Commercial and Residential:
Two Different Real Estate Markets

There has been a tremendous amount of publicity on TV and in the press about the weakness in the U.S. “real estate market”. Many people, both in the United States and abroad, who are exposed to continual news stories about the decline in the real estate market, have every reason to conclude that sales are stagnating and prices are declining in all segments of U.S. real estate. The media seem incapable of differentiating between the commercial real estate market, on the one hand, and the residential market, on the other. While these markets are related to some extent, they are essentially influenced by very different underlying factors, and the two markets can diverge from each other quite significantly, as they are doing at the present time.

While both the commercial and the residential markets benefit from strong economic fundamentals, they perform well at different stages of the economic cycle. Consumer spending is considered to be a leading economic indicator and residential real estate responds to the same stimuli as consumer spending, if somewhat more slowly. As a result, residential real estate will also perform well in the early stages of an economic recovery.

The basic fundamentals of the commercial market, however, generally lag the economic cycle. Before corporations begin to expand into additional or larger offices, industrial warehouses or retail facilities, they will generally wait until the business recovery has proceeded for some time, giving them both the need and the confidence to warrant an expansion.

There are also other differences between the commercial and the residential markets and, while the fundamentals in the residential market have slowed in recent months, the commercial market continues to show impressive strength..

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The Inverted Yield Curve:

Interest rates, of course, have a very big effect on both the residential and the commercial real estate markets. For many years following the 9/11 attacks on New York and Washington, the residential real estate market benefited tremendously from the record low interest rates that had been put in place to stimulate the economy, and that situation existed for almost four years from late 2001 to late 2005. Mortgage interest rates for homebuyers were so low during this period that it was less expensive for a great many consumers to purchase a new home or condominium rather than to go on renting. But the Federal Reserve Board reversed course in mid-2004 and began raising rates. For a time, mortgage lenders offset the higher rates by developing innovative loans, such as interest-only mortgages, that continued to provide low monthly payments for the consumers. But by late 2005, after several years of record sales in the residential market, the increase in short-term rates by the Fed began to have an effect, and sales of single-family homes and condominiums went into a decline from the peak levels of the immediately preceding years. It is this decline in the residential market from the preceding record years that is receiving so much media attention today.

The basic fundamentals of the commercial market, on the other hand, actually remained quite stagnant during the initial stages of the business recovery. It was only in the early part of 2005 that vacancy rates began to decline and rental rates began to increase in various geographic markets around the country. But pricing in the commercial real estate market was very strong throughout this period. Both leveraged buyers and all-cash buyers were able to obtain excellent cash-on-cash returns from commercial real estate, with the added bonus that there could be capital appreciation as the underlying real estate market improved. As a result, capitalization rates in commercial real estate declined to levels not seen in the United States for over 20 years.

But as the Federal Reserve Board kept raising short-term interest rates, something occurred that had not been anticipated – long-term rates did not increase at all but actually declined and the bond market fell into an inverted yield curve. Former Fed Chairman Alan Greenspan described this situation as a “conundrum”. Here in the fourth quarter of 2006, the overnight Fed Funds rate is 5.25%, the six-month Treasury Bill is yielding 5.13%, the three, five and ten-year Treasury Bonds are all yielding about 4.75% and the 30-year bond is just slightly higher at 4.90%. As a result, as we pointed out in our Newsletter of three months ago, it is not surprising that capitalization rates or yields in the commercial real estate market remain at very low levels when one alternative faced by investors is the very low level of interest rates in the medium and long-term bond markets.

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