Market undertow may drag investors down.

During the last decade, the mounting amount of capital poured into the market has continued to press down on capitalization rates. Today, the tide is turning as capitalization rates begin their ascent.

Best estimates indicate there is $9 trillion of institutional grade real estate, one trillion of which consists of cross-border investing. As most savvy investors know, the real estate market is as cyclical as water tides.

For the last five years, the tides have been high with investors swimming, buoyed by global capital chasing real estate projects. Seas have been calm, giving lifeguards plenty of opportunity to soak in outperforming real estate rays. But investors beware: there is a real estate undertow which may have an impact on current markets.

The globalization of real estate has propagated the interconnection of global economies. US and European real estate investments appear ready to outperform most other assets in the near term, but this outlook may be tempered by an assortment of economic concerns.

Consumer debt and rising interest rates will continue to impact real estate performance, while large sectors of the market face surplus capital and a potential lack of investment stock. This is encouraging investors to look for new sources of value in areas including Eastern Europe and South Asia.

Drawing parallels between the dangers of swimming in undertow waters and the current real estate market is quite appropriate.

Undertows are stealthy, under-currents that lie beneath what appears to be calm waters. The physics of the undertow is quite complex. These currents flow erratically, not in steady patterns making them dangerous even to the most experienced swimmers. Rip currents, which are currents flowing at the surface of the water, exit through weaknesses in surface waves. Conversely, undertow currents flow beneath the surface because there is no weak, upper surf to penetrate, and therefore must flow under the waves. Ultimately, one must stay alert and be wary of calm waters.

The real estate market today has very strong upper currents (low interest rates, high demand), forcing many real estate fundamentals to flow under (investment strategies, supply requirements). With real estate continuing to be a safe investment option, the current market will continue to be nourished with capital, the fuel for development and liquidity. The key, however, will be to invest in the proper real estate sectors.

In today's global economy, measures of real estate risk are becoming more and more difficult to isolate. Currency, political and market risks, to name a few, are relentlessly in flux. These risks, for many years, have moved real estate markets through cycles. The sector volatility, for the most part, has been driven by a number of variables, all weather vanes of real estate outlooks.

What does this all mean? Capital will continue to flow into real estate, but in the wake of a revitalized attentiveness to real estate fundamentals and a reduction in expectations (supply-demand), restraint will be more prevalent.

According to surveys prepared by the Urban Land Institute, commercial real estate appears to be swinging from a wildly appraising asset class to income producing. The flow of funds to commercial real estate is surely driven by the demand for space and short-term returns.

For the sake of argument, the tandem relationship of the strong office market and flow of capital make for interesting bedfellows since larger office markets make for greater volatility. It is very difficult for markets to escape capital gravity, making many markets and submarkets volatile.

In the current cycle, smart investors have surveyed the landscape and concluded that many markets are either over-built or too risky. This has resulted in alternative investment strategies such as infrastructure investing.

Certain market sectors are, for the most part, at a crest--office--others in decline--residential. As an example, office absorption rates are holding steady as supply/demand pressures remain balanced. This may very well be caused by the cooling construction market.

Regional residential markets have suffered and, in my opinion, will continue to experience softening through 2008. Although employment remains strong, creative financing will give way to debt service pressures. Residential owners will begin to see mortgage payments rise with minimal salary growth--a mortgage quagmire being felt by some already.

Manufacturing space continues to come at a premium. Typically, industrial is both low risk and stable, requiring little capital improvement. Remaining locality conscious will continue to play a significant role as regional markets (southern California) continue to see increasing space demands.

Although it is very difficult to corroborate market pressures and capital flows, reasonable, sound assumptions, made of measured coefficients, can act as a barometer to foreseeable and unforeseeable real estate currents.

Although real estate is largely a lagging indicator, there are market barometers that nevertheless influence real estate conditions. Most recently, core inflation dropped, indicating an easing on inflationary pressures--good for real estate developers as commodity prices decline, and good for residential investors (in the short term), as spending power remains strong, especially for debt service.

Real estate developers, however, are beginning to reassess investment strategies, sagging construction. This translates to increasing Tractable-Homeless Capital looking for alternative investments.

The undertow, while surreptitious in nature, will have a direct, unconcealed impact on both commercial and residential real estate.

Read Part II in next week's REW.

BY CHRISTOPHER P. NESTERCZUK, SENIOR PENSION FUND INVESTMENT OFFICER