Should You Really Care What Everyone Else is Paying for Commercial Real Estate?

No transactions means no basis of comparison for cap rates: retailtrafficmag.com

The Problem
The point of the article is this: without numerous transactions taking place in an open market, determining the prevailing cap rate for a given property type in a given market is nearly impossible. Traditional wisdom says that buyers pay what other buyers are willing to pay for a similar asset. That price is usually based on the income stream generated by that asset and the risk associated with the source of that income, namely the tenant. As the world economy has contracted, and in particular as the American real estate business has imploded, buyers, even those that are well capitalized and have the ability to buy, have taken a wait and see attitude.

This has done a couple of things which have exacerbated the commercial real estate drop:

1) it has stopped the flow of transactions (bad news for those of us in the brokerage business!) and therefore has reduced the flow of money through the system which normally creates ancillary benefits like construction and renovation sales and land transfer taxes to name just two; and

2) a lack of transactions takes away the ability for those buyers who are ready to buy to make, what they deem to be, intelligent offers based on historical deals.

As to the first, there's not much we can do about the economic side benefits of real estate transactions until those transactions start flowing again. It's the second item that I'd like to discuss.

As I said, traditional wisdom is that buyers pay what other buyers are willing to pay for a similar asset in a similar geographic area. Geography matters because of the local employment climate, demographics of every location, and a host of other factors that can affect investment decisions and risks. What does all of this mean?

In the investment vacuum in which we find ourselves today, no body really knows what to pay for property because no one else is buying!

On an intellectual level, I understand this. This is what we were taught in CI 101. On a gut level though, I'm having a hard time with this. Here's why: if I expect to make a certain rate of return on my investment dollars, does it really matter what everyone else is paying for similar assets? Doesn't this kind of mentality smack of playground kids whining, "That's not fair! Jimmy got TWO popsicles, and I only got ONE!" If one popsicle was refreshing and you really only expected to get one in the first place, does it really matter that Jimmy got two? Similarly, if a 9% ROI was a sufficient rate of return last year or even ten or twenty years ago, why isn't it sufficient this year (assuming similar risk factors etc.)? If you have a clear set of investment goals and you can find a piece of real estate that will allow you to achieve that goal, does it really matter if a similar property might be purchased more cheaply? What is the opportunity cost of waiting until someone else buys property? What if, by waiting, you not only lose revenue today, but you wait too long and miss the market?

A Renewed Thought Process
I think it's time we stopped looking at what everyone else is doing. Let's use our heads and look at investments that have sound overall fundamentals. Make sure the tenant is solid. Ask questions about their ability to access cash, why they're moving or staying, who is their customer, how long have they been in business, is their industry growing or in decline. Insist that you have an opportunity to look at their financial statements if you're really concerned. Take a good look at the bricks and mortar of the deal. Make sure that the building and grounds have had appropriate capital reinvestments over time and plan for future expenses. Make intelligent decisions about which properties you buy, but stop worrying about what everyone else is doing.

When everyone else is selling, you should be buying. When everyone else is buying, you should be selling. Don't follow the crowd to dinner or you'll end up at the back of the line and all the really tasty food will be gone! All you'll be left with will be the scraps left by those who had the foresight to get moving now!

Invest for cash flow today, and let time do the rest.