The article below was published recently by Torto Wheaton Research, the research arm of CB Richard Ellis. They are a well respected research organization in the real estate area. This article was written by Joh Southard, SVP, Director of Research & Chief Economist
WORRY, DON’T PANIC
Commercial real estate faces more challenges today than it has for several years. That said, however, the recent failures of the residential real estate market have led to far too much innuendo that commercial real estate is “next.” For those less familiar with the industry: that they share the words “real estate” does not indicate that residential and commercial real estate have much else in common.
During normal periods, residential and commercial would share the characteristic of being influenced by the economy, and some of the weakest analysis I have seen has taken this to mean that what happens to residential will always happen to commercial. Not so. What is not normal about this period is that the decline in residential is leading the economy, rather than being caused by a recession. As such, past cycles tell us little about what will happen to commercial real estate this time. Put a different way, commercial real estate is no more related to residential real estate than auto sales, airline bookings, or myriad other industries that are affected by the economy.
Most importantly, commercial real estate has not exhibited the same pattern of building that has been seen in residential real estate so far this decade. While residential already faces a significant overhang of space even without a decline in employment, commercial markets are almost universally in a very balanced position, where fundamental demand is pushing up rents. This can be contrasted with the bust of 1991, in which a recession compounded what was already a problem of overbuilding in the commercial markets. You wouldn’t recognize this difference by looking at some of the price movements that are occurring today, for example, the CMBS market reaching record spreads. One could go so far as to point to instances where short sellers seem to be playing off of the confusion that results from this false association between commercial and residential, thanks to the “real estate” label.
While panic may be an opportunity, the reasons for worry are the same as those shared across many industries. The slowdown in the economy that we project will mean less demand for commercial real estate. Furthermore, if you are a believer that the challenges of the current economy will drive us into recession, commercial real estate would suffer the consequences like many others.
The global re-pricing of risk is also a source of worry. Again, commercial real estate shares this concern with many other categories of investment, from emerging market government bonds to, depending on the day, the U.S. stock market. Even here, this pricing is often measured in spreads over U.S. Treasuries, and to the extent that Treasuries have been declining, the effect has been neutralized so far. In the past we have highlighted concerns about pricing on the equity side and the effect of capital on the debt side, but none of these concerns should be remotely compared to some of the stories of headlong denial of risk that have emerged from the sub-prime debacle.
While it is true that bad decision-making will be exposed if either recession worries or pricing worries come to fruition, it is ironic that the public markets seem to have been the creators of noise in the system in this year, both as the market crested and then as sentiment swung in the opposite direction. Now, many of those players that were viewed askance for not being subject to daily public market pricing scrutiny (private developers, insurance company lenders) are using their longer-term focus to take advantage of the swings of today’s market by having a deep, informed knowledge of the industry that some of the financial players setting today’s public prices may lack.
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