In the last two years nearly $300 billion has been invested in commercial real estate, according to Real Capital Analytics, a national and consulting firm focused on the investment market for commercial real estate.  In addition, Real Estate Investment Trusts (REITs) are clocking their competition.  As 2004 wrapped up, the average total return on S&P 500 stocks was just under 11% while the REIT stock index’s total return was up over 31%.

The gains and challenges of real estate make it an attractive career path for many business undergrads and graduates. At a recent MBA career exchange sponsored by Emory University’s Goizueta Business School career management center, Goizueta alumni in the real estate sector spoke to students about the intricacies of the industry.

In a follow-up interview, two of the industry insiders, Randy Evans ‘79MBA, managing director of Eastdil Realty Company LLC, which specializes in capital transactions involving both individual properties and portfolios; and John Webster ‘86MBA, director of Research for Real Estate Management Services Group (REMS Group), which invests in the equity securities of publicly traded real estate companies; spoke with Knowledge@Emory about the current state of real estate investment from their prospective corners of the market.

Capital Flows into Real Estate

According to Evans, there are several reasons money is marching into the real estate market.  The first is the performance of real estate as an asset class compared to alternative investments such as stocks and bonds.  Real estate continues to perform well and predictably, and that appeals to investors still feeling the sting of the dotcom and tech bubble demise five years ago.

Interestingly, in spite of reports that real estate is a bubble waiting to happen, both men vehemently disagree the industry is heading that way.

One reason, Evans maintains, is that unlike other investments, real estate is more transparent.  “There’s a great perception of predictability in real estate,” explains Evans.

That “predictability” has led many institutional investors to increase the real estate allocations in their portfolios. “As an industry, we’ve always been viewed as a hedging strategy or a small part of a portfolio,” explains Evans.  “Now we’re witnessing real estate being viewed as a mature asset class—as a core asset class.”

The strength of this shift, along with low interest rates, also sparked increased investment in REIT mutual funds.  In January 2000, $7.7 billion was invested in REIT mutual funds.  In 2004, according to investment bank Bear Sterns, that number was $44 billion.

“The REIT market has gained acceptance as a legitimate investment sector—both at the institutional and the individual level,” observes Webster.  “The tremendous growth in real estate mutual fund assets reflects the interest people have in real estate funds and in real estate.”

Not only do REITs give small investors a chance to diversify their portfolios by owning real estate properties, they’re a haven for pension funds and other tax-exempt institutions. Like limited partnerships, REITs don't pay corporate taxes as long as they pass the income they receive along to their investors, which they do as dividends (although the income is taxable at the individual level.)  It’s easier to buy or sell REIT assets or shares than it is to buy or sell properties, making REITs a more liquid asset.

“Because of the acceptance of the asset class and search for yield by investors, fund flows to publicly traded real estate have been off the charts,” notes Webster.

Rocketing real estate valuations

While Evans and Webster see the industry as a solid, both agree the skyrocketing prices for real estate sparked by demand and limited supply is changing the valuation landscape.

Because the supply of real estate can’t match the up tick in demand, prices are driven upward as investors compete for a limited supply of available assets in which to invest. As prices move higher, yields fall.  “There has been a sea change in real estate valuations in almost every product type,” notes Evans.  The metrics used to value real estate—from internal rates of return, yields on cash flows, and capitalization rates—have been reduced by 200 to 400 basis points over the past 24 months.  “Real estate is valued differently today that it has been for decades prior,” Evans adds.

Webster views the change in valuations with caution.  “We’re concerned with what’s happening right now,” he says, adding that investors are paying record prices for properties.  “Public market values as a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) are at an all time high.  As value investors, that makes us uneasy.”

If interest rates rise, Webster explains, it’s likely that real estate prices will fall (less demand would result in a dip in prices) and the spread—the difference between an investor’s profit and the cost of his capital—would diminish, making real estate less attractive. “Clearly there is reversion risk for real estate investors,” notes Webster.

According to recent figures, REITs have been priced at a premium to their net asset value (NAV).  “Right now, people are willing to pay more and more for the same amount of cash flow,” adds Webster.

The long-term outlook

“The most essential question being addressed in our industry today,” Evans says, “is whether this a paradigm shift in real estate valuation or will they remain at high levels and will yields remain low?” says Evans.  “I can’t predict accurately the answer.  You can make a good argument that both scenarios might happen.

Although investors’ willingness to overpay for real estate concerns Webster, neither he nor Evans foresees a dramatic shift in interest rates anytime soon.  As long as interest rates remain low, notes Webster, REITs should be a popular investment vehicle.

Evans predicts that money will flow back into alternate investment areas such as stocks and bonds as the economy recovers.  However, he also believes capital will continue to flow into real estate because of the transparency of real estate, the historical performance of real estate, the extended amount of investment in real estate and the fact that people in all real estate product classes are accepting current yields.

“This is not an over-heated bubble, these are hard assets.” says Evans.  “With this sort of universal adjustment in valuation, there could be some degree of permanence.”