The next major end-of-cycle crash in commercial property values will almost certainly not happen for some time. But if I am wrong and the crash is imminent, the way the market is behaving is very definitely different this time.
It is not at all clear that the industry recognises the breadth and magnitude of the structural changes in commercial real estate (CRE) and their consequences on the behaviour of property through the cycle – on investment decisions, financial returns and the skills, resources and business models required to succeed in tomorrow’s industry.
Take the probability of an imminent boom/bust crash. Office and industrial values stand at between 20% and 30% above the inflation-adjusted long-term average. Historically, this would be a strong signal that the market is in dangerous territory – DEFCON 3. We’ve been here before.
But this time it’s different. Instead of this growth in values being driven by a rapid acceleration of real estate lending, today’s reported total outstanding CRE loans are around 30% below the 2008 high point. In all three of the post-war major CRE booms and busts, at this stage total CRE lending stood at between 200% and 500% above the previous end-of-cycle lending levels – with new loans being made at loan-to-value ratios of 75%, instead of around 60% as is the case today.
Past cycles have shaped our perception of how real estate markets behave, but today’s market is not being driven by excessive CRE lending. To interpret the current cycle, one must explain the voracious flow of global equity into the market and understand how volatile that equity might be in times of distress (true equity investments are far less volatile than leveraged investments) – and, most importantly, how much of that equity is driven by externalised debt (derived from government quantitative easing and the financial structure of international domestic economies).
Also consider the assumption that real estate capital values grow in the long term – a truism hardwired into the industry’s subconscious, based on post-war experience. This is true for most real estate when inflation is high, but with very low inflation (the annual depreciation rate of the fabric of many buildings will almost certainly exceed inflation) and unprecedented levels of disruptive structural change in many parts of the industry, it is easy to conclude that CRE capital values are more likely to fall than to rise, even in the long term.
Property’s 40-year free ride
If you think this is far fetched, remember that the industry has benefited from a 40-year trend of falling interest rates (they were around 18% in the early 1980s). This has boosted capital values, a free ride that is unrepeatable starting from today’s levels of around 2%. So it is probably not surprising that, in spite of huge yield compression, MSCI/IPD All-Property capital values are still materially below the 2007 high. How many investors are factoring these thoughts into their asset pricing, investment strategies and investor reports?
And what of real estate’s nature as an asset class, characterised as a halfway house between equities and bonds? The CRE investment proposition has moved a long way from 25-year FRI leases – buy it, sit on it and collect the rent. With a few exceptions, real estate that aspires to remain economically sustainable (as well as environmentally and socially sustainable) requires a more dynamic business operating model than the traditional manager/owner structure – property manager, asset manager, investor – is geared up for.
“It is easy to conclude that CRE capital values are more likely to fall than rise”
Some industry stakeholders are ‘beach body ready’ for the challenges ahead (or getting there), but is the industry generally? The retail sector requires huge distress to disrupt established operating and financial business models and force a reimagination of a more bespoke and curated product and how it is delivered. To a far lesser extent, the same is true of offices.
Mixed-use, the link between retail, office and residential, is rightly heralded as the way forward – even though it is still hard to name any established mixed-use development, investment or operating specialists.
So the market really is different this time. The beach awaits, but how ready are you?
Rupert Clarke – Lipton Rogers, First Base and Milligan