Money & Real Estate

How to overpay for real estate without seeming to do so In "hot" commercial real estate markets today, there is a near feeding frenzy among buyers seeking to add to their property portfolios - especially real estate investment trusts (REITs). This has driven property prices up to levels where true going-in yields are not really competitive with alternative forms of investments. But buyers often do not want to admit that they are buying at prices that provide overall cap rates of under 8%. So they indulge in other practices that enable them to pay such high prices without actually seeming to do so.

Most of these other practices involve using forecasts of future income and expense flows that are unrealistically favorable. I recently spoke to someone engaged in selling a whole package of properties in a bidding process supervised by a well-known national brokerage firm. He remarked that several dozen assumptions were made in arriving at the numbers in that package. He said that any one of these assumptions could probably be defended as at least possible, but the combination of all of them occurring that favorably at the same time was, in reality, quite remote. However, the potential buyers - though engaged in due diligence - were eager to acquire these properties, so they were willing to accept these optimistic forecasts in order to justify their own high bids without seeming to accept very low cap rates.

Another tactic is making low going-in cap rates seem more acceptable by gambling that some future events will offset them. For example, if the buyer assumes that interest rates will fall in the near future, then the buyer can refinance the properties being acquired at lower debt service costs, thereby raising net income and the associated cap rates.

These considerations are relevant to the current debate in real estate circles about whether there will be as much overbuilding in this property cycle as there was in the late 1980s' cycle. Many observers claim that, since the current upward movement of property prices is being propelled mainly be REITs and REITs can raise more capital mainly by floating more stock issues, the stock market will act as a check on REIT behavior. If any REITs start paying such high prices that they are diluting their overall yields or if they start developing many new properties that are not profitable, the stock market will swiftly stop making more capital available to them - thereby choking off overbuilding before it goes very far.

But how will the stockholders of REITs know whether those REITs are paying excessive prices if the going-in cap rates the REITs report publicly on their purchases are accretive, rather than dilutive? And that can easily be the case because many REITs are accepting overly optimistic estimates of future income and expense flows, rather than because the prices they are paying are, in fact, reasonable.

Furthermore, how will the stockholders of any REIT know whether it is engaging in too much new development until long after the projects involved have been launched? Right now, a new nationwide development boom is under way across most markets for most commercial and industrial properties. Probably most of these projects are justifiable because of the continuing strength of the American economy and resulting expanding demands for space. But hotel occupancy rates have recently fallen for the first time in several years, and industrial vacancy rates are also falling in some markets. These signs indicate some overbuilding is already here.

It has long been my belief that whenever any investors have a lot of cash that they believe they must invest for some reason, they are going to make mistakes in judgment by paying too much, buying too many existing properties or developing too many new ones. That is because their executives are rewarded in the short run for reaping fees or expanding their portfolios - things that are easily measurable - not for exercising prudence - something very hard to measure. This has happened to every type of financial institution that found itself in this position, including savings and loans, banks and pension funds. Right now, REITs are in precisely this position. They have a lot of capital, they feel enormous pressures to grow larger, and so they are out beating the bushes for more properties to buy - and many are beginning to develop new properties. In the long run, "the truth will out." But by then, a notable amount of overbuilding may already have taken place.

* They accept optimistic forecasts to justify their own high bids without seeming to accept very low cap rates.

* They make low going-in cap rates seem more acceptable by gambling that some future events will offset them.

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