By Hans Nordby

Some investors believe real estate has become overpriced. Property sale prices are higher (as measured by cap rates or going-in rates of return) despite tough property market fundamentals. This appears to fly in the face of finance theory, not to mention common sense. However, if you analyze the capital markets and property market fundamentals at work, and the relationships between them, real estate still looks like a bargain.

First, there is a relationship between real estate investment and investment alternatives, such as stocks or bonds. Investing is a relative game, and real estate continues to look very attractive compared to the alternatives. Capital has poured into real estate, and with good reason. The dividend yield on the NAREIT Equity REIT Index is about 7 percent, plus investors have the potential for capital appreciation. Historical performance is outstanding as well.

Office Income vs Pricing

Sources: NCREIF;PPR

Let's consider the argument that cap rates have been driven too low (and prices too high) due to high investor interest in real estate. That argument misses the point. The point here is the spread between cap rates and the risk free rate, not the cap rate itself. The graph on this page shows information for the NCREIF Office Property Index. The blue bars represent the level of net operating income (NOI) on a quarterly basis. The red line is the implied capitalization rate for all properties in the index. The bottom of the graph is the spread, or risk premium, between the implied cap rate and the 10-year Treasury bond, or risk free, rate.

Cap rates declined from 8.9 percent to 8.5 percent in 2002, despite decreasing NOI. However, the spread increased from 3.8 percent to 4.5 percent over that same period. Over the past 10 years, the spread has generally varied between 3.0 percent and 4.0 percent. Therefore, it appears investors are capturing a healthy risk premium for buying commercial real estate in the current market environment. Conversely, for properties with long-term leases to credit tenants, cap rates have been much lower. This is due to the lower risk of these transactions compared to the overall property markets.

Another argument against low cap rates is that interest rates are at historic lows, and that once interest rates increase, these cap rates will not look like such a good deal anymore. However, if interest rates rise, it will most likely be due to an expanding economy, with higher demand for goods and services and higher employment. Last time I looked, the demand for, and therefore income of, real estate investments goes up in such a scenario. If you believe that stagflation will come about due to deficit spending or a sustained spike in oil prices, you should not buy real estate, stocks or bonds; you should put your money in a mattress.

Does this mean everything is a good deal at current pricing? No. Among the many things to worry about are replacement cost, above-market rents in place and the cost of re-tenanting a space if it goes vacant. However, there are relationships at work in the property markets, these relationships make sense, and now still looks like a good time to invest in commercial real estate.