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In September ’08, a year after the mortgage markets seized up, the entire financial system froze—and the already limping property investment markets suffered another tremendous blow. It became clear that the economic ramifications of the credit crunch and this ongoing de-leveraging period would seriously undermine rent and occupancy fundamentals. Both the capital markets and space markets started moving solidly in the same direction: down.
As quickly as property prices rose when the space and capital markets were both positive, property prices could fall with equal force now that the space and capital markets are deteriorating. Cap rates are rising, but prices are more likely to be measured as a discount to what a property recently sold for, what its current mortgage balance is, or its replacement cost, rather than for its yield.
1 Almost overnight in August ’07, trends in the real estate capital markets turned from positive to negative. Deals were either re-traded, delayed or called off as sales volume plummeted and property prices started to fall in a pricing correction that is still playing out.
2 Over a weekend in September ’08, the space markets, or “real estate fundamentals,” turned sharply negative as a recession became not only unavoidable, but also likely to last longer and deeper than had been anticipated. Both the capital and space markets were moving solidly in the same direction: down.
A Brief Retrospective
(Reprinted from Jan.’08 US Capital Trends)
The 2002–2007 bull market for commercial property was largely driven by capital market factors. Equity poured into the asset class from many different sources. Interest rates hit historic lows and the CMBS market generated huge amounts of debt capital. Consequently, asset prices nearly doubled over this period.
While the capital markets were hot, market fundamentals were negative for the first few years. Vacancies spiked and rents dropped in the wake of the dot com bust and subsequent recession. There was a great deal of discussion about a “disconnect” between the capital and space markets as prices improved despite weak fundamentals.
Eventually, fundamentals began to improve and optimism was widespread by mid- 2005. A spike in construction costs and minimal pipeline of new development contributed to the positive outlook. After interest rates hit their lows, lenders continually improved their terms, eased their underwriting, and interest only loans became standard.
The smooth sailing was briefly interrupted when the housing market turned and rates spiked in the first half of 2006. However, rates retreated quickly, buyers had pent-up demand resulting from strong capital inflows and lenders became extremely aggressive. Between Q4’06 and Q2’07, the rate of price appreciation was higher than at any other time throughout the cycle.