Okay, so don’t completely forget about location. It is, however, necessary to focus on timing in addition to location.
Until now, most commercial real estate acquisitions have focused on real estate fundamentals. That’s because information on the space markets is widely available and easily understood. Consciously or unconsciously, the maxim “location, location, location” has driven most acquisitions at the expense of investors, banks and taxpayers.
Sound real estate fundamentals are no guarantee against losses. All types of investors, including institutional investors, have suffered capital losses because they purchased real estate at the peak of the market and then sold at a time that the market no longer supported the prices originally paid. Examples include the experience of Japanese investors in the late 1980s, pension funds, and the experience of investors during the recent cycle.
According to the National Council of Real Estate Investment Fiduciaries, even the most conservative real estate investors experienced significant losses in the value of their properties in the past few years. In the third quarter of 2009, those properties had declined in value by an average of 26.5% from a year earlier, according to data from NCREIF, which tracks returns for more than 6,000 properties owned by institutional investors.
The average annual increase in property values from 1979 to the first quarter of 2010 has been a paltry 1.1%. Conversely, institutional investors garnered positive annual returns from property income every year during that period, with 5.1% growth in the worst-performing year.
Because income levels increased every year, capital losses must stem from changes in capitalization rates. Thus the timing of acquisitions is critical.
What time is the right time?
So how do investors know when to execute acquisitions? While there is no shortage of credible research reports on property fundamentals available to project trends in the space markets, reports that can help time acquisitions have been scarce at best. The default tool to limit capital losses has been appraisals.
Appraisals are good at accomplishing their objective, which is to determine value at a point in time. Because appraisals rely heavily on sales comparables and what I will call “capitalization rate and discount rate comparables,” appraisals only reveal what everyone else is currently paying. Appraisals provide no indication of the risk of capital loss. Thus, appraisals can give a false sense of security.
Given that regulators, banks and purchasers all rely on appraisals, that false sense of security can extend throughout the commercial real estate market. This dependence has consistently led to the greatest acquisition activity occurring during periods when the risk of capital loss was the greatest.
An example of the effects of this systemic risk is a major Wall Street-based commercial real estate fund that acquired more than 80% of its real estate assets in 2007 and 2008. The managers subsequently had to write down more than $1.5 billion of their fund’s value.
The key point is that when an investor makes an acquisition is as important, if not more so, as where the acquired asset is located.
Doubters need look no further than Rockefeller Center in the heart of New York City, arguably the best location in the world. Mitsubishi Estate Co. purchased the 22-acre complex in 1989, only to suffer a substantial loss in the early 1990s when commercial properties across the nation lost as much as half of their value.
“Location, location, location” is a catchy phrase, and location is important. But ignoring timing has proven costly in every cycle. While timing the market perfectly is impossible, an investor doesn’t have to time the market perfectly to significantly reduce the risk of capital loss.
Ignoring timing altogether is like Cinderella not wearing a watch to the ball, and then wondering why her carriage turned into a pumpkin. (credit c. macke nrei)