American real estate markets have been flooded with capital from multiple sources that have profoundly affected market conditions. Surprisingly, this flood is not going to slow in the near future, and may even accelerate. This column discusses the causes and impact of this immense influx of money.

The most important factor is a worldwide shift in the attitude of investors concerning how much of their assets should be allocated to real estate. One reason for this shift is that the stock market suffered big losses from 2000 to 2002, and blue-chip accounting scandals surfaced. A second cause is very low interest rates, which means tiny yields on bonds — plus a threat of falling bond values if rates start rising.

So, there has been a huge shift of assets out of fixed-income investments into real estate, which has provided better yields than either bonds or stocks. Yet $2.5 trillion is still in money-market funds earning less than 2% per year, so more money could make this change.

Transparency Is Key

A third cause is the high level of global uncertainty, which has kept the stock market moving sideways and downward. Even after the U.S. presidential election, Iraq, world terrorism and high oil prices threaten to keep uncertainty high. Still another cause is the flood of capital into hedge funds, which supposedly invest in complex but risky derivative transactions. Such funds now hold over $1 trillion dollars.

As one expert noted, “Hedge funds are no longer a distinct investment strategy, but a wrap to put around all forms of assets to justify high fees.” As more capital has gone into hedge funds, they have diversified their activities, and are pouring money into real estate to get high cash flows.

Yet another positive factor is the increased transparency in the real estate business. That transparency has helped investors justify their reduction of the high-risk premium they put on real estate.

The final cause is real estate's ability to provide attractive dividends. This appeals both to baby boomers entering retirement and to pension funds needing cash for their retirement obligations. New instruments like private real estate investment trusts (REITs) are making it easier for average individuals to invest in real estate.

Cap Rate Compression

All these factors combined have produced a flood of capital gushing into real estate investments, from single-family homes to REITs and commercial mortgage-backed securities (CMBS). This immense inflow has driven cap rates down to very low levels via intense competition for properties.

True, markets differentiate between well-occupied properties with long-term leases vs. high-vacancy properties where rents are falling. So, there are still many distressed properties that opportunity funds can seize upon.

Part of the drop in cap rates has resulted from the general decline in interest rates, but it is also due to the shift in allocation attitudes. This flood of capital has produced the widely recognized disconnect between adverse conditions in space markets — high vacancies and falling rents — and positive conditions in investment markets that result in rising prices and intense competition among buyers.

What to Expect in 2005

In a normal cycle, economic expansion would cause a rapid increase in demand for capital to cover the cost of plants and equipment and inventories. Moreover, rising prosperity would cause stock prices to escalate, drawing funds away from real estate. General prosperity also would raise interest rates, making bonds more attractive and increasing real property operating costs.

But this cycle exhibits slower growth than most. Despite the Federal Reserve's determination to raise short-term interest rates, long-term rates have not ticked up much. High oil prices are even threatening to slow consumer spending, which has made retail real estate the jewel of this cycle. Nothing in the near term seems likely to slow down the determination of investors to pour more funds into real estate.

Furthermore, slow growth has kept high vacancies and weak rents in space markets, especially in offices. So another accompaniment of rising prosperity — a new development boom — has not yet begun. Except for new lifestyle retail centers and condos, property construction has been dampened by low rents and high vacancies.

Also, construction lenders are constrained by the advent of Sarbanes-Oxley and corporate accounting scandals. Thus, the flood of capital into property markets remains focused on existing properties rather than new development, further compressing cap rates.

Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at anthonydowns@csi.com.