Friday, June 09, 2017

Goldman: "Prices and Risks in Commercial Real Estate"

by Calculated Risk on 6/09/2017 10:16:00 AM

A few excerpts from a research note by Goldman Sachs economists Spencer Hill and Daan Struyven: Seven Years of Feast: Prices and Risks in Commercial Real Estate

Commercial real estate prices have increased 76% in real terms over the last seven years and are now above pre-crisis levels. At the same time, elevated supply growth, demand risks, and rapid credit growth in some subsectors suggest additional focus on the asset class is warranted ... we believe commercial real estate valuations are becoming increasingly stretched and are now moderately overvalued – between 0.5 and 0.9 standard deviations rich – even after taking into account the lofty levels of other assets classes.
[W]e think it’s important to note two key distinctions between the CRE market today and that of 2006. First, lending standards appear meaningfully tighter today ... Second, valuations do not look nearly as stretched today, with the extent of overvaluation 2-3x larger in 2006

[W]hile we believe commercial real estate markets were reasonably valued during most of this expansion, our models now suggest they could be moderately overvalued – even taking into account the lofty level of other assets classes. Furthermore, the combination of higher interest rates and potentially unfavorable supply & demand dynamics suggest heightened risk that the misvaluation could worsen. Indeed, these developments could ultimately become the catalysts that produce such a repricing.
CR Note: there are several warning signs for commercial real estate.  As an example, even as the economy approaches full employment - and the demand for office space will likely slow - new construction is still strong and vacancy rates are already high.  

Office Vacancy Rate Click on graph for larger image.

This graph, based on data from Reis, shows the office vacancy rate starting in 1980 (prior to 1999 the data is annual).

Reis reported the vacancy rate was at 15.8% in Q1.  The office vacancy rate is at the lowest level since early 2009, but remains elevated.

Slowing office demand, more supply and an already high vacancy rate imply weaker fundamentals going forward.