This article is an attempt to make a defense of real estate prices which have risen over the years. If it appears flimsy that is because it is based on the theory of real estate being the "cleanest dirty shirt" in our closet of investments options rather than a powerful argument of guaranteed strong demand going forward. This extends to real estate investment trusts (REITs) as well. REITs are companies that own and in most cases operate income-producing real estate such as malls and office buildings. Needless to say, those that have paid way too much or spent way too much for a property will not walk away unscathed. While I have grave concerns for the economy going forward to anyone questioning whether "I do eat my own cooking," and have invested in real estate the answer is yes. Because of my background in construction and development, I lean towards the area of commercial real estate and consider this my wheelhouse.
It is often because of the high entry bar for getting into this market that many people choose to invest in REITs rather than buying commercial property or income producing real estate. We should always remember that real estate has several big negatives such as being expensive and difficult to maintain, especially when vacant, and that as an investment it is often very illiquid. As in many other sectors of our economy the bigger players are pushing out and eliminating their weaker and smaller competition; this means as the mom and pop operations slowly exit this market once and for all both prices and rents will most likely firm or may even explode.
In many areas of the country, companies are paying rents that are far too low in relationship to the real rate of inflation and the standpoint of current replacement cost. Of course, we cannot enter a conversation about real estate without hitting on the factor of interest rates and the availability of securing suitable financing. These factors have a direct bearing on the value and ability to sell a property as well as its worth. Over time they also tend to play havoc with supply because when rates are high or money is tight, new construction gets difficult to finance and little gets built. The length of time of both the loan commitment and how it will end, such as in a "balloon payment" becoming due or an escalating interest rate, are also important. In recent years the life expectancy of many types of real estate is changing, especially here in America where it is not uncommon to tear down a relatively new building for obsolescence or to avoid taxation when it cannot be leased.
When I entered the business decades ago, the rule of thumb was even with high single digit interest rates if the property could make payments amortized over 30 years and make a little money inflation and time would make it profitable, these rules no longer apply. Time and Mother Nature are enemies of developed real estate, the constant assault of the wind, sun, and rain over time take a toll on all aspects of a building. When a building becomes vacant income stops but taxes, insurance, basic utilities, and maintenance continue. What is considered a great location one day can rapidly be reduced to merely so-so with the announcement of a factory or plant closing. This is why it is very important to have a keen knowledge of an area, what makes it tick, and current trends when determining what a property is worth and whether to invest. The size and age of the building, as well as a person's ability to find hidden value in how the building can be used, are all important factors as to its potential.
Changing trends are constantly feeding into the math that affects property values and ultimately determines supply and demand. The very nature of our changing business environment, where outsourcing has become so common, creates an environment where whole departments can be shut down at a moment's notice; this makes building ownership a much riskier proposition. An example of just how important this is can be in altering a market is apparent in the shrinking demand for office space and workers due to computers and new technologies which lessen back office and record-keeping operations. Even as the demand for such space has abated, companies have chosen to crowd more workers ever closer together in smaller workstations and cubicles. This has resulted in many office buildings "under-leased" or a sitting empty all across America.
With so much of the value of real estate based on income and cash flow, it is not surprising that when a building goes vacant its value tends to drop like a stone. This means, if you are toying with putting your foot into the real estate pool, a key message here is avoid debt! It is one thing to buy or own property but getting it to show a profit is a horse of a different color. Taking this to the next level, when a building and its owner fall into financial difficulty it is often a case of "watch out below" as its prospects and price diminish. Bring the combination of a desperate seller together into an illiquid market is the formula for chaos. Another situation that puts a seller at a strong disadvantage is owning out of state property where they have nobody with real skin in the game in the area to protect their interest. Financial difficulties such as being foreclosed on or lengthy legal wrangling can place a building in limbo and take a property off the market for years.
Whether it be through mergers or consolidation of operations, the total demand for space is not increasing in many regions; this makes it difficult to increase rents to cover rising cost and upgrading properties to keep them competitive. When a business leases a building seeing the transaction as an alternative to building or buying, it can simply be to maximize flexibility. In such a situation leases negotiated tend to be rather one-sided if several suitable options exist and the lessee chooses to exploit the lessor who knows it may be several years before another tenant materializes. One place an independent owner will most likely not find help is by hiring a big firm to manage and lease their property. It is only logical that they will steer the best prospective tenants into one of their closely held properties first.
Real estate, especially commercial real estate, is not an investment for the meek or inexperienced investor, and while I mentioned REITs it was not in any way an endorsement of such investments. It is important to remember that when wisely purchased real estate does have certain investment characteristics that hold merit, chief among them is that real estate is tangible and real. When things go well real estate has the potential to produce a stream of steady and growing income for decades. In addition, replacement cost has soared in recent years and is not expected to drop going forward. Much of this is the result of changing codes and requirements fostered on builders and developers by the government on all levels. The bottom line is that if you can keep someone in a building that pays rent when all is weighed and measured, real estate can be a much safer investment than holding debt that might end up in default or paper promises that may never be fulfilled.
Footnote: In the past, I have put forth the idea that inflation could rule the day even if central banks are unable to keep the wheels on the bus and we suffer an economic collapse. This powerful force also known as stagflation can devastate those improperly invested. This article explores the basis of this theory.