Recent evidence on property prices and market liquidity along with developments in the broader capital market suggest prices are firming and buyer valuations are increasing, say Jim Clayton and Michael Gately

As the ‘great' recession comes to an end, investor sentiment is improving and investors have begun to increase their risk appetite; stock and bond markets have improved dramatically over the past two quarters. While recovery in core real estate pricing lags the economy and financial asset returns, there are increasing signs that property prices are bottoming. In this article we synthesise recent evidence on property price and market liquidity dynamics along with developments in broader capital markets that, taken together, suggest property prices are bottoming as GDP growth turns positive, cumulative price declines and deteriorating space market fundamentals catch up with over-leveraged property owners and the significant and growing weight of equity capital on the sidelines competes for relatively limited institutional product offerings.

Property transaction price and appraisal-based (valuation) indices fell sharply, and in similar fashion, during late 2008 and the first two quarters of this year, with the pace of transaction price decline particularly rapid in the second quarter (Figure 1). Through Q2 2009, both the broad-based Moody's/REAL Commercial Property Price Index (CPPI), derived from Real Capital Analytics database covering transactions of US$5m (€3.1m) or greater, and the more narrowly focused Transaction Based Index (TBI) produced by the MIT Center for Real Estate and derived from properties sold from the National Council of Real Estate Investment Fiduciaries (NCREIF) index, indicated that property prices had declined about 40% since peaking in 2007. However, in the third quarter, as capital markets continued to stabilise and economic uncertainly diminished, the three main US indices began to follow somewhat different trajectories, possibly suggesting the beginning of inflection point in the pricing cycle.

The Moody's/REAL CPPI continued to fall in Q3 2009, dropping another 11%, while the MIT TBI moved upwards for the first time since peaking in 2007. This suggests that core institutional property prices might have hit bottom in the second quarter. The difference in the direction of the Moody's/REAL CPPI and MIT TBI in Q3 2009 likely derives from the fact that the CPPI is more likely to contain debt-related distressed sales than the TBI. The capital component of the appraisal-based NCREIF Property Index (NPI) continued to fall in the third quarter, but the rate of decline continued to slow.

Figure 1 also shows that public equity REIT prices have rebounded and appear to have reached a cyclical bottom. Share prices of equity REITs have historically tended to be a leading indicator of pricing declines and recoveries in private real estate markets. Information on property market conditions is more quickly reflected in REIT prices than in property values and hence REIT values tend to lead property market values; turning points in the property market value cycle tend to show up in public equity REITs first. While REIT pricing can be volatile and noisy in the short run, so that false signals can occur, large sustained movements around cyclical peaks and troughs usually forecast same direction movements in property values in coming quarters.

In contrast to liquid public stock markets that adjust quickly and primarily through price, private asset markets adjust through both price and liquidity jointly. A prerequisite to prices bottoming is an improvement in market liquidity. In down markets liquidity takes the initial brunt of the hit, moderating the impact on values relative to what would transpire in a highly liquid public market. As has been the case in this downturn, the dearth of property transactions coincides with a widening of the bid-ask spread. Demand-side (buyer) valuations have fallen much further than seller valuations. We can get a sense of the relative differences from the separate demand and supply-side value indices that the MIT Center for Real Estate compiles in conjunction with the TBI. Figure 2 reports cumulative price declines for the TBI, labelled ‘Transaction price' as well as Demand and Supply versions of it.

The TBI Transaction Price index is derived directly from realised transaction prices, whereas the Demand Price index is a ‘constant liquidity' index defined under the assumption that all adjustments in the real estate asset market take place through price change; the price is more reflective of what you could sell the property for today. Transaction price is a variable liquidity index that reflects the joint determination of the price and liquidity feature of private asset markets; price and liquidity jointly adjust to market shocks. Changes in demand price will be more volatile than changes in transaction price. The supply price essentially tracks seller reservation prices. Notice that if all adjustment took place in the price dimension in private property asset markets, more along the lines of public asset markets, then according to the MIT index, property prices would have dropped by about 50% as of the end of the second quarter since the peak in 2007. This, of course, did not happen because part of the adjustment has taken place in the liquidity dimension; sellers have not lowered reservation prices nearly as much as buyers. Figure 2 shows that liquidity improved in the third quarter as buyer valuations increased.

In our view there are three key, related fundamental factors leading to the improvement in market liquidity and the bottoming of the pricing cycle.

The economy and the lack of an excess supply overhang. Property prices are expected to bottom as GDP growth turns positive and investors begin to price the upside of the economic recovery. Unlike the early 1990s, oversupply of newly built space is not a major issue. While high unemployment will continue to pressure property cash flows into 2010, prices and then valuations are expected to bottom as GDP growth turns positive, ahead of leasing fundamentals. The combination of large, rapid price write-downs and lack of an excess supply overhang suggest property returns are more tightly linked to GDP growth today than in the early 1990s; Current pricing relative to government bond benchmarks. Core institutional property cap rate levels and spreads to 10-year Treasuries are consistent with an approaching market bottom; historically, acquisitions made at times when cap rates and cap rate spreads are unusually high, and property market liquidity low but improving, have tended to provide relatively high returns over the next five years; Current pricing relative to stocks and corporate bonds (Exhibit 6). Core real estate appears to be priced inexpensively relative to both stocks and bonds; the spread between transaction cap rates and Baa corporate bond yields is historically high.


There is risk - high unemployment will continue to weaken demand-side fundamentals and property cash flows in 2010, but are not expected to exert significant downside force on property values and in fact may help force distressed sellers to bring product to an under-supplied market. Investors recognise that real estate is a long-term investment and that pricing will firm ahead of improving leasing market fundamentals. There is significant equity capital on the sidelines that has been waiting for signals that the market bottom is in sight.

Michael Gately is managing director of research at Cornerstone Real Estate Advisers
Jim Clayton is vice-president of research at Cornerstone Real Estate Advisers