Don't Waste Your Cash on REITs
"Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning."
Sir Winston Churchill, November 1942
As the credit crisis that started over a year ago enters its next phase, and Wall Street bankers look to Washington, D.C., and taxpayers to rescue them from their own mistakes, the world of commercial real estate has just begun to recognize what is happening and how it will change the industry.
Commercial real estate, which is broadly defined as income-producing properties such as office buildings, malls, industrial parks, hotels and apartments, is a fairly simple business to understand.
The value of income properties is determined by the demand vs. the supply of space by tenants, the demand for properties by investors, and the availability and cost of credit to purchase these properties. The most common way to evaluate earnings multiples in commercial real estate is referred to as a capitalization rate (or cap rate), which is basically the inverse of a price-to-EBITDA ratio.
Historically, prior to the last few years, cap rates for income properties averaged about 300 to 400 basis points higher than today's cap rates that range from 5% for some high quality apartments to 8% for some low quality and unanchored retail.
If you interpret that in terms of property value, it would be the equivalent of saying that the P/E ratios of companies in a particular industry were historically 30% to 50% lower than they are today.
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Christopher Grey is a Managing Partner of Third Wave Partners. Third Wave focuses on investing in and advising borrowers and lenders in distressed real estate situations. He currently has no positions in the stocks mentioned in this article. This article should not be interpreted as personal investment advice or a recommendation to buy or sell any security. Interested readers may contact the writer by e-mailing cg@thirdwavepartners.net or visiting the company's Web site, www.thirdwavepartners.net.
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