Friday Letter Crazy caps

A Boston office deal with an expected cap rate of 6% begs the question - are some investors in danger of repeating the mistakes of 2006 and 2007? 

Just 18 months into the worst global real estate recession in a generation, few would have expected to hear fears of “crazy” cap rate compression.

However that’s exactly what’s happening in some US markets, as a dearth of transactions and increasing amounts of capital combine to create “bubbles” for high quality, core assets in the country’s most stable cities.

As investors search for the discounted deal of the decade, many industry professionals are warning cap rates for certain transactions are starting to reach levels not seen since the peak of 2006 and 2007. Delegates attending the annual winter forum for the Association of Foreign Investors in Real Estate in New York this week heard just such concerns when it emerged one Boston mixed-use office-retail property was expected to close at a near 6 percent cap rate after 27 qualified bidders threw their hats into the ring.

Such intense bidding has already seen several notable private equity real estate firms – across all the risk spectrums of core, value-add and opportunistic – withdraw from the Boston process. With a final 6 percent to 6.5 percent cap rate, the transaction was labelled “too rich” by one PERE source. Cap rates for central business district offices in Boston in 2009 ranged between 7.7 percent to 9.1 percent, according to data provider Real Capital Analytics.

With a reputed 10 bidders left in the game, the deal has highlighted fears of a liquidity bubble for the few trophy properties coming to market. Those fears are easy to understand. Global property deals are down more than 70 percent from the peak of 2007 and real estate investors worldwide view the US – particularly core assets – as the best opportunity for capital appreciation, according to the latest AFIRE survey. “The only explanation I have for that crazy pricing is that there are just not many alternatives to invest in,” one AFIRE speaker succinctly said this week.

Yet, in this desperate search for the best assets at the best prices, it’s vital to ask whether investors are forgetting the most important lesson learned from the last bubble: that of risk-management.

During the height of the market, buyers were often caught up in bidding wars and criticised for overpaying for assets which they then overleveraged. Leverage is no longer a real worry today, but – if the Boston deal is anything to go by – potential overpaying as a result of bidding wars could be. As the AFIRE speaker added: “Chasing what everyone else is chasing doesn’t seem to be a clever plan.”