An Economic Pillar on the Verge of Collapse

Major institutional investors -- pension funds and university endowments -- that used to stick to bonds and blue-chip stocks have concluded that the only way they can meet their investment targets is by allocating 15 percent of their portfolio to real estate.

And don't forget the whole panoply of new financing mechanisms -- collateralized debt instruments, mortgage-backed securities and the like -- that have made it easier and cheaper to finance real-estate deals.

And if all that is not enough to convince you that commercial real estate is quite cheap right now, industry boosters claim that many leases coming up for renewal were negotiated in the lean years of 2001 to 2004, when rents were low. Now that the market has recovered and rents are significantly higher, that almost guarantees that rental income will increase by 5 percent in each of the next five years. That will boost annual rates of return and, with them, the value of the properties.

It's possible they are right, of course. People like me have been warning about a bubble in commercial real estate for more than a year, during which lots of money was made by people who didn't believe it. Now there's so much momentum behind the market that it is almost inevitable the party will continue for at least another six months, driving prices even higher and cap rates lower.

But at some point this commercial real estate bubble will burst. The cause may be a sharp decline in the dollar that scares away foreign investors. Or an unexpected spike in interest rates. Or a recession. Or a surge in new construction that causes supply to outstrip demand. Or a pushback from tenants who decide they simply can't afford to pay $70 for a square foot for prime downtown office space.

I can't tell you exactly how it will unfold, or when. But when it does, probably sometime in the next two years, everyone will look back and wonder why anyone could have doubted there was a bubble, why credit-rating agencies didn't warn of the risks, and why bank and securities regulators didn't step in.

By then, the fund managers who made and financed the deals will have gotten rich from all the fees they collected. It wasn't their fault, they'll explain: They merely took money from people who had already decided to invest in real estate and put that money to work.

And the Journal will run a front page story quoting some Wall Street executive on his surprise at how fast it all came unraveled.

Steven Pearlstein can be reached at pearlsteins@washpost.com.