Real Estate Pricing: Spreads & Sensibilities: Why Real Estate Pricing Is Rational

Journal of Real Estate Portfolio Management, Jan-Apr 2004 by Chen, Jun, Hudson-Wilson, Susan, Nordby, Hans

Executive Summary. Some investors believe real estate has become overpriced because cap rates seem numerically low when compared with historical rates. Cap rates do not, by themselves, signal an over- or under-priced market, or a cyclical or secular trend. One needs to look at the connections between the capital markets and the real estate markets, and to look at the relative investment environment as captured by cap rate spreads-a good measure of the real estate risk premium. This paper presents an analysis of the interactions between the capital markets and property market fundamentals that drive asset pricing. The findings indicate that real estate in most property types still looks reasonably priced.

Introduction

Where do I invest my money? This is the question pension plan sponsors, private investors, investment bankers, really everybody, asks themselves each day. Investors can put their money into stocks, bonds, real estate, their mattresses, or any number of riskier alternatives such as antique cars, fine jewelry, or venture capital. Investing is always, always, always a relative game, and the performance of one asset class should not only be judged against its own history or benchmarks, but rather, investments must be compared to their alternatives.

This article explains real estate pricing in two parts. The relationship between real estate and its investment alternatives is the first area that needs to be examined when assessing whether real estate equity investments are attractive or overpriced. This paper begins by examining a ten-year track record of real estate and alternative investments' performances. Next, an analytic framework is developed to assess the over or undervaluation of real estate. Then, there is a historical examination to see if this framework holds up. Finally, each property type is examined to see the connections between property market fundamentals, pricing and the capital markets. The article concludes with some investment recommendations.

Real Estate Performance and Pricing-A Historical Interpretation

Real Estate versus Alternative Investments

Investors, burned badly by public equities and venture capital markets and increasingly concerned about achieving attractive returns in the bond sector, have turned their attention toward real estate. The performance of real estate debt and equity over the past ten years makes a compelling case for this attention.

Over the past ten years, real estate investments have been top performers when compared to the leading investment alternatives. The NAREIT Index (leveraged institutional quality public equity real estate) takes first place with a 10.1% total annualized return. The NCREIF Index (which is composed of unleveraged, institutional quality private equity real estate) was a close second with a 9.6% total annualized return and the Gilberto-Levy Mortgage Index, which measures the performance of commercial and multifamily real estate debt, was in fourth place with a 9.0% total return. In comparison, the Wilshire 5000 was third, posting a 9.5% total annualized return and the Lehman Government/Credit Bond Index (U.S. bonds) placed fifth at 7.4%.

Over the past two years, interest rates have plummeted and, correspondingly, domestic and global (ex-U.S.) debt has been a strong performer, accompanied by real estate debt. Over this time period, all forms of debt have come out on top versus equities. However, despite the recent increase in interest rates, yields on debt are now low versus history, and many believe there is more downside in the debt market than upside. In fact, one pension fund consultant refers to institutional bond portfolios as "ticking time bombs." A 100 basis point interest rate increase on a 10-year treasury yielding 4.0% produces a capital value loss of 7.8%, a worrisome result for investors seeking safe returns from treasury bills or other forms of debt. Also, through the bull and bear stock equity markets of the past ten years, real estate has not generally lost money. No real estate sector posted negative returns in any period shown over the past ten years. In comparison, the Wilshire 5000 and Dow Jones World Stock Index have been deeply in the red for most of the last five years.

Going forward, stock market gurus like Warren Buffett, Byron Wein and Roger Ibbotson are forecasting stock equity returns in the 5% to 9% range. By comparison, unleveraged real estate returns for the office, apartment, retail and warehouse property types, which Property & Portfolio Research, Inc. forecasts at an average of 7.8% for the 2003 to 2007 period look very attractive. What's more, stock market indices present leveraged performance. Publicly traded companies have debt, and quite a bit of it, too. If average forecasted stock market returns are de-leveraged from 10% using current five-year corporate debt rates, plus a few other reasonable assumptions, the unleveraged return of the stock market would be about 7.3%.

Real estate investments are also attractive because most of the returns come in the form of cash from rents. Between 1982 and 2002, 100% of the average returns in commercial real estate came in the form of income returns. In comparison, during the same time period, 27% of returns from the S&P 500 came from dividends, whereas 73% resulted from increases in capital value. In this era of increasing corporate bankruptcies and financial shenanigans, many investors appreciate the security of obtaining realized cash returns, instead of potential capital gains, based on sometimes questionable accounting statements. Exhibit 1 shows historical cash returns since 1979 for the NCREIF Index, the S&P 500 and the 10-year Treasury bill. Using these data, real estate is currently yielding 8.3%, well within its historical range of 7% to 9%. In comparison, the S&P 500 dividend yield has fallen to 1.7% and the 10-year Treasury to about 4%, versus averages of 3.3% and 8.2%, respectively, during the same time period.