The Real Estate Capital Institute®

What's Wrong With a Real Estate Correction?

The real estate correction is just that... a true correction of values based on historical norms.


Chicago, IL -- (ReleaseWire) -- 09/16/2008 -- About a year ago, the real estate capital markets turned topsy-turvy. Investors, lenders and real estate professionals alike panicked. Debt and equity funds nearly evaporated based on false risk/reward expectations. Nearly all capital markets reached “pricing nirvana,” leaving no room for error as prices peaked to unchartered levels. Typical income-property loans often were priced within a percent of treasuries -- well beyond any historical underwriting guidelines measuring debt coverage margins, leverage and valuations.

Today, the opposite is true. Over-reactive fear governs expectations. The aftermath of the mortgage-backed securities re-pricing and fresh concerns about financial institutions’ real estate portfolios force investors to the sidelines. Mortgage markets remain dislocated and more problems appear on the horizon.

Are real estate markets in a continuing downward spiral? Not exactly, if history is any guide.

Markets are reaching "correct" levels as measured by the past decade. Many will argue the past five years’ realty capital market conditions were abnormal. Investors scrabbled from the “tech wreck” in search of new profit frontiers; Wall Street greeted them offering lucrative yields blessed by the rating agencies. The model worked as long as values continued climbing.

The rating agencies claimed the new role as risk arbitrators of real estate capital – an untested valuation model for monitoring rapidly expanding mortgage securities market. Wall Street became Main Street for policing realty supply-and-demand risk fundamentals as well as the traditional role of providing capital. The judge and the jury.

By the end of 2006, overall commercial property pricing skyrocketed to unsustainable levels as values increased by as much as 40 to 50%, while rent levels remained flat -- or even declined. Investors justified such economics by accepting lower profit thresholds often based on optimistic cash flow projections.

In contrast, more “correct” market conditions existed during the late 1990s. Project yields were more evenly matched to interest rate costs. During this era and for most of the Twentieth Century, investment returns normally required positive leverage based on current cash flows, resulting in positive leverage.

In conclusion, John Oharenko, a Member of the Real Estate Capital Institute’s advisory board, notes ”the [current] correction will continue with prices trending downward until equity investors start capturing more sensible yields in line with the cost of debt”. He adds, “Unrealistic equity premiums need to be removed from pricing expectations.”

This re-pricing is a healthy side effect of excessive capital market behavior. Measurable, risk-adjusted cash flow will dominate investor’s return expectations -- back to basics!