Why You Shouldn’t Hold Your Breath Waiting for Commercial Real Estate Prices to Fall
Contrary to popular wisdom, CRE prices don’t drop just because interest rates go up, or recession comes.
July 4, 2017 BY IAN IPPOLITO
(Usual disclaimer: I’m just an investor expressing my own personal opinion and not a financial advisor. Consult your own financial advisor before making any investment decisions).
Commercial real estate prices have skyrocketed since 2010 and almost doubled in less than a decade. What goes up eventually comes down, so many people are understandably wondering when the good times will end. And many people think they know exactly when it’ll happen.
Several times in the past few months people have told me “Why should I buy into that deal now? Interest rates for loans are going up!” (or “A recession is coming soon!”). “And when that happens, prices will fall and I’ll be able to pick it up much cheaper then. If I buy now I’ll end up kicking myself later. ”
This sounds completely logical. And yet it’s actually dangerously wrong because it’s based on two popular but untrue beliefs. The first is the interest rate myth.
The Interest Rate Myth
The story behind the myth goes like this: Almost every real estate deal depends on financing. So when interest rates for a loan go up it makes costs for every deal go up. This makes some deals unworkable, and makes the rest less profitable and less desirable. This causes a decrease in demand which drives down all the prices of CRE.
This sounds so logical. But history (as we’ll talk about in a second) throws a bucket of water on this narrative.
The Recession Myth
Here’s the second myth. It’s story goes like this: In a recession, rents drop and vacancy and turnover expenses increase. This reduces net operating income (NOI) of all properties, which is a key metric in evaluating them for purchase. With the desirability of every property going down, CRE prices all drop as well.
Again, it sounds completely reasonable. And again it’s equally as wrong. Let’s look at why.
A Brief History of CRE
Here’s a history of commercial real estate mortgage interest rates. CRE rates are based on the 10 year treasury, which is shown below from 1998 to 2017. As you can see, on a daily basis it’s extremely "noisy" and going up and down constantly.
If we smooth it out to look at the long-term trend (by looking at it just once a year and taking the average), we see that the overall trend was still noisy, but essentially a long downward drop over the 19 years.
Now let’s look at commercial real estate prices. If prices drop when interest rates go up, and vice versa, the two graphs should have the same shape. But they don’t. Here’s the Costar commercial real estate repeat sale index.
The 2 look nothing like each other. Interest rates look like a losing stock graph, and CRE prices look like the back of a camel. Comparing the two closely: in the same period where loan interest rates mostly fell, prices rose from 1998 to 2007, dropped severely to 2010 and then rose again to 2017. Clearly the two are not directly related.
And if you look back at the smaller time periods where rates were rising, we should see prices falling if the interest rate myth were true. But the 3 biggest interest rate increases were accompanied by prices increasing rather than following. Despite conventional wisdom and what makes intuitive sense, the two are not related.
Recessions and Prices
The same is true for recessions. The theory says that prices get hammered and go down every recession. But here’s what it looks like (I marked the recession of 2001 and 2008 with yellow lines to mark the start and end):
Prices did drop during the great recession, but they also clearly went up instead of down in the 2001 recession. If you believe that recessions make prices drop, 2001 was like holding a plate out with your hand, letting go, expecting it to fall to the ground, and instead watching it slowly levitate and then rise to the ceiling! That 2001 scenario should never have happened if recessions cause prices to drop.
And if you go back further in time, 50% of the last 6 recessions were also “plate floaters” where prices rose instead of fell (including both stages of a double dip recession).
So What DOES Cause Prices to Fall?
So if prices don’t fall reliably with interest rate rises, and they don’t fall reliably in recessions, what exactly does make them fall?
MIT’s Dr. David Geltner is the author of the most widely cited book on commercial real estate. In a 2015 interview with The RECF Review he explained that pricing is driven by international investment markets and inflows/outflows. This is driven by many things completely outside the US macro-environment (including US interest rates and US recessions). Additionally, in a recession (or when interest rates rise) many other asset classes suffer worse than real estate. So ironically, people will switch from them and buy more real estate (which causes a “plate floater”).
“Commercial property, that is, income-producing property, the type of property that can serve as an investment asset class, reflects pricing in two markets:
1. The space market, where the occupancy and usage of built space is traded (aka, “rental market” or “leasing market”);
2. The property asset market, where the ownership of real property assets is traded (the investment market).
The former, commercial space market, usually suffers during a macro-economic recession, for most types of property in most locations, that is, rents and/or occupancy falls, so net income falls (often somewhat lagging behind the recession, both in the drop and the recovery). But there can be some types of space markets that are income-inelastic, such as moderate-income apartment properties and grocery-anchored retail centers or bargain outlet centers, which do not fall, or not much, depending on the nature and depth or length of the recession.
But more importantly, the other market that determines property prices, the property asset market, which is a branch of the international capital markets, may react more independently of U.S. macro-economic fundamentals. That is, money may flow to investment real estate assets even though current rental fundamentals have taken a downturn. This is especially true for “first tier” properties (well-leased prime properties in prime markets, presently the “gateway six” being: Bos, NYC, DC, Chi, SF, LA), which may be perceived as a type of “safe harbor” investment.
Capital may actually be relatively reallocated away from more risky or problematic asset classes (tech stocks in 2001, long-term bonds in 1981) and towards real estate. This can prevent property asset prices from falling, or from falling as much as they otherwise would.
However, a lot depends on the nature of the recession and the financial system at the time, and also on the state of the space market. If the space market is severely over-built (excess physical supply), as it was in the late 1980s, then even a mild recession can be perceived as very bad news for commercial property, and that can scare the money away (perhaps rightly so, to some extent). Often it depends on how the equity capital reacts. The debt sources, being conservative, almost always shy away from commercial property in a recession (at least, the domestic sources of debt). But if there is sufficient equity capital (domestic &/or foreign) to temporarily take the place of the debt, then the overall property asset market can ride out the storm relatively well.
So when will prices fall?
So now we know why prices fall. But knowing why, is different than knowing when. I love writing these articles, but if I was able to tell you exactly when it’ll happen, I’d be off in my secret lair counting my billions of dollars instead!
But if you can’t know exactly when, you can keep tabs on the situation so it doesn’t catch you by surprise. Don’t be suckered into assuming that interest rates are recessions are going to do it.
Instead, keep an eye on real estate inflows and outflows. Read international business news beyond the US (a nationwide crackdown on wealthy Chinese is great news for US real estate as they shift assets to safer stores of value here). And constantly reevaluate the relative desirability of real estate versus other asset classes. If you do these things, the next change in the cycle won’t catch you by surprise.
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About Ian Ippolito
Ian Ippolito is an investor and serial entrepreneur. He has been interviewed by the Wall Street Journal, Business Week, Forbes, TIME, Fast Company, TechCrunch, CBS News, FOX News and more.
Ian was impressed by the potential of real estate crowdfunding, but frustrated by the lack of quality site reviews and investment analysis. He created The Real Estate Crowdfunding Review to fill that gap.