A Clash of Cliches - "The Rules Have Changed", but "This Time It's Different"

Have you heard the saying "The Rules Have Changed" when discussing real estate development and investment? Have you heard what got us in to this mess of a recession is the thinking "This Time It's Different"? While the words are different, from my point of view, they really are saying the same thing. Both sayings are always true when taken out of context of the situation being referenced. It is true - the rules have changed in terms of development if you are talking about financing and investment expectations. It is also true that it is different "this" time in the context of the "last time" we have done anything. Every time I kiss my wife it is different.

Ahh, but the fundamentals really have not changed, just our perception of them. True, it is much harder to get a loan today, so that much has changed...since 2005. The pendulum had swung so far to the easy side of getting a loan that it had to swing in the other direction for a while. That does not mean there has been some cataclysmic change that will forever wipe out lending on commercial real estate and development loans. What it does mean is once banking capital has normalized, in terms of the ratio of deposits to performing loans, lending will return. More cash will be needed from borrowers. Shorter terms will prevail for a while. Rates will most certainly be higher. These changes are merely going to be a return to the norm and not a significant departure from standard lending practices 10-15 years ago.

Also true is there is little need for new commercial development for next few years. Vacancy rates in many parts of America are approaching or exceeding 20%. The retail and office vacancy trend will continue until job growth returns. There will always be special circumstances requiring new development (before vacancies are lower) and that is no reason to get excited when a new building or project goes up in your area. This is still America and we like new things.

What has not changed, in a meaningful way, is people. Specifically, investors have not changed as they still want to make money with their capital. There is not much of an appetite for a real estate investment that will yield less than 8% these days. If an investor can get a 10% return on the investment with some degree of continuity then they will generally take the risk of owning a property. Ten years ago, the rule of thumb for non-institutional investors was a target cap rate of 10%. From a 2005 buyer's perspective the world must look like it is crashing all around them with rental rates down and vacancies increasing especially when you consider a 2005 buyer was willing to live with a 6% cap rate. In real terms a cash buyer in 2005 has watched their investment decrease in value by at least half while at the same time had their cash flow also cut in half. For these people, the rules have most definitely changed! What is different this time is they are now broke.

As baby boomers and insurance companies need to put money to "work" and create a predictable cash flow, real estate investment and subsequently development of real estate will come back to sustainable levels. Land will be developed, buildings will be erected and investors will look for yield. The rules really have not changed and it really is not different this time when looking back over the last 50 years. I have a final cliche for you, the more things change the more they remain the same. That my friends, you can bank on.

Unconventional Wisdom

I had lunch with an investor friend of mine on May 18 and we had a very interesting discussion about the economy in general, real estate prices/values and the stock market. First let me say if a man is measured by his friends then I am the richest guy in the world. Not only are my friends smart but they are generous with their time and allow me to probe their thoughts on what is happening but also why it is happening (in their opinion).

My friend sees the general economy as sluggish and thinks it will continue to be flat for some time. He sees much trouble ahead for the commercial real estate market. It may be because there is too much space and not enough tenants or consumers may not be spending enough to keep the tenants in place. Regardless, he sees cap rates heading back to the historic mean of 10%. In english that means retail/strip centers may fall as much as 40% in value from 2006 prices. Compounding the situation is many centers are not stable as in they are not 90% full and most are losing tenants such as Circuit City, Linens & Things and other bygone companies.

On top of that, rents are still falling in centers across America to entice tenants to move from one center to another. Plain and simple, the commercial market IS ugly and will get worse. I have to say I agree with my friend. With that said, I also have friends in areas that are not overbuilt and their centers are staying full and rents are stable but these are in less populated areas.

As for the stock market, I keep reading about how much cash is sitting on the sidelines ready to invest in anything that makes sense. I was talking to my friend about a graph someone sent me that showed money market deposits as a ratio of the S&P and it showed a monster amount of available cash. My friend pointed out how the graph misrepresented the actual amount of available cash because the S&P index is down by almost 50% since a year ago. Therefore there is not twice as much cash as a year ago as the graph indicated, it is more of a reflection of how the S&P is down. My friend really likes SRS (Super Short Real Estate Index) and I will tell you I am also a fan of SRS and I own it as part of my own holdings. All of my investor friends believe the stock market is over bought and we are in a secular Bear Market that just happens to be in a rally.

Back to real estate in general. One thing my friend has been saying for some time now is do not buy (for investment purposes) anything for a year or so. He believes the prices will be the same if not lower a year from now and the chance of further decline is just not worth the risk of marginal returns (rents) and carry costs such as taxes and insurance. In general I agree with him but there are always exceptions and one should keep their eyes peeled for those exceptions (i.e. some distressed bank own property for example). It also depends on why you are buying too. If you are buying to use for your own purposes, then there is no risk of lost expected rental income and you will pay taxes and insurance wherever you live or run your business.

In closing I hope everyone has a great Memorial Day weekend. Stay safe.

Let's Make Hay While The Sun Shines

Remember when everyone was making money hand over fist in the real estate market? Boy the sun was shining then. Now that it is raining cats and dogs in the real estate market, I believe the sun is shining for investors. Sorry to mix my metaphors. I will not go out on a limb and say this is the perfect time to buy because "perfect" means different things to different people. Some investors are looking for income producing properties, and others are looking for an end return on their investment.

With that caveat behind me, I will say this; it is the perfect time to look for/at whatever type of property appeals to you. The market will be flat for some time, so many will want to wait for prices to move up before they buy. I respect that. However, the best properties will be purchased and therefore off of the market first. As prices rise it will be the inferior properties that will be left to choose from. The sellers and developers I am talking to are increasingly willing to deal if you have cash and a quick close. We are emerging from the winter of real estate market cycle and headed into spring. Spring is the time to sew our seed for future harvest. As investors we take on risk, that is just part of the job. That does not mean we need to take on unlimited risk. We can measure risk and take steps to mitigate for present or future risk. If you are concerned that you may buy something too soon, then you may want to take on one or more partners to share that risk with you. Another way to mitigate risk is to only buy when the investment pays for itself in terms of cashflow. The way to make money going forward is to NOT take large risks but a lot of calculated risks.

The market of 2005 is gone forever. It was too good to last and was therefore destined to end. There is nothing wrong with assets that do not double in value every year or two. While the stock market has been trading sideways for the last 6 months I have been buying stocks and selling options against those stocks to lock in a 25% return. In some cases I made 25% and in others I only made 25% while the stock doubled. My point is this; if you protect your principal with risk mitigation, there is nothing wrong with double digit gains. So, while it is raining cats and dogs, let's make hay while the sun shines. I am telling you the future is so bright we will need to wear shades.