Real estate undertow could pull investors under.

This is the second part of a 2-part series first run in REW Jan 24.

By 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 (Office space demand? Residential demand?), 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.

There are several primary market indicators, all having weighted importance. Included are: 1) Employment rates, 2) Interest Rates, 3) Vacancy Rates, 4) Absorption Rates, 5) Supply/ demand ratios and 6) Realsyche (the processing of societal stimuli and behavioral responses to real estate). Each coefficient impacts capital markets in different ways.

Once these influences are acted upon, the market responds accordingly. Whether it is a capital inflow to real estate or capital exodus, real estate development will be affected. Investment pressures have included commercial office building construction, residential and recently, infrastructure investing. This capital machine, however, is not required to allocate money to real estate.

If this lack of investing, or Tractable-Homeless Capital, sits idle, real estate faces greater alternative investment risks. Capital, by its very nature, is excitable, moving. Tractable-Homeless Capital is capital which remains noninvested, orphaned.

Unhappy in its homeless state, it continues investment quests. At the end of the day, venture-capitalist seek returns and any investment lag is money lost.

So, what other market sectors absorb this capital, and what impact does it have on the office, residential and alternative investment pipeline? This is a very difficult question to answer. The key, however, is to preempt the Tractable-Homeless Capital syndrome (unforeseen real estate investing/alternative investments).

This is accomplished by infiltrating markets that are not ripe, or past prime for investing. This Capital Volatility Model can serve as a hedge and allow investors an opportunity to prepare in advance of capital allocations.

Europe appears to be in proper alignment with investment expectations. Spain continues to see strength in its residential rental market due to high demand, low interest rates and a stable economy. Countries like Estonia, Latvia, Lithuania and Argentina (emerging markets) are experiencing a rise in transparency, together with economic and political stability.

In 2005, the India government opened the door to foreign real estate investors. Since, India has seen remarkable population, income and IT growth (estimate: 3 million square feet shortfall in IT space). Meanwhile, China, a much localized market, has seen GDP growth of 10.1%. Although land-use rights still remain unfavorable, as state owned lands fall into private hands, the need for regulatory change will have a colossal impact on real estate development and investing.

Today, surface currents remain strong. This strength has buoyed the markets' investment success. Capital markets' experienced swimmers are surfing, but in which direction? Sound investors must be sensitive to the shore because in most cases, investors have to dry their feet, investing in stable return sectors.

The weighty surface pressures (short-term, high-yield investments) are forcing some real estate currents to go subsurface, transforming important real estate fundamentals into undertows. This results in investors being pulled away from the shore.

Market exit is as crucial as market entry. Investors, single or co-investor, must align their expectations. With the surge in capital availability for both global and domestic real estate investing, in my opinion, experts must not spotlight entry strategy plans only (Arizona and Florida residential market).

This to me is indicative of two things: 1) irrational investing--non-due-diligence and 2) short-term investment strategies. Fold them together and any real estate advisor would be gravely concerned.

Today, get out your scuba gear. The shipwrecks are plenty--south Florida condo market is well submerged thanks to a flood of capital and short-term holding strategies, compounded by an imbalance in supply-demand. Investors were looking over the horizon, not realizing real estate currents had surfaced. Ultimately, ignored surface currents are as dangerous as sub-surface currents.

The undertow in today's real estate market is in the Tractable-Homeless Capital. Investment forces continue to gather steam as real estate capital continues to stockpile. It is very important that tow-locked investors not allocate capital to past-prime markets.

The undertow (THC) current must reach the surface, allowing investors to make rational investments. Looking back, the collapse of many communist countries at the beginning of the 1990's fueled a surge in the immigrant population both in the United States and Europe. This made for long-term real estate development in many sectors, which in theory, eliminated Tractable-Homeless Capital.

Although this might be a one time event, at present, China's political and economic restructuring will continue to improve its market efficiency. The line starts here: as barriers to entry begin to crumble, venture capitalist will inundate China's fertile economy. The difference, however, between the communist downfall and the China-to-be, will be the speed of investment. Restless industrial property developers will continue to remain patient as their capital, albeit homeless, 'taps its toe'.

Antsy investors will begin to reallocate capital in the early part of 2008. Investments will center around industrial development here (US) and in emerging markets (China), while India and Asia mature as the next growth markets. Residential and office developers' "fill wanted" signs (A.K.A. money) will once again speckle the real estate landscape while office space pressures mount. Residential will remain cool as mortgagors continue to carefully evaluate their financial positions, putting away old "back of the envelope" calculations which got them where they are.

In the end, residential owners will be better swimmers; commercial developers will be wiping the sand from their feet, while waters remain shark infested (lending institutions).

BY CHRISTOPHER P. NESTERCZUK, SENIOR INVESTMENT OFFICER