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EXPERT ANALYSIS: Riding the investment cycle

The election of George W. Bush certainly changes the political landscape in Washington, D.C. But if history proves anything, the result of the presidential race will have no bearing on the real estate market for institutional investors. As always, the laws of supply and demand will dictate how that market performs.

In the past decade, the economy performed beyond expectation, yielding high rates of return for stock market investors and single-family home buyers. The institutional real estate investor, however, did not realize the same rates of return. Why? As the economy burned hot, so too did the institutional real estate market. This super-heated market changed the dynamics for investors in a relatively short period of time. Properties sold at bottom-market prices 10 years ago now command premium prices. Today, the market has climbed so high that prices have surpassed the point where strong returns on large properties are feasible.

Blame the economy

The prosperous economy is to blame. In the early ’90s, consumer appetite for urban residential real estate exploded, thanks to lifestyle changes driven by the economy. Young professionals flush with dollars and empty nesters enriched by the sale of suburban homes returned to cities in droves. Once there, these consumers demanded luxury units, with an emphasis on amenities and service. Many urban areas experienced an influx of residents looking for cultured experience found in revitalized and reinvigorated cities.

This boosted rents in residential properties, and as rents rose, so did property values. The value in urban areas rose in tandem with the stock markets, notably the tech-heavy NASDAQ, which experienced an enormous surge in value over the past five years. This buoyed portfolio funds for small investors and pension funds managers alike, which had a dramatic effect on real estate markets.

Typically, real estate represents approximately 5% of an institutional investment portfolio. Huge returns from the stock market, however, increase the portfolio's value and the amount of available cash. Thus, when the so-called economy inflated the value of investment portfolios, the traditional 5% allotment for real estate shrunk as a percentage of overall value.

With the market now at its highest point, investors face a serious challenge: how to find investments that can yield the industry standard of 10% in returns on the initial investment? The recent corrections in the Dow and NASDAQ may be an indicator of a coming correction in the superheated real estate market. If so, pension funds and money managers may sell real estate holdings in search of bigger profits. Or, perhaps, a collapse or consolidation of companies will fuel an increase in residential vacancies and thereby lead to a decline in values.

Supply is short, but this will change if prices drop. For example, commercial space in the high-demand, short-supply market of downtown Boston rents at $100 per sq. ft. This may prove difficult to sustain given the less expensive office space available in the suburbs. If companies in the city are forced to tighten their belts, they may relocate, reducing demand while increasing supply.

For now, the reality of institutional real estate investment remains the same. Smaller players must hunt for more aggressive deals and assume greater risk, even as those deals are increasingly difficult to find. With the stock markets in flux, sharp real estate investors will look for economic indicators showing a slowdown or downturn in the economy. This type of trend — certainly not election results — will usher in the next strong real estate investment cycle.


Jeffrey J. Cohen is president of Metropolitan Properties of America, a real estate investment and management firm based in Boston.

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