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By Jon Southard, Chief Economist, Torto Wheaton Research "Now, as ever, Mr. Trump is a real estate developer who wallows in glitz, congratulates himself over the art of his own deals and cares little about who is displaced or whose view is blocked by his slabs of phallic architecture. But his business, unlike that of the Skillings and Waksals, is far from exotic. He wants, he buys, he builds, he slaps his name on everything in sight...Though Mr. Trump may have the same taste, ego and fortune as a Kozlowski, he's a hero because he conducts his business so transparently." -- "Trump Is Firing as Fast as He Can," NYT 3/14 While I'm not one to sing the praises of an egomaniac who once proposed understanding real estate as "The Art of the Deal," I'm also not afraid to say that I like to watch a bit of reality TV now and then. Unlike Trump's own self-aggrandizement, the above characterization of the reason for "the Donald's" success is also at the root of real estate's current popularity. Moving away from the sharpshooter era coinciding with the last time Trump was famous, real estate's current appeal has much to do with its newfound transparency and the simplicity of its value proposition. In particular, pension funds that are direct equity owners of real estate assets in effect own one of the most straightforward "companies" imaginable. Funds pay an amount upfront for a building to receive, in exchange, a stream of income that comes from tenants paying rent. No financial wizardry required. Real estate suddenly can, and has, made hay from being the anti-Enron. This is one of the reasons why investors are willing to pay more for the same amount of current income, i.e., the cap rate decline. More power to real estate for finally getting its due, and there is an element of change in real estate's image that will continue even after this cycle plays out. However, investors should not be sucked into believing that this makeover can single-handedly buoy values forever. We at TWR believe that there are other reasons for low cap rates that will prove to be cyclical. But, as one element among many, capital flow planning needs to be watched. The graph below from IREI shows how pension funds plan to invest their assets going forward. IREI Survey of Net Allocations to Real Estate The sheer amount of money involved from these major players provides a real tailwind to demand for investment properties. And while plans do not make an ironclad guarantee, this survey has been provided as evidence that cap rates can indeed stay low even as interest rates move up. Even a small change in the percentage of total assets this group devotes to real estate translates into a deluge of money that is put to use chasing properties. And with the uncertain prospects for the alternatives in the stock and bond markets, who can blame the funds for leaning in real estate's direction? To continue this goodwill, real estate will have to deliver on the terms it has agreed to. If the appeal of real estate is avoiding tasks like option swapping and sticking to simple tasks such as collecting rents, real estate will have to deliver despite the mixed economy. Our prediction is, like the Apprentice, management decisions (and asset selection) will make or break results in this environment. Investors without a good handle on market fundamentals and how they affect their income stream risk hearing the two dreaded words...YOU'RE FIRED.
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