Commercial real estate over the long run

Commercial real estate over the long run

October 11, 2009 in Commercial Real Estate, Real Estate Analysis

Available time history for commercial property data is usually rather short. Time series indices that go back beyond 1980 only exist for a very limited number of property markets. So sometimes the only thing a researcher can do is to look at some economic or historical studies that refurbish informations and events of the past. A study by Wheaton et al published in the Real Estate Economics in 2009 sheds some light over the evolution of commercial property prices over the longer term. They analyzed the behavior of real estate prices for the Manhattan office market between 1899 and 1999. Such scientific studies are rarely noted among practitioners but can nevertheless yield valuable insights for investors. That‘s why I would like to discuss some results of this outstanding paper from the investors’ angle and augment the results with some own comments.

  • They show that property appreciation over the long term was just in line with inflation. Actually they point out that prices in 1999 were in real terms 30% below the level of 1899. That‘s noteworthy, as at the same time they demonstrate the high volatility of commercial real estate prices over the longer term. Theories of risk suggest that investor needs to be compensated for excess volatility. The result that buy to hold investors are not compensated for volatility over the last century challenges such an investment approach and would strengthen the reasons for a more activist approach to real estate. It provides a case for a tactical asset allocation for commercial real estate that tries to realize gains and identify attractive entry points into the sector. I argued at several occasions in the past that the most prominent characteristic of commercial real estate is its cyclicality. The paper shows that this cyclicality was not just a feature over the last thirty years but is an important lasting attribute of commercial real estate
  • They are not directly addressing the inflation hedging characteristics of real estate but from their return estimation one can see that commercial property was not a good hedge against inflation in the first couple of years after the First World War. This is also in line with what Prof Shiller reported for US one  familiy home prices in his latest version of Irrational Exuberance. Between 1900 and 1920 commercial real estate prices in New York and residential real estate prices in the US fell by 35% resp. 25% in real terms. This is indeed striking as a broad majority of practitioners and academics argued recently for the inflation hedging characteristics of real estate. And the period between 1917 and 1921 was the period with the highest inflation over the last hundred years in the US. (CPI Inflation was 12% in 1917, 20% in 1918, 18% in 1919 and 17% in 1920.) This challenges the inflation hedging characteristics of commercial real estate. Commercial real estate is usually perceived as a hedge against inflation as rents are indexed to the CPI. My interpretation of these results is that the inflation hedging characteristics of commercial real estate only holds true if inflation is within a specific threshold. When inflation rises above certain percentage it can hurt the values of commercial real estate. Values are always a function of two factors: The expected income and the discount rate. So if inflation rises above a threshold the negative effect from the discount factor magnifies the income effect
  • Cap rates for New York office properties have traded in the last hundred years in the band between 5% and 10%. The point here is that cap rates seem to be stationary over the long term. This is  remarkable in the light of the recent cap rate declines. At the peak of the commercial real estate market in 2007 some properties in NYC were trading at cap rates of around 4%. Just a few years ago (2001) they were at  8-9% and almost at the higher end  registered within the last hundred years. So within ten years they fell from peak to trough. Now in the course of recession and the financial crisis cap rates increased again by 200-300 basispoints. The stationary property of cap rates and its quick reversal just in a few years provides also the case for a cyclical timing of commercial real estate in the context of a tactical commercial real estate asset allocation.

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