VOICES FROM THE INDUSTRY: Bubble won’t burst on commercial real estate investors

Winding down his remarkable tenure as chairman of the Federal Reserve, Alan Greenspan seems to have chosen “real estate bubble” as one of the themes of his swan song. And with housing prices in some cities soaring, the rest of us as mere mortals can reasonably wonder how long
it will be before the bubble bursts and what will be the fallout if and when that happens.

Many private equity investors with holdings in commercial real estate are beginning to ask questions about the “bubble” and wonder if they too should be concerned. The answer: yes and no. Yes, an important factor in the run-up of housing prices-historically low interest rates-is critical in the commercial market as well. But no, trends in the residential market cannot be directly compared with those in commercial real estate.

Automobiles and bicycles are both vehicles for transportation, but no one would lump the two together when analyzing the transportation sector. The same is true for residential and commercial real estate. When Mr. Greenspan talks about the bubble, he is referring to residential real estate, not commercial.

The residential real estate bubble, which has produced spectacular increases in prices and therefore in homeowners’ equity, is concentrated in the East and West coasts and Sunbelt areas of this country.

This phenomenon has been brought about partly by unusually low mortgage rates, aggressive lending programs by many lenders and continued migration of people to markets with great weather, jobs, mountains, water-all of the quality-oflife issues many people look for. In addition, markets such as Florida and Arizona are experiencing wild appreciation as baby boomers spend, sometimes indiscriminately, settling into their retirement homes.

In much of the nation, including Indianapolis, prices in commercial real estate have been rising, largely because capital that otherwise would be invested in stocks and bonds has been flowing into alternative investments.

The one connection to residential real estate is that low interest rates have had a positive impact on commercial real estate values. It is true that some naive investors, thinking low interest rates are here to stay, are making bad investments and feeling smart today. When it is time to refinance, many of these investors will find they may need to put additional cash into their holdings as the cost of debt goes up. This, however, is not the sign of a bubble.

A bubble is created either by speculation or artificial stimulation. There is no sign of rampant speculation in commercial real estate. Investors generally are not buying in anticipation of rapidly rising prices. As always, savvy investors do look for opportunities to actively create value through management of the investment.

And, while interest rates remain low, there is no artificial stimulation running up prices in Indianapolis commercial real
estate. Rather, fundamentals are sound. The economy is steady but certainly not overheated. Interest rates will rise for commercial properties, but there is no sign of the deal-killing rates many of us remember from the 1980s. And most important, Congress is not meddling right now.

The biggest bubble in commercial real estate this generation will ever see was the result of Congress and President Reagan using popular artificial stimulation-tax incentives, notably accelerated depreciation-in real estate to get the economy going in the early 1980s. It worked. But after a period of extraordinary overbuild
ing in which prices were artificially driven up 20 percent to 30 percent over pre-taxincentive values, the bubble burst when Congress rescinded the tax advantages it had created only a few years earlier.

There is limited risk of this kind of fallout happening again because tax benefits are not the major consideration for most real estate investors.

So yes, there is a possibility that commercial real estate price increases may flatten out as interest rates climb. There is even a chance that eventually values may come down a bit if interest rates rise out of control and the stock market shows signs
of life again. But there is no bubble for Indianapolis investors to be afraid of.

It is the residential buyers who are overleveraged in overheated markets who need to worry. The Indianapolis commercial real estate market continues to be sound, with un-dramatic but steady growth. There is not much opportunity for a windfall by riding an irrationally exuberant market, but neither is there much chance of being drenched by a bursting bubble.