Real estate markets: Not necessarily created equal

Eric Odum MIBS
May 2, 2008 — 1,279 views  
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Struggling. Sluggish. Damaged. A bust. These are just a few words to describe the real estate market these days. But, which real estate market? Aren't they all the same? Yes and no. 

While related, there is a difference between residential and commercial real estate. One can't disconnect them completely, but they can and do move in distinct and separate cycles.

Residential real estate: making headlines regularly

Residential real estate right now, dwellings that are owner-occupied, used as second/vacation homes, and investor-owned single family properties, currently have high inventories and a high default on loans. According to cnnmoney.com, foreclosures have risen to 112% -- with no end in sight. Therefore, it is no secret that the housing market is deflating.  It all started with the rapid implosion of the subprime mortgage market in February of last year and wiped out an entire support base. Next the "flippers" - the speculators who bought homes hoping to quickly resell them and turn a profit - left the market. Thus, two legs of the housing market table came down causing it to fall over.

The depression in the residential market has also affected consumer confidence. Retail growth and demand for real estate declined so there are fewer furniture retailers building or growing, fewer electronics being sold, etc. Bloomberg.com reports that home-equity financing served as a major source of spending recently, but as property values decrease, homeowners are feeling less wealthy.

Though the housing market and home construction remain sluggish throughout the nation, there are not any signs of quickening in the deterioration.  New residential construction is reported at depressed levels.  None of the Federal Reserve districts reported any pickup in the residential market since March.  Federal Regions noted some price declines in areas that had previously shown resilience such as New York and the Pacific Northwest.  Cleveland, on the other hand noticed some stabilization in home prices. 

Commercial real estate: Holding its own

Commercial real estate - namely office, multi-family, industrial, and retail - tends to be holding up fairly well, in spite of the residential markets. Fundamentals in the apartment, medical office, industrial, hospitality are surprisingly good.  The dynamics of this market are significantly different than the last real estate downturn we had in the early 1990's.  In the late 1980s and early 1990s a lot of commercial development was just coming on line that had been planned and entitled prior to drastic tax changes in 1986, a portion of which adversely addressed passive income losses in real estate.  The result was that there was supply that outran real demand, leading to a lot of commercial vacancy and excess space. The problem with speculation was more serious in the commercial markets than the residential.  That is not true today - in fact it is exactly the opposite.

What factor has enabled the commercial market to stay afloat this time around? Trade, for one, has been a driving growth of this market.  Areas with international trade have been resilient in absorbing vacancies.  Despite all the concern about recession, we have not really seen the kind of increase in vacancy rate in a substantial manner in significant portions of the country.  Riverside, California, Northern New Jersey, and other areas of international trade have held up surprisingly well despite the rapid expansion of commercial space.  While Federal reports on commercial development state that activity had weakened in the Atlanta and Philadelphia regions, Cleveland, Chicago and Kansas City show healthy increases. Overall, it appears that in this downturn, the health of the commercial and housing markets are mutually exclusive.

The residential ripple effect on commercial real estate

How has the downturn in the residential market affected the commercial market? Traditional lenders (banks and insurance companies) have historically packaged their loans and sold them in the public markets as securities, residential mortgage backed securities (RMBS) and commercial mortgage backed securities (CMBS).  You can probably surmise from the aforementioned debacle in the sub prime residential market that the RMBS has not faired well.  In some instances, it was quite a shock for RMBS holders to learn that default rates in their portfolios climbed so steeply and suddenly.  The CMBS, on the other hand, actually has held its own with a surprisingly low default rate.  Fear is driving this entire market right now, though, and demand has dropped off to almost non-existent levels, as a direct result of the downside surprise that investors were handed in RMBS. Because of the challenge in assessing quality of products inside both mortgage types of mortgage bundles, investors have opted to leave the market in mass and avoid and further downside surprise.

Commercial lenders with no outlet for liquidity in the securities market have become decidedly more leery and tight in their lending practices, squeezing further development and flow in all real estate markets. The resulting effect is necessary for the residential markets to absorb excess inventory.   While the commercial market has fewer issues, if the foundation of the market is in fact healthy, some limited period of tightened credit standards may actually be a good thing and will potentially help the market by creating pent up demand.  Additionally, falling 10-year mortgage rates are offering some opportunities for both sectors to enjoy some interest rate relief.

Summary

Next time somebody tells you the real estate market is bad, you will know to ask them what sector, what region and what city. Real estate markets and cycles are and can be distinct and uncorrelated.

What happens in the residential market does not always mean that it will happen in the commercial marketDepression in one sector can lead to problems in the other, but does not always mean that the depression will carry in to the other sectorIndividual cities and regions are independent and can be correlated or uncorrelated to the greater market sector

Eric Odum MIBS

Triple Net Lease Real Estate

Eric Odum is a veteran in the real estate and financial services industry with over 13 years of experience. Mr. Odum holds a Masters in International Business in Finance from the University of South Carolina (consistently ranked as one of the top International Business Schools by US News and World report).