Big Increase in Commercial Property Values: Don't Be Fooled

Includes: FTY, ICF, IYR, RWR, VNQ
by: Brad Case

The Moody's/REAL Commercial Property Price Index (CPPI) for September, released on 11/22, showed the largest monthly gain in the history of the index (back to January 2001) at 4.3%. That's misleading, though, because the small number of transactions gives a lot of turbulence to each month's reading. As Moody's noted,

The relatively large swings in the index in recent months are due in part to the uncertain macroeconomic environment and the low number of repeat-sale transactions.

I've said before that we're likely to continue bouncing along a bottom in commercial property values until private real estate investment funds are forced to recognize the losses that they've already experienced but that they've been able to hide thanks to the government's "pretend and extend" policy. When maturities finally become binding, the number of transactions will finally increase sharply and the market's direction will become more clear month-to-month.

In his monthly commentary on the CPPI, Professor David Geltner of MIT's Center for Real Estate published an especially good discussion of the overall picture:

This type of extreme volatility probably largely reflects what is actually going on in the U.S. commercial property market, as asset markets typically display greater volatility during periods of fundamental uncertainty, rapid economic and institutional or political change, and transition in the markets. But it is important to understand that extreme returns in a real estate transactions-based index can also be indicative of statistical noise, as such noise is characterized by individual periodic returns of large absolute magnitude (in either direction). During the last couple of years as the markets have experienced turmoil, one symptom has been a lack of liquidity in real estate markets, which means few transactions by historical standards, and that translates into a smaller sample of price observations on which to compute a transactions based index. This could also be a partial explanation for the relatively large number of extreme returns the CPPI has been experiencing in the past two years.

My translation: overall the commercial property markets are still unhealthy, not so much because fundamentals aren't improving (indeed, improvement in rents and occupancies seems already to have started) but because the busted deals from the bubble haven't been shaken out yet.

Investors have to remember, though, that bad news among private investors in commercial property markets is still good news for publicly traded REITs, because it means that their advantage in terms of access to capital on good terms will give them more chances to acquire properties at good prices. Any publicly traded REIT that has prepared its balance sheet is a candidate for relatively strong earnings growth from the combination of acquisitions and operating improvements going forward.

Disclosure: Author is long Vanguard REIT Index Fund and ING Real Estate Fund.

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.

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