Appraisal is a process which finds rationality in market behaviors that strike the average person as mysterious, not logical, and sometimes irrational. In markets such as we are experiencing today there is a certain inexorable motion where many are striving to see what may be below the surface. Is there an underlying rationality or is it economic behavior based on the herd instinct with over-reliance on extrapolation, habit, benchmarks, or simply the idea that it’s all going to fall back eventually, so why not go for it until it does?
Real estate markets are dynamic, and changes there are subtle; often not immediately apparent, even to the most perceptive observers. We have much data; we lack strong ways to understand it. Being able to define the market and understand nuances and how externalities can destabilize an otherwise orderly and reasonable progression, is crucial to success in development, brokerage and valuation.
Investment real estate markets are for the long term. Their assets lack immediate liquidity otherwise available to stock and bond market investors. And, while real estate has become more transparent and real estate product somewhat more easily traded, lack of liquidity is not necessarily a bad thing, as it makes investors pause and possibly think harder and better before getting in. But, in the end, getting in is mostly easier than getting out.
Given relatively long horizons of real estate, short term gyrations – take the recent volatility of stocks – shouldn’t (and generally don’t) worry real estate investors. Movements that signal changes in the direction of trends do worry real estate investors. Here are a few.
Rising interest rates worry investors. Money costs more, and can become harder to get. Cash flow is affected; fewer dollars are available both to debt and equity positions. Higher interest rates can signal inflationary pressures or a tight money environment. That means less money for new investment. Upward trends in interest rates have been a worry since the Fed announced that it would raise rates, albeit slowly, and unwind the buildups of quantitative easing.
Flattening cash flow also can occur from less robust increases in rental rate increases. For any who got in at the top, managing lower expectations will prove to be harsher than forecast.
Less robust cap rates worry investors. The dramatic compression at the height of this market has been replaced by an environment of static or increasing rates. Combined with less rent appreciation, those optimistic projections made a few years ago seem to ring less true.
Higher rates worry developers. At least for now, there don’t appear to be sectors of oversupply. Product of all types gets taken off the shelf relatively quickly. Higher rates will first put the clamps on residential activity. If end buyers have a hard time qualifying for loans, that will have an impact on activity. Given the stickiness of high quality buyer demand in an economy essentially at full employment, this may not become an issue immediately.
Investors worry. The smartest of the bunch have a deep understanding of asset quality, location and market positioning and are willing to pay a fair price. They are willing to sit on the sidelines while less worried investors rush out to overpay.
In the end, asset values are moving targets. The income produced by an asset is far more valuable to investors and indicative of some intrinsic worth more than the value ascribed to a property at a point in time where market supply and demand are grossly out of balance.
Much optimism abounds about real estate in its many forms and overall economy in which it plays such a crucial role. The cycle we are in is beyond mature. Realism is indicated, as is watching the market ever so carefully. Time to stay out of the clouds and keep boots on the ground. Watch for assumptions that get compounded seemingly conservatively over long holding periods. The numbers can sneak up on you.
A heady dose of common sense should rule in watching markets. Don’t just listen to the pundits; go out and see what people are saying. Then do what you need to do in light of what you learn. Above all, be alert and realistic.
Bill Pastuszek, MAI, ASA, MRA, heads Shepherd Associates, Newton, Mass.