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REITs and other 'opportunities.' (evaluation of real estate investment trusts) (Mid-Year Review and Forecast, Section I) (Column)

Before attempting to assess the immediate future for commercial real estate, it's essential that we clarify exactly where we stand, particularly in regard to investment opportunities. To start, there has lately been a good deal of excitement about REITs (Real Estate Investment Trusts). As I see it, the explosion in REITs appears to be a little more late-cycle panic by investors to find the next "hot" area. In other words, it is speculative rather than based on sound analysis.

It is simply too early to bet on a commercial real estate upturn. Moreover, investors in REITs are making completely unrealistic assumptions about the chances of an early rise in property values .

In the late 1980's, the real estate investment mania was justified by expectations of rising property values. However, a building's underlying value depends on cash flow, present and future-nothing else. Investors ignored the fact that the rising excess supply of office, retail and hotel space would inevitably lead to a sharp drop in cash flows that would be inconsistent with rising property values.

I fear that today's REIT investors are making a similar mistake. Cash flows from most buildings will deteriorate in the next few years. Therefore, it is doubtful that prices have hit bottom. After all, there is still a massive excess supply of space -- both in the office and retail sectors. The national average vacancy rate for offices is close to 20 percent with rates in the range of 30 percent in some areas.

The fundamental imbalance between supply and demand means that prices must continue to fall in order to restore equilibrium to the market. It's straight out of Economics 101.

This imbalance will take a very long time to correct. For example, if the trends of the past six years persisted, it would take 30 years to absorb the Class-A space on Houston's central business district. That may represent an extreme case but it will probably take until the late 1990's before the national vacancy rate fails back below 10 percent -- the level that would be consistent with a firming in market conditions.

No doubt there are good deals to be had, but they are extremely scarce. Furthermore, there are too many people chasing these few "bargains." Rather than concentrate on finding that one chance in a million, investors would be better advised to make sure that they avoid being lured in to bad investments on the basis of false expectations about potential price gains. Price discounts of 50 percent or more may sound attractive but these prices represent declines from speculative levels.

Any real investment can only be justified if it promises to deliver a positive cash flow using very conservative assumptions about future rents and occupancy rates. The fact that a building may currently have a good occupancy rate is no guarantee for the future. You need to know both the time profile of leases and tenant creditworthiness in order to assess the risks that cash flows will be undermined by a drop in average rents.

On a more positive note, while speculative real estate development has ground to a halt, buildings are beginning to change hands at more appropriate price levels, reflecting the "anticipated" cash flow with more realistic assumptions. Also, new developments are only taking place in response to firm orders. What's more, real construction on office buildings has plunged 60 percent in the past three years and the economics of the industry should prohibit speculative building for a long time --further helping to rectify the supply/demand imbalance.

Market conditions will improve by the end of the decade if the economy continues to grow. With no new buildings in the pipeline, shortages of space will likely emerge in some areas. By the time that new buildings can be put in place, shortages could be severe, leading to marked upturn in rents. Until then, the challenge for the current generation of developers and owners will be to stay in business and to identify and capitalize on the few real opportunities. The good news is that the true real estate professionals will emerge from this chaotic period.
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Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Hemmerdinger, Dale
Publication:Real Estate Weekly
Article Type:Column
Date:Jun 23, 1993
Words:685
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