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In real estate investing, pick prospects carefully

It would be difficult to find an industry in the United States that appears to have more cyclical swings than the real estate industry. There was a severe real estate recession in 1974 caused by overbuilding, which resulted from too many construction-loan REITs (real estate investment trusts). There was another major downturn in 1989 caused by high short-term interest rates, and a virtual depression in 1990 caused by the Tax Reform Act of 1986, the savings and loan crisis and general overbuilding.
The industry is presently in the midst of a boom. Many respected investment advisers are telling their clients to commit 10 percent to 20 percent of their portfolio to real estate. This is partly caused by the uncertainty of the stock and bond markets, but also by the positive trends in various segments of the real estate industry. The key question is, how can we be sure that another downturn isn’t just around the corner? Secondly, in which segments of the real estate business should investors be concentrating?
Real estate, like everything else in economics, ultimately comes down to supply and demand. Supply in real estate is very much directly related to the availability of financing. The rule of thumb in this industry is that as long as developers can continue to get financing, they will continue building.
In the mid-1980s, developers had an almost inexhaustible supply of capital from the S&Ls on the debt side and the tax-shelter investors on the equity side. The result was serious overbuilding, declining rents and an overwhelming number of bankruptcies.
The situation in 1996 is quite different. The major suppliers of capital are REITs and traditional mortgage sources such as banks and insurance companies. The good news is that the REITs seem to be moving forward with a significant level of discipline. They are reviewed by highly qualified stock analysts on Wall Street; they are expected to provide investors a reasonable annual return; and they tend to be conservatively well-managed without taking too much risk.
Also, the traditional lending sources have begun aggressively pursuing real estate mortgages, as opposed to the early 1990s when they were not really in the market. However, enough of the investment officers of those institutions have survived from the late 1980s to add a real element of caution. In summary, there seems to be enough conservatism in the equation to mean that we probably won’t have the same kind of a down cycle that we have become used to over the last 30 years.
This doesn’t mean that certain segments of the industry won’t become overbuilt. This means that if you do commit 15 percent of your portfolio to real estate, you have to be careful about exactly where you place it.
I think that one of the key things to look for in real estate segments is barriers to entry. By this I mean that the most appropriate segments to participate in are those that for one reason or the other will not have an inflow of additional capital in large quantities. Let me be more specific with three very diverse examples.
First, over the years many mobile-home parks have been very good investments. The barrier to entry here is that most people don’t want a mobile-home park next to their conventional home. Because it is difficult to receive approval for a mobile-home park, those already in existence may be able to achieve above-average pad-rental increases and higher returns for investors. You may not want to talk about this investment at a cocktail party, but you may be very pleased with the cash flow generated.
It is possible to participate in this industry through the direct ownership of a mobile-home park, a partnership interest in a park or a REIT concentrating on so-called manufactured housing.
Second, my company, Essex Investment Group, this month will open a Marriott Courtyard in Scranton, Pa. The development that contains our project has the capability for additional hotel sites. But we have obtained exclusive rights to any such hotels. While this strategy may not totally prevent additional hotels from being built in the immediate neighborhood, it certainly goes a long way toward eliminating at least some potential competition.
A third example of barriers to entry is Home Properties of New York Inc., a Rochester-based REIT that concentrates on the apartment market. Now it is true that any major real estate developer can build an apartment project, so there is not a barrier to entry in the traditional sense. However, Home Properties is the only apartment REIT concentrating in Central and Upstate New York.
This part of the country may not have the same perceived growth rate as Texas, Florida or Atlanta, but it does have reasonable growth and a shortage of competition in the REIT market. High-growth areas of the country tend to have more than one apartment REIT, and these entities tend to compete with each other for properties, sometimes paying too much for acquisitions.
Home Properties, with an initial capital base of more than $100 million–and an expected increase in that total through a secondary stock offering–is the only major buyer of apartment projects in this region with that type of capital base. The barrier to entry here is that there is only one apartment REIT in this part of the country. It is also very unlikely that another apartment REIT will be created in this market, so Home Properties could have this niche for some time. Maybe this is why Home Properties as of May 20 had provided a year-to-date return to investors of 23.9 percent.
In conclusion, I believe the next slowdown may not be as severe as some expect, because some discipline has been injected into the industry. Also, I believe that if you concentrate your portfolio on segments that are both well-managed and have reasonable barriers to entry to limit new supply, your chances for success may be quite good.
(John Mooney is president of Essex Investment Group Inc., a diversified financial-services firm and real estate developer.)

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