Thanks to the precipitous drop in the stock market over the past several months particularly tech issues the region’s real estate market is once again drawing the attention of many institutional and high-net-worth individual investors.
Until recently, many of these investors, lured by annual returns of 25 percent or more during Wall Street’s dot-com frenzy, had shunned real estate. It’s a tide, say real estate investment specialists and fund managers, that’s starting to turn.
“The high-net-worthers were not that focused on real estate because it was much more exciting to get rich overnight in the dot-com world,” said Gary E. Mozer, CEO of George Smith Partners Inc., a real estate finance and consulting firm.
The rich stock market yields raised the expectations of investors to unrealistic levels, according to Chuck Bruni, a senior vice president for investment banking at Jones Lang LaSalle, and as a result, many properties listed for sale during the last year never sold. He said potential buyers were demanding returns that matched those of the high-flying stock market as much as 25 percent to 30 percent annually but now, out of necessity, attitudes are changing.
“This year, they are looking at high teens in terms of returns. Because the equities are not sky-high, they have lowered their requirements,” Bruni said. “Their requirements have come down, but they just don’t have as much money to play with.”
A widespread return of investors to the real estate market has yet to happen, but many believe it’s on the horizon. And in an interesting twist on basic economics, more buyers in the market would not necessarily drive prices higher. That’s because buyers are still insisting on high returns, relative to historic norms for real estate investments. That means sale prices will need to remain relatively low for a given operating income to generate a return sufficient to entice those buyers.
“I think what will happen over the next three months to a year is that you’ll see the market turning from a seller’s market to a buyer’s market,” said Steve Solomon, a senior vice president at Colliers Seeley International Inc. “It’s been a very good run for the owner’s of property over the last four or five years. The class-A product is at all-time high prices. I just think that’s going to correct, and it’s going to slow down.”
The result, Bruni predicted, will be that fewer deals will come to market in 2001, but a higher percentage of those deals will close.
Mozer agreed, saying that real estate will become a more popular investment choice because, despite a slowing trend nationally in many economic sectors, the returns remain good.
Using a recent deal as an example, a client whom Mozer declined to name, bought a $30 million shopping center with net annual operating income of $3 million, a return of 10 percent.
While that may seem lackluster, a property that’s fully leased with long-term tenants can guarantee a consistent return for many years, something the stock market has proven it can’t deliver.
The result, said Jacques Gordon, managing director of LaSalle Investment Management in Chicago, is that real estate is gaining positive momentum in the January/February financial planning season. He said advisors for high-net-worth individuals, as well as those administering 401(k) plans and Individual Retirement Accounts, are placing increasing confidence in property investments.
“It all has to do with having proven out the thesis that holding real estate does diversify your investment and is a risk-reducer,” Gordon said. “Not only did it dampen the shock of (investors’) tech investments, but had returns that any investor would be happy to get.”
In addition, when consistent returns are coupled with tax advantages, real estate looks to many investors as a safe harbor. Mozer said investors have to pay taxes on stock dividends and capital gains, but they can take the proceeds from the sale of one piece of property and plunk it down on the purchase of another piece of property to avoid paying taxes.
Not only that, but depreciation can shelter earnings from taxes, as well as much as 40 percent, according to Kevin Burkhalter, senior vice president at Johnson Capital Group.
Michael Ross, managing director of the investment division at Colliers Seeley, said that broader economic conditions may slow the trend, but that the return of investors to the real estate sector is inevitable.
“We have a lack of buyers in the marketplace. We’re just right in the flux of that right now,” he said. “Southern California is a very healthy market right now, but the rest of the U.S. is influencing what’s going on here.”
While fund managers and real estate investment specialists see a return to the market in the coming months, some institutional investors never abandoned real estate.
John McClelland, principal investment officer for real estate at the Los Angeles County Employee Retirement Association, said that LACERA has been using real estate to diversify its portfolio since the mid-1980s.
“We never left it and it’s doing now precisely what we started (investing in) it for,” McClelland said.
LACERA has targeted 10 percent of its portfolio in real estate investments. The total is around 11 percent today because losses on Wall Street have changed distribution of investments within the pension fund’s portfolio.
While Gordon acknowledged that there are higher yields to be found, real estate is stable and consistent, with a near-guaranteed 8 percent annual return. And in a tight market such as Los Angeles County, rents will increase faster than inflation, he said, which in turn raises the real return on investment.