Capitalizing on Irrational Pessimism

By playing up commercial real estate's woes, cagey investors stand to buy assets at bargain-basement prices.

Throughout a brokerage career that has spanned more than 25 years, I have seen savvy investors take advantage of fear in the market. The first property I sold as a broker was a memorable event. It was a tired property in a risky and declining market. When I presented it to the most likely buyer, his first comment was, “You expect me to invest in that? What a piece of $#[email protected]!. Good luck.”

When I told my senior partner about the exchange, he started laughing. What I didn't know at the time was that the investor was purposely denigrating the property in order to drive down the price as far as he could before acquiring it.

This was my first lesson in watching someone use fear and negativity as a negotiating tool. Throughout the transaction, the risk-averse investor complained that he was making a bad decision. He kept trying to improve the deal, knowing full well what he was doing. To this day, he still owns that property, which continues to provide handsome returns.

This is what many smart investors do — they create or play into conversations that center on supposed inflated values and an uncertain future in order to take advantage of the mass fear that type of conversation creates.

For years, many conservative, experienced investors have been saying the market is overheated, pointing to the last three years in particular as a time of greed. Now that the real estate bubble has popped and the economy has contracted significantly, the shift in market psychology from greed to fear has taken hold.

One investor's fear is another investor's playground for opportunity. It is no accident that fabled investors Warren Buffet and Charlie Munger often talk about “being fearful when people are greedy and being greedy when people are fearful.” In the end, savvy investors look at the long-term value they get instead of the mood of the overall market.

Fear is a powerful force

All forms of investments are susceptible to irrational behavior. Nothing is immune. Equities, bonds, commodities, real estate, and all asset types are subject to the fallibility of human decisions and the herd mentality. Commercial real estate investment is no different.

There was plenty of irrational behavior on display in the commercial real estate community during the five years leading up to today's recession. Overly optimistic assumptions about vacancy levels and growth in rental rates and property values contributed to the excesses. In addition, bank balance sheets featured a historically high commercial real estate exposure during that period.

Today the market is ruled by much more rational behavior, particularly with real estate prices falling. With February office sales volume down 73% and industrial down 79% from a year ago, according to Real Capital Analytics, the trend is clear. Savvy investors are waiting for the desperate seller to make an irrational move based on fear so they can scoop up assets at bargain-basement prices.

The dearth of transactions is due to the fact most sellers are not yet desperate enough to sell at the prices buyers are offering. When this standoff will end is tough to forecast. Confusion around pricing hinders buyers and sellers, but once comparables are available and valuations are set activity should accelerate.

As home prices nationally have dropped significantly from their peak, residential real estate has seen a rise in sales activity year-over-year. Since commercial real estate lags behind residential by about four to six quarters, I would bet that we see an uptick in commercial real estate activity by the end of 2009.

For investors who are not highly leveraged, possess a solid understanding of submarket fundamentals, and remain rational and disciplined when evaluating an asset, the market is ripe with opportunity. When the market overcorrects on the down side, seasoned investors will be more than eager to swoop in and capitalize on the swinging perception of property values.

Craig Robbins is president of U.S. brokerage services for Colliers International based in Los Angeles. He can be reached at [email protected].

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