Over the past decade or so, long term investors who have followed the herd, whether it was in high flying internet stocks, or more recently buying homes as an investment in hopes of turning a quick profit have been burned. The massive amounts of liquidity and cheap rates initiated or overseen by the Federal Reserve fueled not one, but two bubbles, the likes of which have not been seen in generations. Prudent asset managers were forced to compete with speculators boasting of impressive, yet short term returns. As we all know now, the dramatic rise and fall of the residential real estate market threatened to take down not only the US financial system, but the global economy as a whole. We will leave the question of whether or not the government’s response to this crisis was appropriate for another day. The reality is that the government chose a course of action which includes massive amounts of printing and borrowing of money in an attempt to ease the stress on banks.
In simple terms, an investor can allocate resources to five different asset classes. These include stocks, bonds, commodities, real estate, and currencies. As the turmoil in the residential real estate market begins to subside, and the economy as a whole begins to digest the various stimulus packages provided by the government, investors should adjust their portfolios accordingly to benefit from and guard against oncoming inflation. Despite the negativity surrounding the real estate market in general, we believe that attractive opportunities can be found in certain regional commercial real estate markets for the medium to long term investor.
The ability of real estate to provide a hedge against inflation is one of the primary arguments for including the asset class in a diversified portfolio. Research on the question of the inflation hedging ability of real estate generally shows that when markets are experiencing equilibrium, the lack of rental space alternatives provides negotiating power for the landlord. By contrast, during periods of high vacancy rates, the negotiating power transfers to the tenant who will have options available to move and/or lower rental expenses. Thus, it is important that the investor consider what kind of companies and industries inhabit a given region and will be positioned well for turnaround growth. For example, since the current downturn has centered on the financial community, major money center metropolitan areas such as New York City will most likely not benefit greatly from inflation unless a new industry quickly emerges to fill the void left by the financial companies who are forced to cut costs and downsize. It is our view that regions which are not heavily concentrated in finance should only see a temporary weakening of rental demand as the economy works its way through the recession and recovers more quickly. With a long term view in mind, we believe that the 2009 inflation rate will remain moderate at best while beginning to pick up steam in the latter half of 2010 at which point the Federal Reserve will have a tough decision to make around raising interest rates. We do not believe that the Fed will be able to raise interest rates in 2010, even with higher inflation, due to fear of damaging the recovery and causing a double dip recession or worse. Therefore, the next 12-18 month period should provide an excellent window to find value in select commercial real estate markets.
Most analysts agree that technology companies, which spent the last 8 years cutting costs and raising cash due to the bubble burst of 2001, may be one of the strongest sectors to emerge from the current recession. In addition to tech, well diversified regional economies with access to the global supply chain, including and especially commodity transportation and the global trade network, should stand to benefit from some of the strongest growth as the economy begins to improve. Finally, regional economies with a high concentration of small business entrepreneurs and professional services should also perform well in a growth scenario. We are beginning to see parallels between the commercial real estate market today and the values seen after the recession of the early 1990’s. With interest rates at a 40-year low, massive fiscal spending by the federal government, and unemployment rates now beginning to stabilize we believe the time is right to invest in commercial real estate in well-positioned markets. However, as value investors, we know that sometimes good prices can turn into outstanding prices with a little patience. There is no substitute for doing the research and diligence necessary for making a good investment. That definitely holds true in this market.
Earlier this month, Paulson and Co., a hedge fund which made billions by correctly anticipating a crumbling housing market, said that it would buy $100 million in stock of commercial real estate services firm, CB Richard Ellis Group. Additionally, the hedge fund company is in the early stages of raising “a couple of hundred million dollars” for a fund focused on a medium- term property recovery. The smart money has always known to enter the marketplace when fear is at its highest. By including commercial with residential real estate, the financial media and misinformed analysts and investors have created an artificially high risk premium for commercial properties. The big difference that many people aren’t recognizing between commercial and residential real estate is that the hype and annual median price increases seen on the residential side were not seen in commercial real estate. After almost two years now of monthly declines seen on the residential side, and some overheated markets such as Florida and Nevada falling as much as 40% from their peaks, we believe the downturn in housing has finally begun to stabilize. And with major commercial operators such as General Growth Properties declaring bankruptcy, the supply of quality properties at good prices are plentiful. Commercial property investors should not expect a straight ride up, but we do think most of the risk of investing in commercial property is already in the price. And there are good reasons to believe that today’s opportunity to invest at decent yields won’t last forever.
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