Now would be a good time for real estate investors to make less risky investments because market overpricing or another economic crisis is on the horizon, according to a first-quarter report by Real Estate Research Corp.
Real estate's risk-adjusted returns have caused investors to pile into the asset class, resulting in increased competition and higher prices. Meanwhile, investors' discipline is dropping slightly in their rush to invest the rising pile of cash available for real estate investing.
“We've seen major markets, like New York City, get fully priced and a little ahead” of themselves, said Kenneth Riggs Jr., chairman and president of RERC, a Chicago-based real estate research firm in an interview. “We anticipate the (commercial) real estate market will overheat next year.”
At the same time, officials at the Federal Reserve recently signaled an ending of the bond buyback program that has kept interest rates low, which could lead to a market correction, the RERC report on the survey noted.
“It would be a good thing if the air was taken out of momentum right now,” Mr. Riggs said.
According to RERC's first-quarter report, based on a survey of institutional real estate investors, investment ratings for cash and commercial real estate, which may be perceived as safer investments, have increased while ratings for stocks and bonds, considered riskier investments, were lowered or remained the same. (In the survey, investors were asked about specific investment criteria and to assign ratings on a scale of one to 10, with 10 being most favorable.)
Investors in the first quarter raised their commercial real estate investment rating to 7.1, higher than stocks, bonds or cash. The commercial real estate rating is up from 6.7 in the fourth quarter of 2012 and 6.9 in the first quarter of last year. Despite a stock market rally, survey respondents lowered their investment rating of stocks to 5.7 from 5.8 in the fourth quarter and 5.9 in the first quarter of 2012.
Of the commercial real estate sectors, apartments received the highest return-vs.-risk rating of 7.1 in the first quarter, up from 5.9 in the fourth quarter and 6.8 in the first quarter of 2012. Hotels had the lowest return-vs.-risk rating with 5.8 in the first quarter, a slight increase from 5.6 in the fourth quarter and a dip from 5.9 in the first quarter of 2012.
However, the overall discipline of capital rating (gauging if investors are sticking to a disciplined approach for investing) dipped to 6.5 in the first quarter from 6.7 in the fourth quarter of last year, while the availability of capital rating rose to 7.6 in the first quarter from 7.4 in the fourth quarter of 2012.
There is a lot more money available to invest in real estate and the cost of capital is low. Managers are not being as rational and disciplined in their investment decisions, Mr. Riggs said. “This is a signal the market is overpriced.”
“Maybe it's time to take a risk-off attitude,” investing in less risky investments, Mr. Riggs said. “Today, availability of capital is above the discipline. ... It is a signal that the market is overpriced.”
RERC conducted the survey of 34 respondents from Feb. 25 through April 12. Respondents include LaSalle Investment Management Inc., CBRE Global Investors, Ullico Investment Advisors Inc., the $69.2 billion State Teachers' Retirement System of Ohio and the $22.5 billion Utah State Retirement Systems.
RERC executives' main worry is uncertainty over how long the Federal Reserve — and other central banks worldwide — will continue keeping interest rates low. They are not certain the U.S. economy can stand alone without the help of the Federal Reserve.
“The trigger of concern is mainly focused on the Fed,” Mr. Riggs said. “That is what keeps me up at night.”
The Federal Reserve's actions are temporary and the transition from the Fed's support for the economy will lead to economic disruption and dislocation, Mr. Riggs said. “We've never been through this before.”
Currently, the markets are priced as though there will be very little disruption, Mr. Riggs said.
What this means for commercial real estate is there will be drawbacks, prices will go down, he said.
Even so, commercial real estate will fare better than bonds and equities because real estate is a tangible, income-producing asset, he said.