Schafer: Starved for returns, investors turn to real estate

Investors led by MetLife just bought the Normandale Lake Office Park complex for $368.95 million, and it's safe to assume they won't get nearly the return on their investment as did the ­previous owner, the legendary Sam Zell of Chicago.

A broker involved with the recent sale politely declined to reveal the expected return, but informed speculation puts it at just over 6 percent.

That's an awfully low number, and thus a high price, for nearly any building that's not the IDS Center in downtown Minneapolis. Yet it wasn't the only eye-popping deal price lately.

A German investor bought the 50 S. 10th St. building in Minneapolis for $164.5 million this year at a yield reportedly lower than that of the Normandale deal. And an apartment building called Junction Flats near Target Field sold for about $49 million, a price competitors suggest works out to an initial return closer to 4 percent.

The last time prices like these were paid for investment real estate was just before the Great Recession, and with the perfect clarity of hindsight, we now know that was a time of rank speculation.

In talking to people in the real estate market last week, however, no one expressed concern about prices getting out of hand. Sure, higher prices mean lower returns. But what's the alternative?

"In a low-interest-rate, low-growth world, people are starved right now for yield on their investments," said Matt Richmond, who leads the real estate equity investing team for St. Paul-based ­Advantus Capital Management.

Bonds and real estate are actually close substitutes in a portfolio, which is why you hear real estate talked about in terms of yield, or something called the "cap rate." Both real estate and bonds have predictable, stable cash flow.

To German investors, 10-year U.S. government bonds that last week yielded 2.34 percent must look like a fantastic bargain. Ten-year German government bonds yield 0.8 percent. And that probably looks pretty good to Swiss investors, as their 10-year government bonds yield only 0.36 percent.

So while real estate prices in some U.S. markets may even have climbed higher than the peak before the Great Recession, Richmond said, a top-of-the-market downtown office building and a 10-year U.S. Treasury may have both paid about 5 percent in 2006.

With 10-year U.S. Treasury notes now paying less than half that, he said, 5 percent in real estate can look pretty good.

The result is that by now, institutional investors have picked over the so-called gateway markets like San Francisco and have started to come to second-tier markets like the Twin Cities.

Think about that. Highly paid investment managers are scouring the globe looking for opportunities to not lose money.

Not all the rise in real estate prices can be explained by poor alternatives for investors' cash, of course. The fundamental measures of market health, like rental rates and vacancies, continue to improve. New buyers are counting on the income from their properties to increase as rental rates start to inch up.

And this recovery phase of the real estate cycle doesn't look like a normal one yet to Arthur Hurley of Columbia Management, an asset management unit of Minneapolis-based Ameriprise Financial. The portfolios of the real estate firms that Hurley closely follows report having very little vacant space to lease.

"We are talking occupancy of almost 95 percent," he said. "Typically when you see that kind of occupancy, we then see an increase in the supply. So far we're just not seeing that."

But bullish views were common in late 2006 and early 2007 as well. At least one huge real estate investor wasn't buying, however, and that's Sam Zell. As his career has demonstrated, it's not just what you buy, it's what you sell — or maybe when — that builds the legend.

Without knowing how much money was spent on improvements or had been borrowed for the purchase, calculating a precise annual return on investment isn't possible. But it sure beat 6 percent.

With more institutional money chasing deals, it wouldn't seem to be the time to sell, but Zell might be one of the most famous sellers in real estate history.

In early 2007, Zell sold a portfolio of 573 properties known as Equity Office Properties Trust for about $39 billion. The press couldn't figure out what he could have been thinking. "Almost to a person," wrote BusinessWeek, "commercial real estate analysts are predicting rising rents and tighter vacancy rates in the near future."

Of course, what actually happened was that market values rolled off the table.

"It's important to keep in mind guys like Sam Zell sell and buy for a lot of reasons," Hurley said, cautioning me not to draw too many conclusions about the market from the recent Normandale deal. "One individual sale by him doesn't necessarily mean he's calling the top" of the market.

lee.schafer@startribune.com • 612-673-4302