Institutional investors are not pricing their real estate investment realistically and could be in for a shock when the value of their portfolios decline, according to a new report.
Return expectations are based on the current rosy real estate picture and investors are not considering how global economic changes will affect their local investments, said Randy Mundt, chief investment officer for Principal Real Estate Investors and co-author of a new report sponsored by Principal, Torto Wheaton Research and Real Estate Research Corp.
"I think there will be some disappointments because in our view, real estate is increasingly priced to perfection," said Mr. Mundt, who is based in Des Moines, Iowa. "Investors are assuming that rents will go up strongly, that interest rates will stay low and residual cap rates will stay very, very low. Almost all assumptions are very optimistic, and there is no room for a downside."
Returns for unleveraged core real estate are expected to decline to 7% to 8% in the coming year, the study noted. By comparison, the NCREIF Property Index rose more than 19% for the year ended Sept. 30.
Institutional investors are becoming desensitized to risk as they take on more in their portfolios. Real estate has been on its longest-running ride in history. Returns have remained robust despite high vacancy rates and rising prices, factors that should have pushed down returns, Mr. Mundt said. Low interest rates and a massive amount of capital inflow have kept returns high.
According to the report, the total U.S. institutional quality real estate market is estimated around $3.5 trillion, with U.S. commercial real estate equity estimated to be $1.16 trillion. About 19% of the investors are U.S. pension funds and 24% are public real estate investment trusts, while foreign investors own 8%, private investors make up 46% and 3% is from others.
In the real estate market, debt has doubled during the past seven years, to nearly $2.4 trillion in mid-2005 from $1.2 trillion in 1997, the report noted. Commercial mortgage-backed securities have exploded, now making up 19% of U.S. commercial real estate fixed income. Commercial banks still have the lion's share of total real estate debt, with 43%.
But these artificial highs will not last. Real estate investors need to be prepared for a time when values reach a new equilibrium, Kenneth Riggs, chief executive officer and managing principal of Real Estate Research Corp., Chicago, said in an interview.