The Paradox of Frothiness


Is there a bubble in the office sector? In the market for the most visible and best-located assets, Manhattan’s current spate of trophy sales begs a more nuanced question: has pricing moved from merely aggressive to excessive? The dominant view amongst high-profile investors and lenders is that pricing remains in check. But that means very little, it turns out, since frothiness in the asset market can only persist as long as the chief stewards of capital believe we remain on an even-keel. Baudelaire could have been talking about real estate markets when he surmised, “the finest trick of the devil is to persuade you that he does not exist.” Likewise, in assessing whether trophy office prices may be prone to correction, we need something more than our basic intuition.

Localized Mispricing

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The question of pricing cannot be applied to the office sector in a way that is overly broad and undifferentiated. National averages for cap rate spreads and corresponding aggregates for construction may shape common opinions, but these numbers are less instructive when liquidity and location within the metropolitan area matter inordinately. From the vantage point of investors and lenders entrenched in America’s suburbs, in particular, it seems less plausible that prices have diverged significantly from underlying values. With a few notable exceptions, such as the Bay Area, low- and mid-rise office properties located outside the urban core have seen relatively unexceptional recoveries since the recession.

The hunt for yield has allowed stronger capital inflows to a range of opportunities that were off limits in the early stages of the recovery, including suburban markets, secondary markets, and lower quality properties. But even as equity and credit gaps have closed, higher cap rates and debt yields have persisted in these segments, reflecting lower liquidity and a more reserved long-term outlook for suburban fundamentals. All else being equal, there are also fewer competitors in the suburban environs, both in terms of buyers and sources of financing. Loan structures, sizing and pricing evince somewhat higher standards for underwriting than in the central business districts, even as regional and community banks find themselves toe-to-toe with a surfeit of conduits. On balance, suburban property values are more closely anchored to income.

As New York City’s investors and lenders can attest, the landscape shifts dramatically as we move closer to the strongest agglomerations of our gateway markets. For highly coveted assets in central business districts, most unambiguously the trophies of the Manhattan skyline, concerns about prices that may have decoupled from long-term fundamentals are more credible and deserve assessment. In this setting, where supply constraints are typically stronger, the imbalance of abundant low-cost institutional capital and a finite number of tradable assets has played a role in lifting prices that is not fully appreciated.

Elusive By Definition

The average cap rate in Manhattan was roughly 4.5 percent in the third quarter, only marginally higher than its pre-crisis nadir. Believers will argue that spreads are still within historic norms and real estate still offers more attractive yields on a going-in basis than other asset classes. They should be cautioned. This reasoning ignores the impact of distortions from monetary policy as well as global inflows into treasuries and agency debt that are motivated by much larger forces.

Observers will also point to a diversity of investors, both domestic and foreign, as the market’s verdict on prices. The current lineup of buyers attests that a subset of commercial properties is a strong lure for cross-border investors, many of which have longer investment time-horizons and are strongly   motivated to diversify into the United States. But cross-border investments’ larger slice of the pie is not a validation of pricing trends as much as a contributor. History is not without examples of foreign buyers snatching up New York trophies at the market peak only to realize or wait out losses later on.

Does this amount to a bubble? A problem emerges when prices diverge from levels consistent with a market that is functioning efficiently—where currently available information with regard to the future performance of an asset is internalized rationally. Symptoms can include rapid increases in prices and transaction velocity that allow for outsized gains over short holding periods. We may not be there yet, but we are on the right road.

Since significant mispricing has roots in  irrational expectations, the-ex ante identification of bubbles can seem an arbitrary battleground for debate. By definition, the identification of mispricing will be contrary to the market’s widely held views until such time as expectations and behaviors change and a correction is underway. For properties that have seen prices lifted inordinately by enthusiasm or the free flow of capital, that means intuition is subject to error.

Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School, University of Pennsylvania. The views expressed here are his own. He can be reached at