The Abundance of Real Estate Capital and the Pitfalls of Dumb Money

Dumb money is now entering the commercial real estate market. The last several years have been amazing with abundant deals, low interest rates, rising demand, and positive corrections in most real estate classes.

As a result, the professionals of the real estate industry are celebrating the economy and the industry’s rising tide. Capital is on the move, and low-cost debt and equity are ready, willing, and able to be put to work in real estate.

In the next few years this capital, or “dumb money,” will be mostly institutional capital, which is typically the last money in and it will be invested at a much riskier time. After all, this money is not the institutions’ money, but rather it belongs to average people that pay very little attention to the fees they are being charged or where their money might be invested. This “institutional managed money” goes to money managers that work for pensions, life insurance companies, retirement plans, hedge funds, private equity, and so forth. Typically, these funds come from hard-working people’s paychecks, usually via direct deposit (but sometimes through direct investment).

Most people stake their entire financial future on the decisions of money managers that are often more focused on fees rather than performance. In the majority of these investments, regardless of the performance of the investment, the money manager still gets paid. There is something inherently wrong with this scenario.

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Yet private equity funds are pooling capital from the “one percent” and beyond to bid on the most notable of trophies, while also scouring the country for any overlooked property opportunities. So we find ourselves in a situation where “everyone is in the pool.” The amount of capital flowing is frustrating because there are just too many people, with too many dollars, and too few deals. Demand for property investment is much higher than the supply of property.

Real estate investors continue to be willing to pay what either are, or quickly will be, record prices for assets in the major markets in the United States. Meanwhile on the debt side, every lender is in every other lender’s business, making this environment as competitive as it has ever been. This is a great time to be a borrower. The continued loosening of debt underwriting standards will be one of the most important trends in 2016.

For the last couple years, my partner Ross and I have been financing or refinancing huge amounts of debt at a very low cost as we navigate with the decision of future interest rates as it relates to our future cash flow. We believe that institutional capital decisions for both debt and equity are getting ahead of the market fundamentals in this cycle and will trend toward a closer alignment in the near future. This could be one of the most significant developments in the coming years.

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Since real estate’s value is a function of how it serves its users — like workers, consumers, businesses, travelers, homeowners, and apartment renters — we look to the human elements in making our future investment decisions. Demographics, labor force characteristics, location preferences, and motivations discerned by observed behaviors are among the most reliable indicators of trends.

“The amount of capital flowing is frustrating because there are just too many people, with too many dollars, and too few deals.”

– Ken McElroy

Worth noting is that, remarkably, residential housing seems to be putting the excesses of the bubble and the ensuing collapse behind it. The trend in residential real estate looks to be one of returning to the classic principles of supply and demand. As this represents a major segment of the economy, and is still the principal repository of wealth for tens of millions of households, we should see increasing confidence emerge in the residential sector. There could hardly be a more positive trend for the economy as a whole.

Real estate investment is not immune to the economic laws of supply and demand, and as more capital flows into the asset class, two main scenarios present themselves. The first is that competition for desired assets increases, driving up prices and lowering returns. The second is that capital begins to look for alternative investments where there is less competition. We are seeing now that investors are moving into an array of asset choices in a widening number of markets as they seek ever more attractive yields. This of course drives up pricing in these markets as well.

The basic “principle of anticipation” posits that any investment is priced by the expected benefits of ownership into the future. The outlook for 2016 is that commercial real estate fundamentals will continue to improve but its popularity, as evidenced by everincreasing investment flows, could create the conditions for another bubble in some areas.

I believe that the success of real estate investing over the next few years will be a direct result of basic supply and demand and, ultimately, paying attention to what the local real estate investors are doing. If the locals are not investing in their own markets, then why would you? If your money manager is investing in these markets, then you need to ask that same question.

About The Author

Ken McElroy

Ken McElroy is the co-partner of MC Companies in Scottsdale, Ariz. He is the author of the best-selling books, The ABC’s of Real Estate Investing, The Advanced Guide to Real Estate Investing, and The ABC’s of Property Management. McElroy is also a contributor for The Real Book of Real Estate by Robert Kioysaki, and The Midas Touch by Donald Trump and Robert Kiyosaki. McElroy’s fourth book, The Sleeping Giant, is dedicated to the new class of entrepreneurs who are emerging in today’s economy.

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