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President's Column
September 2007 - Liquidity
and Real Estate
In the
beginning there was barter.
Fred Flintstone grew corn
and Barney Rubble raised
hogs. When Fred got tired of
eating corn, he began
negotiating with Barney.
Fred agreed to trade bushels
of his corn for one of
Barney’s hogs. This worked
well for both as their diets
were diversified and it
allowed each to specialize.
Barney became better with
each passing year at raising
hogs while Fred got
progressively better yields
with his corn.
Eventually other people
gathered to form the town of
Bedrock, and each
contributed their own
production. This worked well
for several centuries. At
some point in time it became
apparent that a boat builder
could only consume so much
food and only so many
farmers wanted or could
afford a boat. Eventually a
medium of exchange was
devised. Initially, readily
available prized metals were
utilized such as silver or
gold.
This
evolved into the current
system whereby each country
prints their own paper money
or mints coins which have
designated denominations and
whose values float on
exchange markets on a
constant basis.
In
modern society, individuals
perform increasingly complex
and specialized tasks and
are paid in currency of the
realm. Individuals have
various decisions to make as
to how to allocate their
scarce resources; food,
clothing, shelter,
transportation,
discretionary items, etc.
Real estate is one of many
options that individuals can
consider with their
investment.
Real
estate has many unique
characteristics compared to
other investments. It is
fixed in place, i.e.
immovable, while art,
jewelry, securities, gold,
etc. are not. It also
frequently requires
substantial capital
investment. And because it
is occupied by humans, it
requires maintenance and
management.
These
attributes contribute to the
way capital is allocated to
real estate. In general,
real estate can be divided
into three categories; raw
land, residential, and
commercial or investment
(which also includes
apartments). Raw land
typically does not generate
revenue and therefore is
purchased for its future
potential. Single family
residential is typically
owner-occupied and utilized
for shelter. Commercial real
estate can either be
owner-occupied or leased but
typically is utilized to
generate cash flow.
Systems
have evolved over many years
in the United States to
provide financing for real
estate. Usually, the
borrower is required to pay
a certain amount of the
price (down payment) and
borrow the remainder from an
outside source. Lenders have
been various entities
including individuals,
banks, savings and loans,
insurance companies, real
estate investment trusts,
and others. Historically
each had their niche.
Savings and loans were
created to make loans to
families to purchase single
family residences. This was
done to promote the
“American Dream” of home
ownership. Banks were
created to facilitate loans
to businesses and farmers,
and this led to loans on
investment properties and
farms. Insurance companies
had large sums of cash
incoming with regular
frequency and needed to
diversify their investment
and increase their yield.
Subsequently, they made
loans for commercial real
estate. Individuals were not
restricted by as many
regulations and could
therefore create more
diversified types of loans,
sometimes with greater risk.
Lenders
lend money based upon
several factors, including
the specific real property
and its characteristics, the
general real estate market,
the financial ability of the
borrower to repay and
of course, the interest
return over and above the
loan repayment.
Though
state laws vary, whether it
be a mortgage or a deed of
trust, the lender usually
has the recourse of taking
possession of the property
if the borrower fails to
make scheduled payments. The
fixed nature of real estate
gives the lender a sense of
security that the land and
improvements will be intact
if the lender needs to
foreclose. As long as
property values stay
relatively stable; the
lender and borrower are
comfortable. In many
instances the values
appreciate and the
properties are more valuable
then at the time of the
loan. This potential
appreciation is a strong
incentive to prospective
buyers of real property.
Residential real estate has
an intrinsic value often
referred to as “pride of
ownership”. It is also a
function of the need for
shelter. There are many
secondary sources of
financing and many
government and
quasi-government agencies
that guarantee residential
loan payments to lenders
such as FNMA (Fannie Mae)
and FHLMC (Freddie Mac). The
residential financing is a
focus of another article.
The
commercial market has
limited guarantees and
secondary markets. Thus, the
lender typically holds the
note until it is fully paid
off either through the
course of the entire loan or
through an early payoff.
Expected
rates of return on
commercial property have
tended to fluctuate in
tandem with costs of funds.
Thus, when many of the
commercial loans were based
on the prime rate, and if
the prime rate were 7% at
the time, typical real
estate investors expected a
premium of 1 to 2 percentage
points over this rate for
the additional risk and the
management factor for real
estate. A typical
capitalization rate, or rate
of return, would then be in
the 8 to 9% range.
This
rate would be an overall
investment rate and gives no
consideration for
appreciation or leverage.
This is strictly the rate
based upon the purchase
price and the anticipated
cash flow. Any appreciation
would increase the rate of
return and conversely, any
depreciation in future value
would decrease the rate of
return. Historically values
over ten year intervals or
greater have increased in
most markets where the
population is growing. There
has been a perception that
commercial property values
in the Sun Belt, New
England, and the Rocky
Mountain states, with
increasing populations would
continue to escalate.
Leverage
occurs when the borrowing
interest rate is different
than the capitalization rate
and when the down payment is
less than 100% of value. If
interest rates are lower
than cash flow rates of
return, the borrower can
benefit from positive
leverage. In addition, if
the property appreciates
over time, the buyer who put
25% cash down benefits from
100% of the appreciation.
The downside is if the
property depreciates, the
owners' real rate of return
decreases disproportionately
to his/her down payment.
Historically, between 1970
and 2004, capitalization
rates (ignoring the fact of
appreciation/depreciation
and leverage) were in the
range of 8.0% to 10%
depending on use type, age,
and location. Subsequently,
capitalization rates dropped
to the point where 5 to 7%
became more common for well
located retail, office, and
multi-family apartment units
particularly.
This can
be attributed to several
factors but I believe there
were four main causes for
these lowered capitalization
rates. All can be directly
or indirectly related to
greater liquidity. First,
interest rates were at
historically low levels
throughout the 2002 to 2006
period. This lowering
borrowing cost would lead to
a greater rate of return,
all other things equal.
The
second was the appreciation
in value of many single
family residences to the
extent that many homes
exceeded $1,000,000 in
value. When many of these
people sold their residences
and realized substantial
gains, they could acquire
new residences at lower
prices in other locations
and shift the remainder of
their gain to investment
property purchases. This
greater number of buyers
helped keep the prices up
and therefore rates of
return lower.
Another
factor has to do with the
international perception of
the United States. Due to
the perceived stability of
the United States
government, many foreign
investors have been involved
in real estate investment in
the U.S. for several years.
With the dollar relatively
weak, foreign investors
perceived real estate to be
cheaper than normal and
purchased more property
and/or lent more money to
the borrowers for real
estate acquisitions.
The
final factor, but by no
means least the significant,
was the influx of new
financing vehicles to real
estate. Real Estate
Investment Trusts or REITs
have been around for years.
They allow investors who
might not other wise be able
to purchase high dollar real
estate to participate as a
minority owner. REITs
provide property management
for the owners and provide
greater liquidity by selling
shares of stock interest as
opposed to the whole
property. In addition to
minimize risk, REITs are
able to purchase many
properties in many
geographic areas. And for
those who want to
specialize, there are
office, retail,
multi-family, and industrial
REITs. Their influence in
the investment real estate
market has expanded
significantly in the past
few years.
For
these reasons, investment
real estate has seen lower
overall yields than
historically. Is this a
permanent or a cyclical
change? Check back with me
in six months and we can
have a clearer perspective.
Contact Garry:
 Garry
C. Duncan
President/Broker
Circle of Distinction
garry@duncanda.com
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