...you'll just LOVE the commercial property bubble!

Every day we hear about a new record price for commercial property. Great news... if you're selling. Alright, you say, here comes another gloom and doom prophecy. Nothing new about that.

But let me regale you with some ancient history. There once was a gentleman by the name of Knuppe. He pioneered mini-storage. His rule of thumb was, 'Build to yield 12% on hard cost. Sell at a capitalization rate of 10%.' Well a few years ago I bought a self-storage REIT to yield 8%. Considering I was paying for management and getting liquidity, thought that 8% was pretty fair. Hoped to get some increase of value with increasing rents. Well, from time to time I checked in on the stock. When I had more than doubled my money and the yield was down to 4%, wondered what the upside could be. Maybe the yield could go down to 3%? I sold.

At the time that Mr. Knuppe was in his prime, normal commercial vacancy rates were on the order of 5% and capitalization rates something like 10%. At about that time there was a very smart gentleman by the name of Michael Young. He asked what made real estate so special that investment in it got such a premium over, say, bonds or equities. Then he proceeded to figure a way to parse out credit leases like a bond strip, selling periodic payments to one buyer and reversion of the property to another. Today the ratios are just about opposite, 10% vacancy and 5% cap rate, except you might have a hard time buying to yield 5%. Capitalization rates are trying to go down to half that.

What happened? Briefly, finance discovered real estate. Recommended reading: "A Demon of Our Own Design" by Bookstaber, "The Black Swan" by Taleb and "The (Mis)Behavior of Markets" by Mandelbrot. Some fairly smart folks figured ways to package and sell "asset based" products without a firm understanding of the underlying assets or their markets. It is fairly well accepted that at the moment the global economy has been awash in liquidity. As most people in normal times would rather put money to work rather than stick it in the mattress, that means that various investments are likely to receive the bounty. The problem, as always, is that supply being roughly equal, more money being bid means higher prices. This has trickled down to real estate through various investment vehicles. Real estate investment trusts (REITs) are an old one. Mortgage backed securities (MBS) and collateralized debt obligations (CDOs) are newer. This doesn't mention synthetic leases, which are, at least priced, a lot like bonds, or Mr. Young's "lease strips". At one time in the paleolithic of real estate, forty or so years ago, a debate was current as to whether the tax advantaged status of limited partnerships inflated apartment prices. More recently there has been discussion of the inflationary aspects of tax advantaged, "1031", property exchanges. Today, however, we are talking about REAL money, that which is under management in pension and other investment funds. If the fund managers can't find a way to invest, they don't make their bonuses.

Every picture tells a story. The office complex in the aerial photo is Pacific Shores.

Touted as being 2/3 leased before ground was broken in late 1999, its tenants evaporated in the dot-com meltdown the following spring. For years it represented a substantial part of the office vacancy in San Mateo County. The picture was taken mid-day, midweek in Fall, 2004. Recently it sold for upwards of $500 per square foot. It is now reported to be 91% leased. The parking lot is a bit more full than pictured, but not 91%.

At a ULI workshop in 2006 one of the speakers opined, "The fun is gone out of this cycle. A few years ago you could buy based on capitalization rate. Then you could justify an investment based on discounted cash flow. Now the only reason to buy is price per pound." I think that price per pound for existing property is now getting high enough to "justify" new construction... if your expectation of investment returns is low, very low.

So what? How does this help? Maybe I get "told-you-so" points in a few years? If you are just a thrill seeker, invest on the momentum and hope to get out before the roller coaster goes over the top of the hill. Or maybe you sit on your money. Earn 5% short term. When the bubble pops maybe at least some real estate might get interesting again. Otherwise,if you're adventurous, you might try shorting REITs.