Dangers of Decoupling: Don’t Call It a Bubble, But Investment Outpacing Cash Flow
By Sam Chandan February 3, 2011 4:44 pm
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New York City’s commercial real estate investment market has rebounded strongly over the course of the past year. Sales volumes and pricing metrics have both climbed from their lows, outpacing improvements in other major markets. The gains measured for the most visible assets, in the office sector in particular, have exceeded upside expectations during the depths of the financial crisis. Even as cap rates have fallen, spreads have remained wide by historic standards, attracting a confluence of investors and lenders.
Unfortunately, the observable improvements in investment activity have not yet been matched by gains in jobs or in the broadest measures of property fundamentals. While the most current data on absorption and occupancy rates show that fundamentals have reached an inflexion point in the city’s strongest submarkets, the otherwise lagging pace of the recovery in cash flow as compared to investment has raised questions about whether the two measures of the market’s recovery are at risk of decoupling.
Concerns about such a decoupling are reinforced by the divergence of pricing trends between the major markets, including New York, and the rest of the country. New York has been a primary beneficiary of the widely observed bifurcation of capital flows over the past year, both in terms of equity flows and credit availability. Investor and lender preferences for a select group of markets have translated into more intense competition in the arenas of acquisition and loan-making, and upward pressure on asset prices as a result. Few if any markets have matched New York in this regard.
One basis for the market bifurcation that has received scant formal attention is the role of liquidity. In New York, the improvement in pricing absent lockstep gains in fundamentals is critically reflective of the role that liquidity has played in fueling the recovery and its geographic peculiarities. If we think of liquidity as the ease of trading of real estate assets, New York has a material advantage over its peers.
Measures of liquidity rise in the presence of diverse buyer and seller groups, as well as the financing. The persistence and durability of those market participants and the efficiency with which counterparties can be identified also limit downside risks of a shock to liquidity. While the vast literature on the role of liquidity in financial markets demonstrates that it plays a role in asset prices, the underlying theory and empirical models have not been widely deployed in the practical study of commercial real estate. The current recovery cycle, however, suggests that liquidity plays an important role in the property market and that it can, under some circumstances, dominate fundamentals drivers.
The Problem With Measurement
As far as the drivers of fundamentals are concerned, New York City’s office-using labor market weathered the recession far better than was originally expected. The drop-off in demand for space exceeded actual job losses, reflecting the uncertainty that characterized the financial services outlook during this period. Many firms were understandably hesitant to commit to long-term leases, even if their own payroll outlook was stable.
As compared to 2009 and early 2010, business conditions have normalized significantly. This has emboldened firms that previously held off on committing to new space, driving a marked increase in leasing activity in the second half of 2010 and in the New Year. The uptick in leasing activity has tended to favor the highest-quality and best-located properties, which are now capturing a disproportionate share of absorption.
Just as overall fundamentals trends lag behind relatively healthier gains at the subset of prime properties-and weaker improvements elsewhere-measures of pricing and investment activity also capture buyers’ and lenders’ elevated bias in favor of premium assets. As a measurement challenge, this means that investment metrics will only reflect those properties that trade while rent and occupancy measures will reflect the average across the broader inventory. The fundamentals trends for all properties in the market will necessarily dilute the cash-flow trajectory of the assets that are currently defining the investment momentum. A direct comparison of the two trend lines will overstate the extent of decoupling.
Risks Remain Idiosyncratic, Not Systematic
Ultimately, the empirical analysis suggests that investors in high-quality assets remain on terra firma. The appropriateness of pricing and the potential for a winner’s curse can still be determined on an asset-by-asset basis, alongside an assessment of buyers’ capital costs.
Where the structure of financing covers risks of rising interest rates, the evidence currently weighs against arguments of systematically inflated prices in New York City or an imminent reversal in the positive trend. That may not remain the case, however. If prices continue to improve and current expectations of stronger gains in fundamentals are not met, the situation could grow more problematic.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.
