Favorable interest rates, tight supply, and a strengthening economy bode well for commercial real estate in the US. But at the recent Booth Real Estate Conference, alumni and faculty members probed the topic in true Booth fashion.
They questioned whether risk is being mispriced and pointed out that the buying power of US households has been weakened by poor income growth and high debt.
Despite the favorable conditions for commercial property, owner-occupied residential real estate is likely to remain a soft spot, said Amir Sufi, Chicago Board of Trade Professor of Finance. The strong rebound in prices from 2011 to 2013 “should be viewed as a bounce-back from the excessively depressed housing market” and is unlikely to continue, he predicted. He does not expect prices or investment in housing to grow beyond consensus forecasts in the next two to three years, even if interest rates remain low. And the rate of home ownership probably will keep falling.
This is a direct function of the weak economic position of the median US household, which has suffered poor income growth, low levels of wealth, and high student-loan debt burdens, he said. “Unless median income growth improves, I don’t see how we beat forecasts. I don’t see how we generate house price growth and residential investment. Forget about the boom years; I don’t see how we get back to 2001 or 2002 levels.”
In contrast, investors in commercial real estate find themselves in a sweet spot, said Kenneth P. Riggs Jr., ’94, president and CEO of Real Estate Research Corp., a Situs company. Interest rates likely will stay low, occupancy rates are strong, rents are going up, and there is not much fresh supply coming onto the market.
Riggs took an informal survey, asking attendees if they thought the market would be “great” in the next 12 months. Plenty of hands shot up. A slightly smaller number thought 2015 would be average. “And how many think it will be worse?” No hands.
That could be cause for concern. “Are we entering an overpriced phase, basically a bubble?” Riggs asked. “Are the values supportable, relative to the prices paid? Why don’t we anticipate things?”
Or, is yield being chased and is risk being mispriced? is the provocative formulation of Joseph L. Pagliari Jr., clinical professor of real estate, who organized the eighth annual symposium. As one of the day's presenters, Pagliari spoke of the need to better understand the impacts of leverage and fees (and costs) upon the investor's net return. From his analyses, too little attention is paid to these impacts and, accordingly, investors in short-term, high-risk/high-return real estate strategies frequently underperform long-term, low-ris/low-return real estate strategies.
Riggs said he believes real estate is "reasonably priced" right now but is troubled by what may be lurking under the surface. "I don't understand why we did not see the subprime crisis," he commented, and suggested that things might not be as they seem, as was the case seven or eight years ago.
People misread circumstances and other people all the time, observed Nicholas Epley, John Templeton Keller Professor of Behavioral Science. We are all much more assured of our ability to comprehend the world than we should be. "The problem in social life is not imcompetence. The problem is overconfidence," he explained. "We think we undersnd each other, our client, our adversaries, our future selves, better than we do."
If married couples, after 30 years together, can be astonished by how poorly they understand each other, as behavioral research indicates, then it's no surprise that even sophisticated, knowledgeable authorities in their industry--real estate investors, perhaps--might fail to see the warning signs of the disaster around the next bend.
People don’t know how to evaluate the evidence before them. David Twardock, ’82, principal at DT Capital and the former president of Prudential Mortgage Capital Co., was in China last year with his wife. On the ring road outside a major city of 10 million he counted 123 major buildings under construction and dozens more finished buildings sitting empty.
“I started asking around: ‘Who holds the bag here?’ A lot of the GDP of China is tied up in these buildings.” He asked his Chinese friends what to make of these projects. “They said, ‘Don’t worry. They’ll move people in from the rural areas.’”
“I worry anyway,” Twardock said in his keynote speech. The overbuilding in China could have global economic consequences. “How do we understand what others think, believe, feel, and want?” he wondered aloud. In 2007 his company looked at the subprime market and decided it wasn’t likely to significantly impact the broader economy. “There was a bubble staring us in the face. We were the experts and we didn’t see it.”
Speakers on the capital markets panel said they didn’t believe there is overbuilding in the United States and capital flows remain strong. Money is moving into real estate, and huge funds such as CalPERS, the California state pension plan, have indicated they will raise their allocations in real estate. “Capital is arriving from every corner, with no signs of abatement,” said Bruce Cohen, ’89, chief executive of Wrightwood Financial. “These strong fundamentals and tailwinds from the capital markets will make this an outstanding investment vintage.”
Eugene “Gene” Gorab, ’89, president and chief executive officer of Greenfield Partners, sees “robust rent increases in industrial and commercial. We haven’t seen a lot of supply additions on the office side, other than in major markets.” David A. Helfand, ’90, CEO at CommonWealth REIT, said his outlook was “generally pretty good.” He foresees virtually no supply coming on in the secondary markets where they operate, and expects improved occupancy rates this year.
Given the ability to borrow at favorable rates and the underlying strength of the economy, “We’re gearing up for a pretty interesting development cycle,” Gorab said. “I just hope rates stay low so we can exploit it, and rents continue to go up.”—J. Duncan Moore Jr.
More on the Real Estate Conference: A letter from Professor Joseph Pagliari, as well as conference videos and PowerPoint presentations.