For many months, real estate has been flooded with funds. The resulting “Niagara of capital” has driven up prices of both housing and commercial properties throughout the economically developed world. In the past, such massive capital inflows have eventually ended. Then at least some of the capital that had flowed into real estate shifted into stocks, bonds and other alternatives. How long will this inflow last, and what might reverse it?

The answer is that investment money will remain focused on real estate as long as major alternative asset classes seem less attractive. That has been the case since the collapse of stock markets in 2000. True, many stocks have recovered much of what they lost after 2000. But high-tech stocks as measured by Nasdaq are still far below their highs. Stocks in general, as measured by the S&P 500 or the Dow Jones Industrial Average, have moved mostly sideways since early 2004.

Bond markets did well when interest rates declined, as central banks around the world flooded their economies with liquidity to head off a recession in 2000. But recently, the threat that long-term interest rates might start rising again following several hikes in the short-term rates by the Federal Reserve has made investors wary of potential capital losses.

Impact of global forces

Other factors have kept both stocks and bonds looking too unattractive to draw money away from real estate. One is the economic uncertainty caused by worldwide terrorism, wars in Iraq and Afghanistan, two “no” votes by European nations concerning the new European constitution, high U.S. budget and trade deficits, and rising oil prices. High oil prices have raised threats of increasing inflation, which would also drive interest rates upward. Yet the continued deflationary impact of low Chinese and Indian wages on world manufacturing markets makes fears of general inflation dubious.

Another investment alternative — hedge funds — has attracted around $1 trillion in the past few years. So much money has flowed into hedge funds that their managers' ability to profit from esoteric forms of arbitrage has been slashed. Consequently, many hedge fund managers have put a lot of their capital into real estate. All these developments have kept alternatives to real estate from gaining significantly in attraction to both institutional and individual investors.

Heightened risks evident

Meanwhile, developments within the real estate industry have begun to reduce its attraction to investors. The sheer volume of capital flowing into property markets has raised prices to levels that make getting “decent” yields difficult. True, continuing expansion of the American economy has notably improved space markets. Vacancy rates are falling, and rents have stabilized and are starting to rise. Yet office vacancies in particular remain much higher than in the late 1990s.

In most past expansions, big inflows of money into real estate generated widespread new development. That eventually led to enough overbuilding to choke off the real estate recovery. Surprisingly, that has not happened in this expansion, except for high-rise condos in many large urban markets like Southeast Florida, Las Vegas, and Southern California. Lifestyle shopping centers are also experiencing overbuilding, and construction of single-family homes may have to slow down for the same reason.

However, if money keeps flowing into real estate, driving up prices and depressing yields on existing properties, investors will start financing new developments that promise higher yields. That would cause a big spurt in new development that would weaken space market conditions.

This has not happened yet, but it will if present massive inflows of capital into real estate continue. Thus, those capital inflows ultimately contain the seeds of their own reversal.

Prepare for winds of change

There is increasing evidence that the relative attraction of real estate has probably passed its peak, and may fall farther if capital inflows continue. The biggest negative effects will not occur until the next recession. But even that will happen eventually.

So it is time both to enjoy the success of real estate while it lasts, and also to prepare for a not-so-distant moment when its attraction compared to stocks and bonds grows considerably weaker. Such preparation by investors includes the ability to keep paying debt service, even if net property incomes fall somewhat. Investors should also stockpile low-interest capital that can finance future investments when bond yields and other interest rates rise higher than they are now.

Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at anthonydowns@csi.com.