation #3. Smaller properties will from now on be relegated to their appropriate place "on the wrong side of the investment railroad tracks." There has always been a gap between the value of a dollar of cash flow from a San Francisco or New York high rise and a dollar of cash flow from an Ohio shopping center or an Arizona mobile home park. The gap has now widened and will remain huge forever.
My Own Interpretation
Personally, I think the rise in REIT stocks, and the related jump in values for top quality real estate assets, is part of a larger flight to safety. Investors are scared. They lost a huge amount of money on real estate in recent years. They need to get back into real estate because there is no way to fund retirement with a 1% or 2% yield from government bonds.
As Warren Buffett said, "be fearful when others are greedy, and be greedy when others are fearful." The best way to apply that advice in commercial real estate today is avoid pricy REIT shares and to embrace the healthy income that can be had from less prestigious properties. Small is beautiful in real estate today.
Disclosure: Our own strategy is to make loans to investors who are buying properties at beaten down prices. This provides healthy income with a margin of safety because the borrower's equity acts as a cushion for our investment in case values fall. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.