The commercial real estate industry has been flooded with capital since 1997. Unable to find decent yields from other forms of assets, investors flocked to real estate, especially after the stock market crash in 2000. The result has been a Niagara of capital that has driven property prices upward and compressed yields to low levels.
True, the capital flow into housing markets is slowing down and home prices are flattening or declining. Yet capital is still abundant in nearly all commercial property markets. But how long can such a massive influx of capital continue? This column explores several developments that might choke it off, especially since so many deals are 100% financed by loans.
Possible liquidity busters
The first possible disruption could be the collapse of a large hedge fund or private equity fund. If such a fund miscalculated and went broke, the credit fallout might cause a cascade of liquidity crunches among many real estate investors. That could weaken the willingness of investors to keep buying real estate paper.
A second possible jolt to real estate capital flows would be an unexpected adverse event in the world economy, such as a radical Muslim revolution in Saudi Arabia. If successful revolutionaries cut back drastically on Saudi oil production, oil prices would skyrocket, creating economic uncertainties that would drive interest rates higher. An economic shock could reduce the profitability of real estate deals by drastically raising borrowing costs and stimulating inflation.
Conversely, a sudden favorable development in world affairs such as a genuine peace agreement between Israel and the Palestinians could cause a lot of capital that had found a safe haven in REITs and property lending to go back into the broader equities market. But even if it did occur, some of the capital that has shifted into real estate would remain in place due to a paradigm shift. Investors today are much more inclined to hold more of their assets in real estate than was the case before the stock market crash of 2000.
A much more probable cause of reduced capital flows into real estate would be a development boom. That could occur if investors become discouraged from buying existing properties due to intense investor competition and relatively low yields. In the past, whenever competing investors drove the prices of properties so high that yields dropped sharply, many developers began to build again.
Such a development boom is already underway in lifestyle shopping centers, industrial properties and high-rise condominiums. Developers always think they can earn higher yields from new projects. But if enough new projects are started, those yields might never appear. That could lead to a massive oversupply of properties similar to what occurred in the late 1980s and early 1990s.
Up to now, a combination of steep construction costs, high vacancies, a challenging entitlement process, and investor fears of getting burned have blocked a development boom. But there is a chance that such a boom may get underway in 2007, if money remains plentiful.
Housing market is a wild card
Another possible cause of slower capital flows into real estate would be a major collapse in housing prices in some large markets, especially those where many loans to homebuyers have been of the no-money-down type. The high-rise condo markets in Florida and Las Vegas are particularly vulnerable, but that's not the case with single-family homes.
Most owners of single-family homes who have been trying to sell them at high prices would quickly remove their homes from the market if prices fell drastically. Owners would rather wait for prices to recover than accept prices far below what they believe their homes are “really worth.” So far, housing price declines have been rather small and confined mainly to the Northeast and Midwest.
The final potential cause for a hiccup in the flow of capital would be an economic recession that would reduce demand for space among both commercial and residential users. I do not believe that such a recession will occur in 2007, though growth in real gross domestic product (GDP) will be lower than in 2006.
In any case, the high volume of capital flowing into real estate can't last forever. Investor competition in property markets has driven yields so low that investors are going to begin considering alternative uses of their money sometime soon. That is one reason it is still a good idea to sell properties you do not want to hold forever before easy credit disappears.
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 [email protected].