Great expectations

The investment landscape is littered with shattered expectations, even among professionals. Indeed, could the most recent batch of real estate investors be lining themselves up for disappointment?

The price falls in commercial real estate have attracted a large number of investors of late, many of them using private equity as a vehicle. They’re hoping to cash in on the recent market correction, reckoning it to be a bargain hunting opportunity. In theory, buying about now should lead to much sort after, but seldom achieved, “Alpha”.

Indeed, in just one week in June more than US$20bn worth of real estate funds were launched involving the likes of Europa Capital and MGPA, part owned by Macquarie Bank. They followed hot on the heels of similar funds raised by Blackstone, Carlyle, JER Partners and Apollo. According to the Costar Group, some US$30bn has been raised since last August to buy into distressed US real estate.

All of a sudden, it seems a lot of people have become contrarian investors. However, the more that do so, the more mainstream the trend becomes.

The fact that investors are being attracted back into real estate is not overly surprising. As an asset class it has performed remarkably well over the past decade. The current price setback is, therefore, merely seen as a hiccup in a greater upward trend.

But investors should be cautious. True contrarians tend to invest when the market is engulfed in despondence, defeatism and depression. And this mood should occur not just with retail investors, but preferably with the professional variety as well.

That’s certainly how consistently great investors such as Mark Mobius and Jim Rogers see contrarianism. Somehow, real estate doesn’t feel like it’s reached that point, yet it still could.

Consider that the economy is now experiencing the secondary impact of the credit crunch. Banks, which are scrambling to accumulate cash, are putting up the cost of borrowing. DTZ found in a recent survey that 75% of European estate agent respondents expect a tightening of credit terms.

In addition, the European Central Bank might imminently raise its base rate to fight inflation. It could later be followed by the Bank of England and the Federal Reserve. More expensive borrowing will hurt real estate markets further.

On top of these factors, secondary effects could seriously impact economic growth – another key driver for real estate prices. A possible recession or even stagflation would be a lethal cocktail for real estate markets. Tenants would default, others would renegotiate rents down, un-let square footage would flood the market and banks would start repossessing.

To the true contrarian, that’s when a market becomes really “interesting” and starts to offer real value. However, does real estate really face such a gloomy outlook?

At the moment it’s hard to tell, but the facts are not encouraging. Long bull markets are often followed by long and sometimes deep bear markets. Also, the best performing asset class for some years now has been commodities, many of which seem to have further to go on the upside. That would mean more economic and interest rate volatility, as central banks regularly have to wade in to curb inflation.

On the other hand, prime real estate can act as a good inflation hedge. But before it can adequately perform that task it may need to fall further in value.

Recent investors may well face disappointment either because their funds are buying too soon or are sitting on inflation-eroded cash waiting for the “right time” to invest. Either way they could face disappointing returns for some time to come.