This article, featured on National Real Estate Investor, was written by Peter Burley, Director of the Richard Rosenthal Center for Real Estate Studies, and David Lynn, CEO of Everest HIP.
As a part of an investment and portfolio management regimen, one can track such metrics as replacement costs, peak pricing, spreads (cap rates over corporate and government bonds) and replacement rents. In the main global gateway markets—New York, London, Tokyo, San Francisco, etc.—all of these metrics, save average spreads, indicate that the assets in these markets may be overpriced and headed into bubble territory.
In the years preceding the last commercial real estate pricing run-up, pricing hit new, all-time highs;
replacement cost became a quaint, old-fashioned metric, and replacement rents were replaced by ever-escalating rents based on forward-looking pro forma to make any acquisition and most developments look promising. Most tellingly, despite rising interest rates, spreads were below their historical averages in most core gateway markets, even becoming negative, seemingly driven by “animal spirits” and the sense that the market could only go higher amidst an environment of optimism, despite uneven fundamentals.
While spreads are wider today, fundamentals are generally improving and rates are very low, pricing does not justify current rents in many markets. Yields on prime core gateway properties have sunk to the 3 percent to 4 percent range, making the margin for error very slim, or null, if cap rates were to decompress as they did from 2008 to 2009. The situation is exacerbated, of course, by leverage. The last bubble was characterized by excessive leverage (sometimes reaching 90 percent or more) on many core assets in gateway markets.
The current environment is not that bad, but it looks likely to worsen in terms of these buying metrics. It will likely worsen with the wall of capital that keeps on rising and flowing to commercial real estate. The returns to private equity real estate over the last four and a half years have been very attractive, inducing more investment capital to enter the sector. Moreover, the United States has been one of the best real estate markets in the world over the same time period.