In America, certain cities have enjoyed nice price increases, but the phenomenon seems more directly tied to employment growth and the failure of builders (or those cities’ permitting departments) to keep up with demand.
Property is, in many areas, considered to now be about fully valued; interest rates can seemingly only go up; and the current low rates have been low for so long now that some observers fear a market top. Why are other observers less concerned?
Low Interest Rates Fuel Exuberance Abroad
Key cities in Canada, Australia, and Sweden are all seeing price gains of over 10% from a year ago. Such gains are likely unsustainable – yet such fears don’t seem great enough to prompt a change in national interest rate policies. Weak growth since the Great Recession “has kept central banks in the game much longer than anyone would have expected,” said Stephen Poloz, Governor of the Bank of Canada, that country’s central bank.
The problem is that central banks can’t address housing concerns with higher interest rates without simultaneously triggering a recession in the broader economy, and global developments such as the Brexit vote have raised uncertainty about global growth outlooks. “When policy rates globally are very low, it’s not in the cards for us to embark on a path which is radically different,” said Sweden’s Riksbank Governor Stefan Ingves.
America’s Growth Seems Reasonable
In America, certain cities have enjoyed nice price increases, but the phenomenon seems more directly tied to employment growth and the failure of builders (or those cities’ permitting departments) to keep up with demand. Denver, Seattle and Portland, Oregon, enjoyed double-digit price increases in the year ended in March, but those cities also saw employment growth of more than 3 percent. Other recently hot cities have started to cool. San Francisco, New York and Los Angeles all showed seasonally adjusted price decreases in May from the prior month.
Supply Constraints Affect Cities Differently
Home prices are tied not only to interest rates and local demographic factors but also to new construction that brings on added supply to the housing stock. History suggests, in fact, that real home prices have grown relatively slowly over the last century – perhaps because of the relatively easy supply response to increasing demand. As prices rise, builders take on more construction projects and the resulting new supply eventually permeates the market and keeps prices down.
This can take time, though, especially where cities make it difficult to promptly create such supply add-ons. Local permitting policies do matter. Places such as Las Vegas; Raleigh, N.C.; and Atlanta have been able to meet rising demand with additional housing units pretty consistently over the past 20 years, with average building permit approval periods of about four months. In New York and coastal California markets, though, new housing supply is slowed; permitting processes in Los Angeles, New York and San Francisco average eight to 12 months.
Housing Seems Healthy, but Prices May Be Slowing
The S&P CoreLogic Case-Shiller Index showed that home prices in 20 U.S. cities rose less than projected in May from a year earlier and actually declined in each of April and May of this year—the first back-to-back price drop in two years.
Robert Shiller, a 2013 Nobel laureate in economics, professor of economics at Yale University and the co-creator of the Index, has prominently noted that home prices, when corrected for inflation, were nearly flat for the century ending in 1990. For Shiller, the more interesting feature of the current housing landscape is how demand has recently skewed toward homes in central cities, rather than in more spacious distant suburbs. Imbalances are created more easily where the where land is scarce.
Is Value-Add the Way to Play?
Because of the supply constraints found in some markets, acceptable investment return rates may well be increasingly driven by value-add strategies rather than merely well-timed property acquisitions (which are increasingly difficult anyway). In more stabilized markets, the execution of business plans based on property upgrades or operational improvements becomes of heightened importance. Real estate companies that create value and execute strategically on their business plans are more likely to achieve attractive risk-adjusted returns.
If some markets are perceived as being fully valued, then the cost advantages available in projects involving minor redevelopment work may also wind up providing more downside protection than may be commonly perceived. If stabilized core assets are substantially fully valued, then “total return” assets – like value-add real estate opportunities – may perhaps be relatively underpriced.
Value-add strategies are normally seen as involving greater risk, but potentially greater returns, than strategies focusing on already stabilized “core” properties. A value-add approach generally relies on greater leverage, increased reliance on renovation or development and (sometimes) a focus on secondary markets. If done correctly, though, the refurbishment or enhanced property management of a property can often lead to a “re-grading” by the market of the property’s quality and thus to potentially increased revenue from greater occupancy and higher rental rates.
Because of these risks, value-add strategies require significant market expertise by the real estate companies sponsoring an investment opportunity. These sponsors must have enough local market knowledge to acquire and reposition older assets by introducing property upgrades or operational improvements that are valued in that market region. Sponsors must evaluate local market information, factor in the cost and time of construction and determine whether they see a higher and better use for the property. The construction risks of such projects include the possibility of higher-than-expected costs (financing, materials, or labor) and uncertainty about the future economic environment, i.e., whether the then-current market rates at the time of the project’s completion will support the costs incurred by the construction.
Commercial Real Estate Remains Worth Considering
Commercial real estate fundamentals — such as demand, occupancy and rents — remain strong, which has kept property values up in the private market, said Steven Marks, a managing director at Fitch Ratings who specializes in U.S. REITs. The famous (and successful) Yale Endowment model has long stressed the importance of alternative assets like real estate – and its 20-year investment return rate is nearly 14%. “Investments in real estate provide meaningful diversification to the Endowment,” it said in its 2015 annual report. “A steady flow of income with equity upside creates a natural hedge against unanticipated inflation without sacrificing expected return. … While real estate markets sometimes produce dramatically cyclical returns, pricing inefficiencies in the asset class and opportunities to add value allow superior managers to generate excess returns over long time horizons.”
Private investments in commercial real estate are subject to significant risks. All of the investments listed by RealtyShares, for example, are private offerings, exempt from registration with the SEC. The required disclosures associated with the offerings are therefore less detailed than an investor would typically expect from a registered offering, and ongoing disclosure requirements are negligible. The offerings are also illiquid, with no preset liquidity terms. An investor should have no expectation of liquidity before the final liquidation of the real estate project. Because these offerings are only available to accredited investors, the liquidity in any circumstance will be more limited than for registered, publicly traded securities. Lastly, all investment involves risk of loss, and past performance is not indicative of future results.
About the Author
Lawrence Fassler, an attorney and real estate investor, is Corporate Counsel of RealtyShares, a leading real estate investment marketplace that places equity investments through North Capital Private Securities Corporation; a registered Securities broker-dealer, and member of FINRA/SIPC. RealtyShares as an institution does not advise on any legal issues, and this article is for general information only and does not represent professional legal advice. Contact the author at firstname.lastname@example.org.