Astute investors are quietly aware that the monetary policies designed to bail out the financial institutions most damaged by the sub prime debacle have a hidden underside of institutionalizing a certain amount of inflation.  In the parlance of Wall Street, liquidity was needed in order to allow the markets to function.  What this means in reality is that a form of easy money was used to allow the financial players to fund their obligations and resume the money trading business.

What does this mean to investors and, specifically, to commercial real estate investment clients of Sourcenet Financial Corporation and www.s-net-invest.com?

1. The first lesson is obvious; bad bets in any field eventually have to be paid off.  Properties without solid cash flow, reliable tenants, or demonstrable growth prospects have little investment value save as chips in a speculative throw of the dice. 
   
   
2. The second is more subtle and will take a while to play out in the marketplace.  The seizing up of a good portion of the commercial funding mechanisms coupled with the end of the 2005-2007 Capitalization rate compression has meant over priced properties would not sell, and if they could, the sale could not be financed.  The market slowed to a crawl.
   
   
3. The third, fundamentals always win out, suggests that investors should be mindful of the interplay between property criteria of value and the monetary world.  When the average federal funds rate is significantly below the average growth rate of the economy an “easy money” climate moves all assets higher in monetary measurement.  It also allows some players to temporarily profit as the easy money environment temporarily masks the economic moral hazard of their behavior.  But temporary is temporary; moral hazards and fundamentals always return and the return is usually quite painful.
   
   
4. Fourth and finally; investors should watch for an inflationary effect from the liquidity solutions used to bail out the holders of institutionalized high risk debt.  The injection of funds to create Wall Street liquidity will necessarily spill into the economy at large.  More dollars always means higher prices.  Expect a substantial lag as the short term issues play themselves out but, absent a political solution (unlikely), the overall climate favors moderate growth in net income and property value. Because both income and asset value grow in tandem the resulting CAP rates will remain static or rise slightly after the correction from the past CAP rate compression cycle.  Properly owned and priced real estate will resume its historic role as a source of income and inflation protected repository of value.

Successful real estate investing will require patience and an understanding of the monetary environment. Fundamentals of solid location, cash flow and market position will reestablish their prominence. Speculation will no longer bail out imprudent decisions.  The era of CAP rate compression will not return.  At the same time the monetary actions taken to restore liquidity will create a modest inflationary trend which will benefit high quality commercial real estate so long as the purchase price reflects solid fundamentals. Investors should watch the relationship between the average federal funds rate and the real growth rate in the gross national product.  Investors attuned to quality property investment criteria will have their diligence rewarded.

Jack Creighton