The Dow Jones Industrial Average plunged 416 points, or 3.3%, on Feb. 27. It was one of the largest one-day price drops since the 30% decline on Black Monday in October 1987 and the 7.1% drop on the day after the terrorist attacks on Sept. 11, 2001. The other major stock averages also plummeted — the S&P 500 by 3.5% and the Nasdaq by 3.86%.
By March 9, all three major indexes ranged from 2.8% to 4.67% below their levels prior to Feb. 27. What, if anything, does this dramatic fall in stock values mean to real estate investors?
No one can answer that question with much certainty, but this column will analyze some underlying factors. One approach is to compare changes in those three stock averages since 2000 with changes in the equity REIT stock index created by the National Association of Real Estate Investment Trusts (NAREIT). Since REIT share prices reflect the investor acceptance of commercial real estate properties generally, this relationship should provide some clues.
A REIT dent, but no crash
On Feb. 27, the NAREIT index fell by 343 points, or 3.25%, and on March 9 dropped to 3.99% below the Feb. 26 level. Thus, the NAREIT index closely followed the other three indexes — with one important difference. Falls in the other three indexes more than wiped out their entire gains since the end of 2006. But the NAREIT index remained about 3% above its value at the end of 2006.
This difference occurred because the NAREIT index had been outperforming the other three indexes since March 2000. In January 2000 the Dow average hit its all-time high — up to that point anyway — of 11,722.98 before beginning a gradual decline. In March 2000, the Nasdaq index reached its all-time high of 5,048 while the S&P 500 stock index reached its still all-time high of 1,527.46. Both began long descents.
At that time, the NAREIT index was around 2,400, down 12% from its high in May 1999. But after March 2000, the NAREIT index began rising as money fled from the general stock market into real estate. The other three stock indexes kept falling to their low points, all on Oct. 2, 2002. Then the Dow was 37% below its previous high, while the S&P 500 was 49% below its high, and the Nasdaq was 78% below. On the same day, the NAREIT index was 33% higher than it had been in March 2000.
A flood of capital fleeing into real estate after the stock market crash in 2000 drove up prices of both housing and commercial real estate properties. Consequently, REIT shares also were being driven upward. By the time in late October 2002 that non-real estate stocks began recovering from their collapse, they were lagging far behind real properties and REIT shares.
This trend is depicted in the accompanying chart, titled “Percentage Change in Four Stock Indexes, 2000-2007.” The NAREIT index increased in value by 330% in that seven-year period up to March 9, 2007. In contrast, only one of the other three indexes — the Dow Jones Industrials — had barely recovered to its high in 2000. The other two indices were still well below their highs in 2000.
Not immune from volatility
Recently the NAREIT index has continued outperforming the other three indexes. In 2006, the NAREIT index rose 32% vs. 14.7% for the Dow, 11.4% for the S&P 500, and 7.65% for the Nasdaq. From Jan. 2 to Feb. 26 of this year — just prior to the recent fall — the NAREIT index gained 8.5% vs. 1.5% for the Dow, 2.6% for the S&P 500, and 3.7% for the Nasdaq. Real estate stocks had outperformed other stocks for seven years straight since March 2000.
However, the NAREIT equity index hit its all-time high of 10,980 on Feb. 7, and then fell 7.9% prior to March 9. The other three indexes declined by only 3% to 4% during that same period. REIT share prices fell slightly more than other stock prices in the month before March 9, 2007, when this column was written.
What's next? From Oct. 2, 2002 until Feb. 27, 2007, the NAREIT equity index moved in the same upward direction as the other three indexes — but faster. When the other three indexes have gone through short downward movements since October 2002, so has the NAREIT index. Thus, the NAREIT index was greatly influenced by movements in the broader stock market. In fact, in percentage terms, the NAREIT index was more volatile than the other three indexes.
Real estate's run is no fluke
The main forces sustaining the superior appreciation of real estate properties and stocks since 2000 have been the (1) immense flow of capital into real estate markets from other types of assets; (2) low interest rates; (3) recovery of real property space markets after the economic downturn in 2001-2002; and (4) a perception among investors that non-real estate stocks were less likely to rise in value than real properties.
These forces have gradually pushed real property prices up, and yields and cap rates downward. That in turn reduced real estate's relative attraction compared to other types of assets — except for the prospect of further appreciation.
I believe that the U.S. economy will slow down in 2007, but both relatively low interest rates and improving U.S. space market conditions are likely to continue in 2007 and 2008, absent any disastrous world events.
If that happens, the flow of capital into real estate markets will probably shift away from purchasing existing properties into developing new ones.
This shift would produce a new commercial property development boom similar to what has already occurred in housing. Such a commercial development boom began in 1998 and lasted until 2001, but then got cut off.
A renewed development boom would gradually undermine the prosperity of existing real properties, thereby discouraging continued capital flows into commercial real estate. Such a boom would take at least two years to deliver enough properties to have a negative impact on real estate markets.
It's unclear if the U.S. economy will continue to expand enough to lure more capital away from real estate into other productive capacities. Or will the economy be notably slowed by a decline in both housing construction and demand for consumer goods? After all, much of consumer demand stems from increases in home equity.
A related issue is whether the risks of putting money back into stocks after the recent crash will continue to persuade investors to stick with real estate instead.
In the short run, February's stock market swoon will neither stop the flow of funds into real estate, nor will it lead immediately to a much larger drop in stock prices. But continued increases in demand for properties plus availability of money will cause new development that gradually undermines the profitability of commercial real estate within the next two years. That will weaken, or end, the superior value appreciation that real estate has enjoyed in the past few years.
Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at [email protected].