Arnold Kling  

Commercial Real Estate Prices: What Inference to Draw?

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Rules and Culture... Two Follow-ups...

Megan McArdle writes,


My latest column for the Atlantic looks at the commercial real estate crash and comes to the conclusion that it effectively undermines the major narratives that many people have adopted to explain the residential bubble. Though the commercial real estate bubble was smaller in scope than the residential one, it was characterized by essentially the same pathologies: rising prices, stupid banks, and stupid borrowers.

Paul Krugman contributes a graph showing that commercial real estate prices followed a similar arc to residential real estate prices in the past decade.

I would not make such a big deal of this. First of all, land is land. It is not surprising that residential and commercial prices move similarly. It would be more puzzling if they diverged.

Having said that, my guess is that in most periods you would see somewhat less volatility in residential real estate prices than in commercial real estate prices. I would think that commercial real estate would tend to be somewhat more sensitive to interest rates and to economic conditions than residential real estate, where prices are probably stickier.

My guess is that the cycle in commercial real estate prices can be explained pretty well by (a) the normal response of that market to interest rates and economic conditions and (b) the sharp movements in land prices due to the housing bubble/bust. My guess is that only a relatively small component of the swing requires a story of irrational investor expectations. (Of course, if you think that commercial real estate investors should have been able to read the housing bubble, then you can argue that a much bigger component of the commercial bubble reflected irrational expectations.)

McArdle and Krugman want to say, "Gotcha! All of your theories of the bubble that are specific to housing and mortgages need to be tossed out. Instead, you need a theory that can simultaneously explain a commercial real estate bubble and a housing bubble."

Sorry, I don't accept the "gotcha." The housing-specific component of the bubble was really, really important, and the component specific to commercial real estate much less so.

[UPDATE: Scott Sumner is with me on this one.]


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COMMENTS (13 to date)
Matt writes:

Like you said, land is land. Doesn't this mean that commercial and residential would be linked throughout? I mean, if the price of houses in a neighborhood goes up, wouldn't the price of the shopping mall next to the neighborhood follow suit?

Also, aren't they both generally going through the same players in real estate? So if excess subsidies in residential causes mortgage companies to give bad loans, wouldn't they also use those subsidies to cover their bottom line in commercial, in effect distorting the marginal profability?

I'd like to know, because I'm not sure how closely residential and commercial are intertwined.

Ryan Vann writes:

My ability to look up stats is pretty bad, but what is the realtionship looking back over a longer time period, say to the early 90s? Seems to me both prices would move together as available land is used up, people accrue more wealth, etc, etc. Building and new starts might move in completely different directions of course.

SydB writes:

Mr Summer, though he probably doesn't intend as such, sounds like a post-modernist constructivist:

"I am not a believer in bubbles. That doesn’t mean I don’t think bubbles exist, rather I don’t know of any coherent definition that is useful."

In short: I don't believe in something that I think exists.

And: If I could assemble some words, then I would believe in it.

He's incoherent. Perhaps he could use some guidance on basic philosophical concepts and expression?

ab writes:

Couldn't CRE prices be driven down by rising unemployment rates and greater uncertainty? If so, then would it stand to reason that the residential real estate crash was a cause of the drop in CRE prices?

I do mean this as a real question, not as an opinion.

Ryan Vann writes:

Ab,

Pertinent question; I'd imagine it is difficult to sort out which is the cause and effect, or if there is some feedback loops involved. There is probably a lot of colinearity going on, which might be the point of the graph posting by Krugman (not saying it is).

Milton Recht writes:

Arnold,
You are correct. There are more boom and bust cycles in commercial real estate (certainly on a regional level) than residential. Bank CRE lending went bust in the mid to late 1970s (money center banks had severe commercial real estate loan problems then), the late 1980s (Bank of New England among others had tremendous problems) through early 1990s (purported reason for Chase-Chemical Bank merger) and now.

Residential housing did not go through the same severe post WWII boom/bust cycle until now. The S&L collapse of the 1980s was due mostly to a mismatch in funding. Using short-term rates to fund long term fixed mortgages and when short-term rates rose, legacy fixed rate mortgages on the S&L books produced losses instead of profits. There was not a similar housing price collapse or excessive residential mortgage defaults that caused the S&L problems.

It would be astounding in this economic downturn if CRE did not show a severe downturn. Commercial real estate developers seem to always overbuild in good times, suffer huge losses in bad economic times and take the banks with them. Their philosophy is if you build it they will come and I will build it if you give me the loan until banks stop lending to them, call in the debt, and they file for bankruptcy or restructure their debt.

CRE difficulties are on a distinct cycle that follows the ups and downs of the economy. The cycle is separate from residential and just happens to overlap this residential housing crisis.

I think the fundamental question is if the economy had not gone into a recession would the housing market have collapsed any way? If it were in a bubble then it did not need a recession to burst and housing would have crashed anyway. Maybe it would collapse later than it did, but it was inevitable.

If the early effects of the recession started and caused the housing collapse (lower productivity, increased unemployment, lower HH income, lower than expected growth in HH income, higher oil prices) then the recession is the prime mover. There may have been feedback and amplification from the concurrent housing collapse, which made the recession worse. In this scenario, the housing bubble is a side issue to the recession causes and is only an issue for why it was not contained and limited in its effect.

We could just be in the unfortunate situation of having two bad economic things occurring at the same time. A housing bubble burst and a recession. In which case, more work needs to be done on the cause of the recession, why it became so severe and on what the Fed missed that allowed the recession to happen. That is a different focus that preventing future bubbles.

There has not been a coherent and clear understanding of why the housing collapse caused such a severe recession (certainly in employment and consumer demand). A homeowner that defaults or walks away from a mortgage, frees up the excess amount of the monthly payment over renting, a lower priced home, or moving in with someone else and consumer demand should not decrease. Even those that foresaw the bubble collapse never expected the economy to collapse as much as it did.

I think we are dealing with two different issues that just happened at the same time. Something akin to a flood and a war, both horrible if they happen at the same time, but neither causes the other. The housing bubble burst and something else caused severe unemployment, a consumer demand collapse and a recession.

Nick writes:

"Land is Land" ? I would not think land is really fungible in the way you seem to be implying due to zoning laws. Residential zoned area prices wouldn't raise the value of commercially zoned areas I would think because you cannot build houses there.

Joe Calhoun writes:

Um, don't Krugman and McArdle realize that the housing bubble related businesses are what drove the demand for commercial real estate space? How many mortgage companies, title companies, etc. are no longer occupying commercial real estate space? Here in S. Florida, most of the vacant commercial space was once occupied by some real estate related company and new buildings were planned/built based on the perceived shortage of space at the peak of the boom. Now those buildings are coming on line - it takes time to build an office building - and prices are plummeting because lease rates are falling. The idea that this somehow proves that government policy was not complicit in blowing the residential real estate bubble is absurd.

Jeff Johnson writes:

Milton Recht is closest to the correct answer in my opinion, writing from my "inside industry" position as both a commercial real estate participant, developer, commercial appraiser, and amateur economist. Commercial real estate fortunes and trends are most directly linked to overall economic conditions (market demand, cost of and availability of money) -- and business trends (just in time delivery versus warehousing stockpiles, suburban commuting versus urban gentrification). Commercial real estate trends are very cyclical. The typical sophisticated commercial developer is looking to create value (money) by creating (developing, selling, leasing) a product, rolling over a price increase or two (a couple of lease rollovers), paying down the principal balance a little, benefiting from some depreciation or tax credits, then flipping the property within 7 to 10 years (at a profit, hopefully) to the next investor.

The early shocks leading up to the 2008 Recession (skyrocketing energy prices, and other expected inflation), and the "freeze up" and sudden downsizing in corporate (read: tenant and investor) decision making, and the Fall and Winter 2008-2009 "freeze up" of the capital markets(which continues today to a large extent with respect to CRE) accelerated commercial markets that were already on somewhat of a "supply/demand" decline from 2005 to 2007 on shrinking consumer spending (loss of paper net worth on home equity) and earning ability, and employment trends. CRE overbuilding was evident in many markets by 2005-2006, and the entry of large institutional investors (always last to the party in CRE trends, and always first to take the big hits) into the office building buying frenzy in Spring-Summer of 2007, surely signaled that the collapse was imminent, to certain astute CRE observers.

It seems the big institutional real estate investors are always the last ones to "jump in" on a rising CRE value market, and are often ill equipped to deal with the mundane local management details that separate a good long-term CRE deal from a bad one, so they usually take the big hit. Smart developers know this, so as we collectively sit on the edge of the coming 2010-2011 CRE abyss in Early 2010, the smart developers are already "sitting this one out", to start development anew in the 2012-2013 recovery. Again, the institutions will miss the good early deals, forget their mistakes and wounds from the 2008-2011 CRE Recession, and show up with hands full of money to invest at the peak of the next market, maybe 2017-2018.

The real determining factors of CRE trends are user demand, availability or scarcity of CRE product and land, and financial (financing) costs, and to a lesser extent (except in the case of Tax Reform Act 1986, or Reduced Capital gains, recently) government or tax policy. These are driven by population growth, infrastructure changes, and job growth, and employee income growth. The flat to negative growth in national household earning and wealth,and employment (especially higher income manufacturing employment) from 1999 to 2009, exposed recently in Wall Street Journal Articles, makes it hard to believe that we will see anything other than a long and protracted continued slide in the national CRE market for the next few years, unless you are lucky enough to live in market that is experiencing job and income growth (government worker SMSA's). UNtil the national economy's systemic (job growth, international competitiveness) issues are dealt with, its hard to see how this ship will "right" itself. Fortunately, CRE is really a huge collection of local markets, so as the "Realtors" say "every market is different".

Steve Sailer writes:

Krugman's graph disproves his own theory -- it shows housing prices going up a year to two years ahead of commercial real estate. The housing bubble was creating wealth, both in cash and in notional values of net worth, that funded more consumer spending, leading to commercial real estate booming later. For example, my barber, a Southern California homeowner, spent about 30 nights per year in Las Vegas during the Bubble gambling. The evanescent wealth generated in Sand State homeowners by the Housing Bubble led Las Vegas to invest in colossal new casinos, many of which, like the $5 Echelon are now mothballed, half finished.

Dave writes:

I can't believe I'm about to do this, but I will defend Krugman's post. When I first saw it, I had the same reaction: duh, land is land, that proves nothing. But his point is that Freddie, Fannie, and the CRA support lending to residential buyers only. If CRE was becoming too pricey, why did lenders lend to the commercial borrowers? Certainly, they would've seen that the borrowers could not afford the commercial real estate and not make the loans. He is merely arguing against the Fannie/Freddie/CRA narrative.

Now, his point could be disproven if you saw that the CRE rising prices resulted in much lower quantities being bought. I don't have the facts on this, so I don't know for sure; but my guess is that quantities did not suffer, and it was part of a similar credit bubble.

Mr. Econotarian writes:

Obviously we had too much aggregate demand during the bubble, and government should have cut spending :)

Mike Rulle writes:

MM's "stupid borrower concept" is funny.

Look how rich Donald Trump got betting with OPM. If the amount you can lose is closer to zero and the amount you can win is closer to infinite----and you get to keep playing the game---its hard to call the borrowers stupid.

Commercial RE is 1/10th Residential. But the latter was also not done in by stupid borrowers either. During the "last days" of the rising bubble, borrowers put zero down or close enough to make it worth the bet. On the margin, these borrowers were the tipping point buyers. Again, why are the borrowers stupid?

The real stupid one's were those who bailed out the financial institutions---that means all of us, MM included.

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