In part 1 MIT's Dr. David Geltner (the man who literally wrote the book on commercial real estate investing), explained what the next recession might look like. In part 2 he talks further about CRE (commercial real estate) and gives fascinating information that will be useful for growing your portfolio.
TRCR: Why hasn't US commercial real estate received the same academic economic attention as stocks/bonds (or even the US housing market)?
Geltner: I think there are several reasons.
First is probably the relative lack of quantity and quality of data. CRE data is rapidly and greatly improving, but so is securities markets data, so it’s a moving target in terms of real estate catching up.
Secondly, property investment markets are more heterogeneous than securities markets, in the U.S. and in other countries. This makes it less easy to study them from even a theoretical perspective, and more difficult to draw broadly generalizable conclusions.
Commercial property asset markets can function very differently from securities markets in some places, making it difficult to even interpret the meaning or meaningfulness of empirically recordable asset transaction prices.
Third, I think there is a cultural issue, especially in the United States, both in the investments industry and in academia. Real estate in this country has traditionally not had the prestige that securities investments have had. The U.S. in general never had a landed aristocracy that was looked up to as the national “upper class”. Land was often almost free for the taking. The country was “land rich”, and what is not scarce is not highly valued, either by markets or by cultures.
Real estate is probably over one-third the value of all investable assets, yet the typical business school finance department will have over a dozen faculty members studying securities investments and corporate finance in various aspects but maybe only one or two studying real estate, part time, if that.
TRCR: Which is a better long-term hedge against inflation: investing in commercial real estate or housing? Do we understand why?
Geltner: Big picture, there are two different issues relating real estate investment and inflation.
One is the inflation “hedging” question, which is about whether real estate protects against UNEXPECTED increases in inflation. This is about the RISK of inflation.
Real estate should be good at protecting against that, whether it is nonresidential commercial or apartment properties. In some ways apartments are a little better because they don’t have long-term leases, allowing unexpected increases in inflation to be more quickly reflected in the actual income earned by the property. (Unless landlords are lazy or sentimental about doing that to their tenants…)
The second issue regards the long-term trend rate of growth in asset values, whether real estate values tend to keep up with purchasing power (without leverage, that is, at the underlying property asset level, for this is something that can be addressed by the use of levered equity). And what matters to the investor is individual property value with actual (aging) buildings, not the average property values in an entire market or area where there are new buildings coming into the stock replacing old buildings such that the average age does not increase year for year with time.
The answer to this hinges on the relative magnitude and role of land value versus structure (building) value in the property, because the structure value component definitely (almost always) is a “wasting asset”, it depreciates in real (net of inflation) terms, even on a “net” basis (after or in spite of landlords’ spending on routine capital improvements and upkeep). But the land value component does not generally depreciate; it may tend to rise, fall, or remain nearly constant, in real terms, over the long run (secular trend).
I think the main reason why the OOH ( owner occupied housing) trend is above the income-property trend (and also slightly above inflation) is because of the different relative secular trend rates in land values between more central locations where income properties tend to locate, versus more peripheral locations where OOH tends to locate (especially when it is first built).
There has been (and maybe continues to be) a long-term secular trend of reduction in transportation costs or commuting costs per mile of distance and per week (or year) of living (e.g., as expressways were built and cars got nicer and then laptops and internet and digital media has enabled less penalty and less need for physical commuting). And cities have sprouted satellite “centers” (“edge cities”) outside of the traditional metropolitan CBD (“downtown”).
The result is what urban economists call a “flattening of the rent gradient”. This tends to, relatively speaking (at least), reduce land (location) values in central places and increase land values in peripheral places. Single-family houses tend to get built in peripheral places while income-generating properties tend to get built in more central places (in both cases for sound economic reasons).
This doesn’t mean that the central land values aren’t greater (per acre) than the peripheral land values. Central land values (almost by definition) are greater. (This is why greater density or intensity of building structure on central sites makes economic sense.) But the difference in relative trend rates over time in land values is what underlies the deviation in the two asset price index lines you’re seeing in the below chart.
It’s not necessarily that houses don’t depreciate as much as commercial structures, but that land values underneath the houses may appreciate relatively more (or depreciate relatively less) than that of the land underneath the commercial structures, on average across the U.S. over that history depicted in that chart. (Again, Manhattan may be an exception!)
TRCR: Institutional investment properties have gotten very expensive due to increased demand over the last several years. It's gotten so bad that Janet Yellen publicly said it could be in an asset bubble. But many investors don't consider the alternative of non-institutional (properties that tend to be located in less prime locations or that have older or lower-quality structures). How has it performed in comparison to institutional?
Geltner: I agree that institutional property prices are at levels that are of concern, approximately where they were at the previous peak in 2007.
The evidence that I’ve seen suggests that smaller, “non-institutional” properties are priced notably cheaper, say, maybe typically 200 bps (basis points) higher yields.
However, this is always the case. So, it does not in itself necessarily imply that non-institutional properties are relatively farther from a cyclical peak, within their own cycle as it were. But in general I think the long-term history suggests that non-institutional property is priced at a higher yield, yet provides no lower long-term growth trend on average, and exhibits no higher volatility or cycle amplitude in general or on average.
This in itself would suggest an arbitrage, that non-institutional property is a “bargain” relative to institutional property (providing more total return for the same risk).
There could be several reasons that allow this to persist. One could be the quality of information available. Investors hate uncertainty (not knowing what they don’t know). Another could be the expense and management burden of dealing with large numbers of small, local assets and players. But there may also be psychological or behavioral factors, some of which could be perfectly rational, which cause institutions that have a regulatory mandate to be conservative in some sense, to shy away from non-institutional property, at least unless or until investment vehicles are devised that facilitate their investment.
And we must allow that probably institutions are not immune from “herd behavior”. And the “herd” is not running to non-institutional property (not the institutional herd, anyway). But there is a pretty broad “borderland”, such as prime properties in non-prime locations, or non-prime properties in prime locations (your new Class-A office tower in downtown Pittsburgh, or your 50-year-old Class-B office building in downtown Boston), which is attracting more and more institutional capital, I believe.
TRCR: Thank you for a fascinating interview.
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About Ian Ippolito
Ian Ippolito is an investor and serial entrepreneur. He has been interviewed by the Wall Street Journal, Business Week, Forbes, TIME, Fast Company, TechCrunch, CBS News, FOX News and more.
Ian was impressed by the potential of real estate crowdfunding, but frustrated by the lack of quality site reviews and investment analysis. He created The Real Estate Crowdfunding Review to fill that gap.