Cross border Capital Flows-perspectives from a mixed asset protfolio investor. (Applications).

One of the clearest points made during the Capital Flows session at the Global Cities conference was the abundance of capital pouring into real estate to escape unattractive return prospects in other asset classes such as stocks and fixed income instruments. The flow is having an unsurprising adverse impact on real estate prices. The rise in prices and decline in cap rates prompted some of the panelists to opine that prices have become too high in both U.S. and major European markets. The price increases were judged to be inconsistent with actual and expected deterioration in occupancy and rents associated with weak economic performance. One panel member diagnosed the price increases as the start of a bubble, implying that real estate buyers were nurturing unrealistic illusions regarding property market prospects.

There is another less alarming explanation for the rise in prices that draws from the increasing integration of real estate into global capital markets. Historically, real estate was in a world of its own. Cap rates responded slowly at best to interest rate changes; property values replied on appraisals; and real estate investment was most commonly done through separate account managers specializing in real estate. In this environment, real estate could be viewed as a separate world in which expected IRRs on cash flowing institutional quality property were always pegged at double-digit levels. If recent price movements are viewed through this historical lens, real estate is indeed priced dearly.

But the world has changed. Capital markets are much more closely integrated than ever before. Ready availability of market data and analysis lubricates the integration. As a result, real estate has lost a good bit of the mystery that historically reinforced its separateness. Unattractive returns in mainstream asset classes is a recent bit of stimulus accelerating the integration process. As a part of the global marketplace, real estate investment prospects are being examined alongside all other alternative investments. For good or ill, the comparison factors boil down to expected return, risk, liquidity and the unique ownership burdens associated with hard assets versus soft.

Capital is flowing to real estate because it is priced attractively when expected return, risk, liquidity and ownership concerns are weighed against similar measures for alternative asset classes. Stocks are coming up short because the market has no real sense of fair value exacerbated by erosion of confidence in corporate financial reporting. Bonds of untainted investment grade borrowers are more palatable but offer yields based on a Treasury rate that has not been this low since the early 1960s. High yield below-investment-grade bonds offer higher yields but suffer from volatile credit risk. Investment in cash flowing properties with investment grade tenants and long-term leases is nirvana compared with the travail of alternatives.

But, of course, the demand is driving up prices-as well it should. When are prices too high? When the expected risk-adjusted return is in line with alternative investments. When assessing risk-adjusted return, real estate investors need to acknowledge that the underlying riskless rate (i.e. Fed funds) is 1.75% and inflation expectations incorporated into the term premium brings the 10-year Treasury to the 3.640% range, absent an oil shock. Expected IRR=s in this environment will probably find an equilibrium below 10% for institutional quality property. How much below? Perhaps quite a bit given that medium quality BBB-grade corporate bonds are trading around 6.50%. But can a real estate buyer really use that 6.5% as a credible opportunity cost when it clearly represents an historically rock bottom and therefore temporary condition? Answering the question again requires that real estate buyers think like bond buyers. When considering a purchase of that 6.50% bond, a bond investor will mull over the duration bet attached to the bond. That involves evaluating how much value will be lost if interest rates rise, what is the risk of an interest rate rise, and again, what are alternative opportunities for my capital.

With all this said, I believe that the danger for real estate investors in the current environment is the temptation to take ever-greater risk in return for double-digit IRRs. For the market as a whole, the danger is that rising real estate prices might be misread as justifying significant new construction. A construction response to higher prices would indeed be a real estate "bubble."

Martha S. Peyton, CRE, is an economist at Teachers Insurance and Annuity Association College Retirement Equities Fund (TIAA-CREF) in New York. (E-mail: mpeyton@tiaa-cref.org)