Saturday, April 09, 2005

Un-Real Estate

James Grant, 04.25.05, 12:00 AM ET

One real estate sage says he has never seen such "aggravated excess liquidity." That's where too much cash is chasing too few buildings.

Markets look forward, except when they look backward. At this moment the real estate market is looking backward. What it sees is comforting but irrelevant. In the past five years real estate investment trusts have outperformed the Standard & Poor's 500: up 19.1% annually for the Bloomberg REIT index, negative 3.2% for the S&P.

Mistaking the past for the future, people are pouring money into houses, shopping centers, office buildings, hotels, anything with a front door and a roof. They are paying some of the fanciest prices on record.

Property bulls come in all sizes, shapes and net worths. "We are living with the greatest liquidity ever," an eminent REIT promoter was quoted as saying in March in the New York Sun. "We're not going to have a crash in the real estate market, there is too much liquidity."

Liquidity is a term of art. It means lots of money. It can also mean--and, in 2005, does mean--"low interest rates," "E-Z financing terms," "low dollar exchange rate" and "value investors go away." In an evident state of liquidity-induced euphoria, a Miami Realtor recently proclaimed to the New York Times, "South Florida is working off a totally new economic model than any of us have ever experienced in the past."

Not true. The "South Florida economic model" is the oldest in the book. An excess of dollars leads to a drop in interest rates. And a drop in rates to a rise in real estate prices. And a rise in prices to massive new building.

Only later does the same surplus of dollars cause a rise in the inflation rate. This leads to a rise in interest rates. And to a drop in real estate prices, with the market now oversupplied by all that new building.

In the U.S. there are, of course, many buildings. Not all are equally overvalued. No doubt some are cheap, even now. But enough are sufficiently overpriced to give pause to careful investors.

Jeremiah O'Connor, founder and managing partner of O'Connor Capital Partners in New York, is one of these conscientious appraisers of value. In his 35 years in the business, says O'Connor, he has never seen such a virulent case of a syndrome he himself has identified: AEL, for "aggravated excess liquidity."

O'Connor, whose organization manages $3 billion in private real estate investments, is talking about income-producing property. When he started his first REIT in 1971, he believed that real estate was a better investment than common stocks. Both kinds of assets could be expected to return 12% a year. But in real estate 9 percentage points of that return would come from income, 3 percentage points from capital appreciation. With stocks it was the other way around: 3 percentage points from income, 9 from growth.

For many years the standard cash return on income-producing real estate was 9%, O'Connor relates. In booms it was less; in busts, more. But 9% was the number to which it regressed. Today it yields 5% to 7% on average--with all signs pointing to even lower yields just ahead.

Which signs are these? First and foremost, the prevalence of penthouse-level prices. Consider that, in 2000, REIT stocks traded at one-third the multiple of the S&P average. Now REITs and the S&P are neck and neck, O'Connor notes. And as multiples have been expanding, the growth in REIT cash flow--so-called funds from operations, or FFO--has been decelerating.

Then why not sell short the REITs and buy property itself? Because the underlying buildings are themselves overvalued. Over the past ten years bricks and mortar had a cash on cash return averaging 3.3 points over the yield on the ten-year Treasury note, according to O'Connor. Today they yield just 1 percentage point more than that not-very-high number (the ten-year is quoted at 4.5%).

Not born yesterday, O'Connor has participated in three brutal property bear markets: 1974-75, 1980-82 and 1990-92. Note, he observes, that 13 years have passed since the last slump, enough time to have erased the institutional memory.

What experience has imprinted is that because interest rates fall, property values rise. But interest rates stopped falling, and started rising, two years ago.

The bulls proclaim a new era. They say that the cheap dollar makes U.S. property irresistible to foreigners. They insist that assets, even today, are trading at, or near, their fast-rising replacement cost, while refusing to acknowledge that soaring building costs make it harder to pay off a mortgage from rental income.

The dividend yield on the Bloomberg REIT index stands at 5.4%, that of the Vanguard Prime Money Market Fund at 2.5%. A suggestion for the long-term investor: For the higher total return, pick the lower yield.


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