Real Estate Market Fundamentals and Asset Pricing Petros S. Sivitanides, Raymond G. Torto, and William C. Wheaton n the last year we have heard much discussion of a disconnect between the commercial real estate cap- ital and space markets. We see declines in the cap rates (yields) of property transactions, while a weak- Iened economy has generated deteriorating real estate market fundamentals (Gordon [2003]; Kaiser [2003]). Corcoran and Iwai [2003] argue that such a pattern could be just what an efficient asset market should pro- duce if the space market is always mean-reverting. If fundamentals are temporarily depressed, an efficient mar- ket will keep prices firm and hence produce lower cap rates—in anticipation of a recovery. If the space market is strong, cap rates should fall in anticipation of eventual new supply and market softening. PETROS S. SIVITANIDES is a Our objective in this discussion is an econometric senior economist at Torto examination of the historical movements in office space Wheaton Research in Boston (MA 02110). market fundamentals (vacancy and rental rates) in order psivitanides@ to compare them with a similar history of office market tortowheatonresearch.com capital movements (prices and yields). This comparison supports three conclusions: RAYMOND G. TORTO is a managing director at Torto Wheaton Research in Boston 1. In examining how market fundamentals influ- (MA 02110). ence asset pricing, it is crucial to control for [email protected] interest rates. In fact, a better way to measure how the asset market views the space market is WILLIAM C. WHEATON is a to look at real estate spreads over Treasuries. professor of economics at 2. The behavior of both spreads and cap rates— Massachusetts Institute of Technology in Cambridge controlling for interest rates—suggests that the (MA 02139). real estate asset market does not look forward, but [email protected] rather looks myopically at current conditions. SPECIAL ISSUE 2003 THE JOURNAL OF PORTFOLIO MANAGEMENT 45 Copyright © 2003 Institutional Investor, Inc. All Rights Reserved Instead of finding low cap rates during market different story from cap rate levels. Our empirical method- downturns, we find strong evidence that they ology involves the estimation of panel-based models of rise—or that spreads widen. office capitalization rates and spreads. 3. There is little evidence to suggest that this pat- tern has changed recently, or that the real estate BEHAVIOR OF OFFICE SPACE asset market has become more efficient. MARKET FUNDAMENTALS To understand the recent developments in real estate During the last 15 years, studies of office market markets, it must be remembered that cap rate levels and behavior have established how slowly real estate markets movements are determined by both space market funda- adjust toward equilibrium (Wheaton [1987]; Sivitanides mentals and broader capital market forces (Sivitanidou and [1997]; Sivitanidou [2002]). It takes only one look at the Sivitanides [1999]; Sivitanides et al. [2001]). Since these historical movements in the national office vacancy rate two sets of forces may exert different pressures on cap rates, over the past 23 years to realize how extremely long the the direction of cap rate movements in any particular last vacancy cycle was: 20 years (Exhibit 1). period must be interpreted as the net effect of these The national office vacancy rate bottomed out most opposing pressures. recently in 2000, just before the burst of the dot-com bub- In past recessions, interest rates have been high. ble and the beginning of the current recession. The bot- To gether with widening spreads, this has raised cap rates tom in 2000 ended a vacancy spike that had started exactly and lowered values. In the current recession, however, 20 years earlier, in 1980, as the market bottomed out just interest rates have reached record lows. Together with below 4%. After that it took the market 11 years to reach widening spreads, this has led to stable or even declining a peak and another 9 years to return to a trough. cap rates—the original puzzle that several articles in this After it bottomed out in 1980, the vacancy rate issue seek to address. climbed quite rapidly. By 1986 it had reached nearly the We review long-term trends in office market fun- 18% mark, but it did not stop there. It continued creep- damentals—vacancies and market rents—and examine ing slowly upward for another five years, hitting its peak the associated behavior of privately held property incomes at about 19% in 1991, when the economy took a down- and values and cap rates. We also examine long- and turn. What turned out to be a relatively mild recession short-term trends in cap rate spreads to see if they tell a for the economy proved to be the ultimate collapse for E XHIBIT 1 Historical Behavior of Office Market Fundamentals 40 20 36 16 32 12 28 8 24 4 20 0 1992 2002 1982 1988 1980 1984 1986 1990 1994 1996 1998 2000 Real Office Rent Vacancy Weighted aggregates for 53 office markets covered by CBRE/Torto Wheaton Research. Source: CBRE/TWR. 46 REAL ESTATE MARKET FUNDAMENTALS AND ASSET PRICING SPECIAL ISSUE 2003 the nation’s office market, as cash flows plummeted and (P). The ratio of a property’s NOI over this value is the the holdings of institutional investors were hit with deep capitalization rate (C): 1 write-downs. After the market crash of 1991, office construction C = NOI/P (1) reached a virtual halt as the traditional sources of con- struction financing dried up. This helped the national Capitalization rates represent required income office vacancy rate to start a long and uninterrupted returns by investors purchasing real estate. Empirical stud- descent that by 2000 had brought it to almost 8%, end- ies of historical movements in these rates have shown ing the cycle that had started 20 years earlier. With the that they are influenced not only by real estate market fun- 2001 recession and an unprecedented collapse of office net damentals, but also by broader capital market forces (Siv- absorption, vacancy rates took an abrupt turn and staged itanidou and Sivitanides [1999]; Sivitanides et al. [2001]). a nearly vertical ascent, climbing to 16% by the end of These dynamics are apparent in cash flow, cap rate, 2002. and value indexes, constructed on the basis of property- To measure office rental rates, we have constructed specific data for investment-grade office buildings from the an index of actual signed leases for comparable space and National Council of Real Estate Investment Fiduciaries then expressed it in 2002 (constant) dollars. Interestingly, (NCREIF), as portrayed in Exhibit 2. As might be office rental rates exhibit, if anything, a slight long-term expected, office property cash flows and values at least par- downward trend—when converted to constant dollars. tially mirror some of the space market movements shown Thus they seem to provide at least a partial long-term in Exhibit 1. The linkage between the two, however, hedge against an economywide inflation. Rental rates reflects both the lags caused by lease structures and the slow also move almost inversely with office vacancy. Finally, adjustment of private market (appraised) values to changes their pattern is again one of extremely slow and pre- in market fundamentals. dictable movements. Of particular interest is the recent Both NOI and property values rose during the first sharp drop in rents, as vacancies have suddenly increased. half of the 1980s, although market rents and occupancies Historical trends of office market fundamentals point peaked a couple of years earlier. During this period, val- basically to three clear patterns of behavior: a high degree ues climbed faster than NOI, thus reducing cap rates as of (positive) autocorrelation or sluggishness of market investors apparently felt that current income growth would adjustment; strong behavioral relationships between rent continue. By 1986, NOI and values began following the and vacancy; and a pronounced mean-reverting behav- downturn in space market rents and occupancies. ior. Real estate market fundamentals are quite predictable, With the 1991 recession, the decline in values accel- and intrinsically behave differently from the largely ran- erated, and a recovery did not begin until 1997—several dom movements of interest rates or stock prices in the years after rents and occupancy began to recover. This broader capital markets. E XHIBIT 2 Long-Term Trends in Historical Behavior of NOI, Cap Rates, Office Property Income and Values and Values for Office Properties 190 Movements in market rents and occupancy rates 170 are not instantaneously reflected in the movements of 150 property income because of long-term leases, particularly in office properties. Large office buildings have many 130 tenants, each with a fixed rental contract. This creates a 110 staggered pattern of renewals and hence exposure to mar- 90 ket rent. With such contracts, property net operating 70 income (NOI) tends to be somewhat smoother than mar- 50 ket rent. 1978 1982 1984 1992 2002 1980 1986 To convert property income into value, in the pri- 1988 1990 1994 1996 1998 2000 vate real estate market, properties are periodically NOI Value Implied Cap Rate appraised, which results in an estimate of property value Source: NCREIF, TWR. SPECIAL ISSUE 2003 THE JOURNAL OF PORTFOLIO MANAGEMENT 47 Copyright © 2003 Institutional Investor, Inc. All Rights Reserved E XHIBIT 3 Movements in Cap Rate-Interest Rate Spread 16 14 12 10 8 6 4 2 0 -2 -4 -6 -8 Spread 10-Year T-Bond Cap Rate Source: NCREIF, TWR, Economy.Com. recovery was quite gradual in the late 1990s, when NOI of the 1970s gradually ebbed). Also during this period, and value again moved closely together. Values and nominal rents (unadjusted for inflation) were rising incomes have not yet reflected the sharp downturn in rents between 2% and 10% annually, even as real rents were of the past 24 months.