Is the Gap Between Residential and Commercial Values Structural or Cyclical?

Is the Gap Between Residential and Commercial Values Structural or Cyclical?

Commercial and residential values have generally moved in lockstep over the last three decades. Today, however, home prices continue to remain volatile and close to the bottom while commercial real estate values are generally en route to recovery.

Did the severity of the last recession alter the fundamental relationship between owner-occupied homes and commercial real estate?

Standard theory from urban economics suggests that the same basic forces influence demand for both housing and commercial real estate, according to seminal papers written by economists Sherwin Rosen and Jennifer Roback in 1979 and 1982, respectively.

A white paper written by economist Joseph Gyourko in 2009 confirmed that the two asset classes do exhibit fairly strong correlation. Interestingly, the results were roughly the same, whether returns from commercial real estate investments were measured using different data sets from the National Association of Real Estate Investment Trusts or the National Council of Real Estate Investment Fiduciaries.

Changes in inflation-adjusted home prices were measured using the Federal Housing Finance Agency’s repeat sales house price index. However, the study’s time horizon covered periods from the early 1980s to 2008. It was in 2009 when the recession became particularly severe.

While 2010 was still rocky for commercial real estate, capitalization rates began to stabilize and even fall slightly. Cap rates for office properties declined from 8.2% in late 2009 to approximately 7.1% by the end of 2010. (The cap rate is the initial return to an investor based on the purchase price of a real estate asset and the net operating income. The lower the cap rate, the higher the price.)

Reis recorded the first drop in national vacancies for office properties in the first quarter of 2011, and both asking and effective rents even posted slight increases. Retail properties are still struggling, but vacancies have remained flat at 10.9% for three quarters, indicating that the sector may have bottomed.

Multifamily properties are the belle of the ball, with vacancies declining sharply from a 30-year high of 8% to 6.2% as of the first quarter of this year. Cap rates for apartment properties, which rose by 100 basis points from a low of 6.3% in 2007, are now back down to 6.7%.

By contrast, home prices have remained close to the bottom, and recent data suggest that uncertainty about recovery remains. Year-over-year changes in the latest S&P/Case-Shiller Home Price Indices through February 2011 register a decline of 3.3% for the 20-city composite.

A page-one story in The Wall Street Journal on May 9 highlighted an 8.2% drop in median U.S. home values in March 2011 from the year prior, using data released by Zillow.

Cyclical factors still at play

While it is tempting to assert that home prices and commercial property values will now follow different structural paths, it is important to consider cyclical factors that are still playing out.

A bust in home prices and the resulting contraction in credit caused the recession. It may take at least a year for the demand for homes to soak up excess supply from overbuilding and foreclosures, assuming the economy continues to recover at its measured pace. Home prices will remain volatile and close to the bottom as a result.

There was far less overbuilding in most commercial real estate sectors. The office sector, in particular, experienced a dramatic pullback in the most recent cycle, when inventory growth only averaged 0.54% from 2004 to 2008. That is only about one-fifth of the inventory growth rate from 1998 to 2003.

In other words, while this recession was characterized primarily by an unprecedented reduction in aggregate demand, commercial real estate sectors like office properties had to contend with far less of a supply glut that would have made matters worse.

This is not to understate the profound distress that office properties went through in 2009, when effective rents fell by a record 8.9% in a single year. At the epicenter of the crash in financial services was New York City, where effective rents fell by 19.8%, more than twice the decline recorded in the 12 months following 9/11.

Still, had there been significantly more overbuilding as in the early 1980s, conditions would have been much worse.

What about the popular notion that national home prices never fell until the housing bust in 2006? Doesn’t that suggest that simple correlations are suspect, and that owner-occupied, single-family homes don’t really follow cycles, unlike commercial properties that have experienced at least three boom and bust periods since the late 1970s?

True, nominal home prices from the Federal Housing Finance Agency index show a steady march upward from 1975 until 2007. However, the inflation-adjusted series clearly shows that home prices experienced a decline of about 12% from 1979 and 1982, and encountered a more modest dip of about 6% between 1989 and 1994. These bust periods roughly correspond to the years when NCREIF’s total returns index also was negative.

A distinction worth reviewing

It is important to differentiate between structural factors and cyclical factors when thinking about gauging the health of one sector in the economy, like commercial real estate, by using a correlated sector such as single-family, owner-occupied homes. The cyclical factors we just discussed imply that commercial real estate values will recover more quickly than home prices.

Structural factors influence long-term changes in demand and supply. For example, if a city like Detroit continues to lose population and employment given structural changes in the economy, then expect demand for both housing and commercial real estate to contract.

At the regional level, some developers are still keen on several markets in the Sunbelt, betting that better weather will continue to prompt population shifts to the area fleeing the cold Northeast. These are bets on structural changes. But these developers are understandably waiting for cyclical factors like the current slump in prices to imply an upturn in demand before diving in.

Structural change may imply inexorable decline for some areas, but the fate of cities and sectors is not written in stone. Pittsburgh reinvented itself from a manufacturing center to a city more dependent on health and education jobs, which served both its residential and commercial sectors well in the last downturn.

There may not be as much demand for housing in Detroit, but recent plans from both the government and private sector players like Bank of America to demolish abandoned homes and “right-size” the city imply that policy can attempt to alter structural decline.

There are, of course, fundamental differences in investing in income-producing properties like office buildings, and owner-occupied homes that do not yield rental income. However, the divorce between residential and commercial properties appears to be a cyclical, and not a structural, phenomenon.

This relationship implies that despite the optimism for commercial real estate, it still behooves the astute investor to look at related residential sectors for clues that specific metros as a whole might not be completely out of the woods just yet.

Victor Calanog is head of research and economics for New York-based research firm Reis.


Roback, Jennifer, “Wages, Rents and the Quality of Life,” Journal of Political Economy, Vol. 90, No. 4 (1982), pp. 1257-78.

Rosen, Sherwin, “Wage-Based Indexes of Urban Quality of Life.” In P. Mieszkowski, M. Straszheim (eds.), Current Issues in Urban Economics, Baltimore: Johns Hopkins University Press (1979), pp. 74-104.

Gyourko, Joseph, “Understanding Commercial Real Estate: How Different from Housing Is It?” Journal of Portfolio Management Vol. 35 (2009), pp. 23-37.

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