I was talking to a portfolio manager last week just as he was reviewing the latest benchmark quarterly return for open-end diversified funds from the NCREIF-ODCE. The total return for the first quarter on the highly followed index was 3.39%, including a hefty appreciation component of 2.20%. The NCREIF-ODCE has been registering annualized returns for core real estate managers in the low teens for the last several years well above the annualized mean, which sits more in the 7-8% range. My portfolio manager friend took a deep breath, a nervous expression of concern about inevitable reversion to the mean.

“We've been talking (in the office) about what is driving these returns,” he said. “The big open-end funds are all writing up their properties in the top urban markets, reflecting the influx of sovereign wealth funds and other offshore capital into these cities, buying up real estate with cap rates as low as 3.”

His trepidation expressed a clear note of “this can't continue.”

At the current point in the market cycle, dealmakers are apt to convince themselves that some sort of secular change is underway, upending the normal cycle. It's a typical rationale for continuing to invest even as prices become extremely dear. And the higher prices escalate, the greater the argument for secular change, because the only other explanation would be “the market is getting overheated, and I should stop buying.”   

But the real estate industry feeds itself off transactions—brokers and investment bankers don't earn much if there are no deals. The acquisitions executives and the developers need to buy and build to score. Pension funds, always late to the ball, want in on the action now. Standing by just doesn't feel good. 

So the secular change argument sounds convincing especially in a world with so few satisfactory investment options: low interest rates make bonds unattractive, the stock market seems fully priced; Europe, Asia and South America appear in various stages of turmoil. All this foreign capital is pouring into the world's safest places—the U.S. 24-hour cities top the list—for sound reason and is changing the metrics for investing. Or so the argument goes.

I've always used the 5-cap rate rule. When investors start buying below that marker raise the yellow flags, and when the market gets comfortable with sub 5s then it's time to stop. Well, we've reached the red flag moment and then some.

Just examine the historic NCREIF numbers.