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Un-Real Estate.
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Author: Grant, James
Section: Yes, But
One
real estate sage says he has never seen such "aggravated excess
liquidity." That's where too much cash is chasing too few buildings.
Markets look forward,
except when they look backward. At this moment the real estate market
is looking backward. What it sees is comforting but irrelevant. In the
past five years real estate investment trusts have outperformed the
Standard & Poor's 500: up 19.1% annually for the Bloomberg REIT
index, negative 3.2% for the S&P.
Mistaking the past
for the future, people are pouring money into houses, shopping centers,
office buildings, hotels, anything with a front door and a roof. They
are paying some of the fanciest prices on record.
Property bulls come
in all sizes, shapes and net worths. "We are living with the greatest
liquidity ever," an eminent REIT promoter was quoted as saying in March
in the New York Sun. "We're not going to have a crash in the real
estate market, there is too much liquidity."
Liquidity is a term
of art. It means lots of money. It can also mean--and, in 2005, does
mean--"low interest rates," "E-Z financing terms," "low dollar exchange
rate" and "value investors go away." In an evident state of
liquidityâ€"induced euphoria, a Miami Realtor recently proclaimed to the
New York Times, "South Florida is working off a totally new economic
model than any of us have ever experienced in the past."
Not true. The "South
Florida economic model" is the oldest in the book. An excess of dollars
leads to a drop in interest rates. And a drop in rates to a rise in
real estate prices. And a rise in prices to massive new building.
Only later does the
same surplus of dollars cause a rise in the inflation rate. This leads
to a rise in interest rates. And to a drop in real estate prices, with
the market now oversupplied by all that new building.
In the U.S. there
are, of course, many buildings. Not all are equally overvalued. No
doubt some are cheap, even now. But enough are sufficiently overpriced
to give pause to careful investors.
Jeremiah O'Connor,
founder and managing partner of O'Connor Capital Partners in New York,
is one of these conscientious appraisers of value. In his 35 years in
the business, says O'Connor, he has never seen such a virulent case of
a syndrome he himself has identified: AEL, for "aggravated excess
liquidity."
O'Connor, whose
organization manages $3 billion in private real estate investments, is
talking about income-producing property. When he started his first REIT
in 1971, he believed that real estate was a better investment than
common stocks. Both kinds of assets could be expected to return 12% a
year. But in real estate 9 percentage points of that return would come
from income, 3 percentage points from capital appreciation. With stocks
it was the other way around: 3 percentage points from income, 9 from
growth.
For many years the
standard cash return on income-producing real estate was 9%, O'Connor
relates. In booms it was less; in busts, more. But 9% was the number to
which it regressed. Today it yields 5% to 7% on average--with all signs
pointing to even lower yields just ahead.
Which signs are
these? First and foremost, the prevalence of penthouse-level prices.
Consider that, in 2000, REIT stocks traded at one-third the multiple of
the S&P average. Now REITs and the S&P are neck and neck,
O'Connor notes. And as multiples have been expanding, the growth in
REIT cash flow--so-called funds from operations, or FFO--has been
decelerating.
Then why not sell
short the REITs and buy property itself? Because the underlying
buildings are themselves overvalued. Over the past ten years bricks and
mortar had a cash on cash return averaging 3.3 points over the yield on
the ten-year Treasury note, according to O'Connor. Today they yield
just 1 percentage point more than that not-very-high number (the
ten-year is quoted at 4.5%).
Not born yesterday,
O'Connor has participated in three brutal property bear markets:
1974-75, 1980-82 and 1990-92. Note, he observes, that 13 years have
passed since the last slump, enough time to have erased the
institutional memory.
What experience has
imprinted is that because interest rates fall, property values rise.
But interest rates stopped falling, and started rising, two years ago.
The bulls proclaim a
new era. They say that the cheap dollar makes U.S. property
irresistible to foreigners. They insist that assets, even today, are
trading at, or near, their fast-rising replacement cost, while refusing
to acknowledge that soaring building costs make it harder to pay off a
mortgage from rental income.
The dividend yield on
the Bloomberg REIT index stands at 5.4%, that of the Vanguard Prime
Money Market Fund at 2.5%. A suggestion for the long-term investor: For
the higher total return, pick the lower yield.
PHOTO (COLOR)
~~~~~~~~ By James Grant
James Grant is the editor of Grant's Interest Rate Observer. Visit his homepage at www.forbes.com/grant.
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