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U.S. commercial real estate

While there are signs of stress emerging in various local commercial property markets in the U.S., this time around does look very different from the edge of the precipice we were looking at last time around.

This time it’s different. Really.

That’s the punch line of one of the longest running jokes in the financial markets – the promise that this time market prices will continue on an upwardly ascendant course, with asset values appreciating like a hockey stick, as far as the eye can see. It’s the mantra of techno-utopians, like George Gilder, and corporate empire builders like Harold Geneen, who promise continued outsized returns based on the notion that digital technology or corporate conglomerates or railroads or tulip bulbs or whatever the mania du jour happens to be changes everything and will enable investors to defy the traditional rules of the business cycle.

While investors are always well advised to be cautious about the promise of transformational change, there nonetheless is much truth to the slogan that this time will be different. It always is, after all, because not every turn in the business cycle follows the exact same trajectory, in terms of the depth or duration of the downturn or the subsequent recovery – history rhymes but doesn’t repeat itself, as Mark Twain supposedly said, which certainly holds true in the financial realm, where the general business cycle follows predictable patterns and yet with tremendous variation from one cycle to the next in all the particulars.

Here for example is a chart based on data from Green Street Advisors showing the swings in value in the U.S. commercial real estate market over the period from 2001 to 2016.

blog graph

There are a number of interesting things in this chart. Financial commentators have noted with concern how the run up in value of the Commercial Property Price Index (“CPPI”) over the last few years has gone well into the stratosphere, climbing more than 23% above its prior peak reached before the bubble burst in 2007. Such dramatic saw tooth price movement certainly gives one cause for concern, particularly if the commercial property market in the U.S. is, in fact, now approaching an inflection point. It’s a long way down from the incredible run up we’ve seen in the last few years.

And yet this time around there really are significant differences at work, at least on the macro level. The CPPI collapse from September 2007 to May 2009 reflects a broad and deep collapse in commercial property values – the sort of sharp broad price movement that you would expect to see in conjunction with a widespread financial crisis. It reflects a collapse in commercial real estate prices in all categories and regions of the country in a short period of time, not so much driven by real estate fundamentals as by financial markets conditions, as liquidity in the debt and equity markets virtually disappeared overnight after the Lehman bankruptcy.

In contrast, the warning signs flashing now in the U.S. commercial property market seem to be focused on particular markets, and driven by traditional factors of supply and demand, including a glut of available office space in the Houston area (driven by the wave of insolvencies rolling through the energy sector) as well as growing concerns about San Francisco, where weakness in the tech sector, and the closing of the IPO window, is creating fears about a potential overhang of available space, when prime tenants back away from their expansion plan and opt to sublet their space.

Looking beyond the conditions in the real estate market, the general state of the U.S. economy today seems far different from the crisis conditions that developed in 2008. While the U.S. has stabilized somewhat, allowing the Fed to raise interest rates for the first time in about a decade, the labour market is flagging yet again.

Wall Street’s top banks have all but abandoned any expectation that the Federal Reserve will raise interest rates in June, and most now see the U.S. central bank’s next rate hike coming in September, according to a Reuters survey conducted after the April jobs report.

So yes, while there are signs of stress emerging in various local commercial property markets in the U.S., this time around does look very different from the edge of the precipice we were looking at last time around.

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