As a large share of alternative investments we cover at FactRight are real estate-based, we’re chewing on a couple recent blog posts from commentators over at NAREIT regarding current real estate values, which will interest many of our blog readers and clients.
As Calvin Schnure notes in Commercial Property Prices: Froth, or Fundamentals?, commercial real estate prices have significantly exceeded levels pre-Great Recession—approximately 22% above their 2007 peak (per the CoStar Commercial Repeat Sales Index), with multifamily alone almost 50% higher than its 2007 level. Mr. Schnure sets out to identify the extent to which the appreciation is derived from NOI growth, and how much cap rate compression is driving increased valuations.
Thankfully, his research shows that while most of the price growth post-crisis was driven by cap rate compression (froth), over the past four quarters it is has been mostly attributable to NOI growth (fundamentals), especially for multifamily and industrial assets. Commercial real estate values do have some exposure to rising cap rates, of course, but Mr. Schnure notes the current spread between cap rates and long term interest rates are “unusually wide” from a historical perspective, which ought to provide some buffer against rising interest rates.
In This May Be the Time to Hedge Your Private Real Estate Portfolio, Brad Case observes the valuation discrepancies between real estate assets held in public and private vehicles in making the case contained in his post’s title. The cited data suggests that large institutional investors are paying 13% higher prices for real estate assets than could be owned through a publicly traded REIT vehicle. He explains the discrepancy through how quickly market development information is impounded into (1) the price of a publicly traded REIT (daily) vs. (2) how long it takes to be reflected in private transactions (maybe two quarters), and then (3) in private valuations (up to five quarters if assets are only appraised annually). He concludes that that private real estate indexes highly resemble a lagged moving average of a REIT index. (Note, however, that private holdings may not be entirely “overvalued”—some (or all?) of the discrepancy may be explained by facts supporting Mr. Case’s argument that REITs are currently undervalued.)
What do these insights mean for due diligence on real estate programs? Of course, it is always critical to seek to understand the extent to which program returns are dependent on a stable long term cap rate environment, low cost of capital, and reasonable NOI growth (among other factors). But even if fundamentals remain strong, modest rise in cap rates will expose aggressive valuations. Property appraisals—even those obtained at acquisition—may not reflect current market information, and should be viewed as only one indication of value. Due diligence officers, advisors, and their clients ought to pay attention to other benchmarks of value and consider insights from the public markets.