A newspaper article recently disclosed the purchase of a trophy office building that sold for approximately $10 million, on a fully occupied property in which the tenants currently pay a combined $300,000. The frictional costs no doubt involved five-figure attorney bills, high title insurance costs, broker fees, and the other costs that are typically associated with such transactions.
The rental income from this property offers an initial capitalization rate of only 3%.
There are only three ways that this could work out.
The first two involve fundamental improvements in value.
You can make money from this base if you are an area like San Francisco, Los Angeles, Southern California in general, or parts of New York where the property has a high percentage likelihood of increasing at almost 8% annualized or higher. This was a Midwestern property where commercial properties have a twenty-year track record of 2.9% annual growth.
You can also make money from this base if the property is undermanaged, which would involve either low rents or an occupancy rate that could be dramatically improved (i.e. if only 40% of the available tenant spots were available, and you had the operational skill to improve that figure to the 90% mark, the rebasement of the rents upwards could shield the investment from failure).
And thirdly, and this the pure speculation part, you could sell the property to the greater fool who comes along and pays a higher price later. You should never rely on this scenario, because if you are the type of person who makes investments with this scenario in mind, well, bubbles have to peak with someone.
I will let you in on a secret. Buying “trophy” assets during good times does not work as an investment. Famed U.S. economist Irving Fisher articulated this well in “The Money Illusion”, written in 1928. He pointed out that the real wealth gets created either by changing something from an inferior use to a highest and best use, or failing that, by holding through during a period when general economic conditions improve so that the pre-existing type of use becomes more valuable in the improved circumstances.
If you purchase an asset that is already being put to its highest use, and you are buying at a time when the general economic cycle is unlikely to improve, you have run out of places to bail you out for paying a premium price.
Glamorous investments, such as high-end real estate, jewelry companies, or restaurants with cachet, tend to deliver poor returns when purchased during the peaks. These assets are already being put to their highest and best use. They are not scalable–a building can only fit so many people, a jeweler has to deal with security and inventory, and a restaurant can only add so many customers in the area through delivery–so you can’t particularly replicate the highest and best use elsewhere. You can’t expect a meaningful uptick in the business cycle. If you overpay for an asset under this scenario, the levers to burn off the excess have already been pulled.
I would go as far as to say that someone who buys shares of AT&T yielding 6.2% and growing at 3% will meaningfully outperform a real estate investor that buys a fully occupied property in the Midwest with a 3% yield in an area where rates historically expand at less than 3%.
The obvious follow-up question would be: Why would investors intelligent enough to participate in $10 million dollar transactions make these types of mistakes that are readily observable to an outsider? Aside from the Aesop fable that it is easier to observe the knapsack on someone else’s back than that of our own, the recency bias of recent property increases in the commercial market can mix with the possibility of gaining more social prestige by owning publicly well-known assets is sufficient to trigger some irrationality and minor disillusionment.