Is there correlation between prices in residential and commercial real estate markets?

Is there correlation between prices in residential and commercial real estate markets?

The simplest answer is affirmative: since prices in both residential and commercial real estate are controlled by identical supply and demand drivers, they are correlated. Low interest rates, low unemployment, increased trade, population growth, and stagnated innovation in transportation technology are some of the many factors influencing growth in real estate demand. Their opposites – high interest rates, high unemployment, dwindling trade, decreasing population, and increased innovation in transportation technology – are, therefore, all negative demand drivers.

Low interest rates

As we’ve seen in Canada over the past decade, historically low interest rates have made mortgages and, consequently, home purchases, more affordable for the average Canadian. This has been the case for commercial real estate as well; new and existing landlords have also benefited from low borrowing rates. Low rates not only make mortgages more affordable but, as investors in the commercial market are by nature concerned with the profitability of their buildings, lower rates also translate into lower carrying costs and higher rental profits. All things considered, low rates make buildings more profitable for landlords. Therefore, low interest rates stimulate demand for real estate assets.

In the apartment sector, market valuations move cyclically with changes in interest rates. Not only do low rates create financing incentives but, as low interest rates increase demand for residential properties, they decrease demand for rental units, thereby drawing households out of the apartment market. Slowing demand for apartments causes rental vacancy rates to temporarily increase. Vacancies drain profits and make it more difficult for landlords to raise rents; however, the profit drain is temporary because as demand for housing picks up, so do housings prices. And, as housing valuations grow less affordable, renting looks good again, filling apartment vacancies and returning profits.

Effectively, low interest rates are both good and bad for commercial properties in the apartment sector. Low rates are temporarily bad when housing demand is rising and renters are drawn out of apartments – but only so long as house prices remain affordable. The good news is twofold: (i) as demand for housing outpaces supply, prolonged periods of low interest rates drive up residential valuations, pricing households out of the market, and increasing demand for rental units; and, (ii) simply put, cheaper mortgages allow for higher profits.

In the end, low financing costs and low vacancy rates increase profits for commercial landlords across the board. And, higher rental profits translate into increased asset valuations, a fact that is directly attributable to the intensified demand for these profitable assets.

Low interest rates are an economic positive for the retail sector as well. When households save money on mortgage payments, it means they have more money to spend on goods. And, as low interest rates increase disposable household income, the extra funds translate into increased demand for goods at retail stores. Therefore, in a low interest rate environment, retail landlords share the benefits with retailers, experiencing lower vacancy rates and increased rental profits.

As retail spending moves increasingly online, growth in household consumption is also driving demand in the industrial sector. What may not be common knowledge is that industrial real estate is not simply manufacturing space. In fact, a growing segment of the sector is comprised of warehouses consisting of inventory and distribution centres for online retailers such as Amazon. This has been great for industrial landlords. Overall, lower interest rates create lower mortgage payments and cheaper credit, increasing the potential for household spending and demand for goods, which translates into demand for retail space to sell – and industrial space to store – inventory.

Of course, too much of a good thing can be harmful. Prolonged periods of ultra-low interest rates may eventually be damaging to the economy: credit bubbles form and assets get valued with the mistaken assumption that rates will never go up. In reality, the illusion of affordability and higher profits lasts only until interest rates normalize.

Once rates increase, to keep the creditors paid, homeowners and commercial landlords had better hope that they’ve experienced commensurate income growth over the years. If not, landlords often have the flexibility to incrementally raise rents but, depending on financial circumstances, homeowners often need to be more creative to keep up with higher mortgage and credit payments. All things equal, higher interest rates squeeze the landlord’s profit margins and restrict household spending causing decreased demand – and lower valuations – for residential and commercial properties.

Low unemployment, income stabilization, and population growth

Increased demand for workers in the job market, leading to lower unemployment, is a driver of demand for both commercial and residential real estate. As firms seek out and hire employees in greater numbers, commercial space is needed to house the workers. Consequently, demand increases for office and industrial real estate, decreasing vacancy rates and increasing the profitability and valuation of these assets.

Residential markets benefit similarly. As the number of active participants in the workforce increase, so does household income. Expected monthly income stabilizes. Growth and stabilization in household income increases the likelihood of households qualifying for mortgages, thus, creating greater demand for residential properties and higher valuations.

Job growth and stability in household income is also a driver of population growth – stability produces a feeling of increased security signaling that it’s an opportune time to increase the number of members in the household. Bigger families require bigger space thereby increasing demand for suitable homes. Growth in demand for workers, followed by stabilization in household income and subsequent population expansion, all drive demand for real estate.

Increased trade

Increasing trade stimulates demand for commercial and residential real estate in the same way that employment growth does. Increasing trade, whether foreign or domestic, is growth in demand for goods, which translates into greater demand for labour. All demand drivers flow together. As such, growth in trade drives demand for office and industrial space, decreasing vacancy rates in these markets, and making investments in these sectors more profitable. Profitability increases demand and demand creates higher asset valuations.

Residential housing, on the other hand, benefits from increased trade because more employees are demanded by firms, lowering unemployment, increasing and stabilizing household income, stimulating population growth, and providing households with the financial foundation to obtain residential mortgages. Increased demand for homes creates higher residential real estate valuations, moving hand-in-hand with heightened valuations in commercial real estate.

Stagnated innovation in transportation

Even with location as the keyword of its catch phrase, real estate valuation analysis rarely hits on the importance of transportation. It is strange that a lack of innovation in transportation – a negative factor – would be a positive demand driver for real estate. But, it makes sense: what good is location if you can’t get there? Some people want to live downtown because it’s where they work. Others want to live close enough to the highway, or to a subway station, because it’s faster for them to get to where they need to go. They are willing to pay for the privilege, for the location and for the proximity to transportation routes, and higher housing valuations in these areas illustrate the heightened demand.

If more efficient transportation is built to travel between the suburbs and the city centre, then people will not demand as much property in the city centre. As the population grows, if the subways and highways get too crowded and slow, then people will demand living space that enables them to avoid the long commute. All things equal, stagnated, or deteriorating, transportation networks create heightened demand for residential real estate in employment centres. And, as always, increases in demand cause increases in property valuations.

On the side of commercial real estate, businesses demand office space in locations notorious for good jobs and qualified employees. Just as employees follow good jobs, employers compete for good employees. Good employees are found in competitive employment markets, and highly demanded office space in competitive markets comes at a premium. Heightened demand drives up the profitability for landlords holding the coveted office space but, in its extremes, high rents force firms to relocate as congestion hinders the local transportation network, and leasing costs grow unmanageable. In the end, location is king, and the availability of an efficient transportation network is a fundamental variable of location.

Supply factors

On the other side of the equation, residential and commercial real estate supply is influenced by drivers including construction of new stock, population migration, and demographic shifts such as ageing homeowners, to name but a few. The magnitude of each driver is fed by economic supply and demand factors of their own. For instance, new residential and commercial construction are influenced by the availability of skilled labour, government regulation and permitting, as well as market prices for building materials, and project financing costs. As with demand, many of these supply inputs are interrelated making for complex analysis even in the simplest of economic scenarios.

With supply, in the worst case, new stock entering the market at the onset of a downturn enhances the deflating effects of slackening demand. Properties sitting unsold put downward pressure on market prices creating a buyers’ market. Population migrations tend to occur around these difficult economic times as well, often because reduced demand for workers is a coinciding phenomenon. Household migration – especially labour absconding in search of jobs – intensifies the supply of residential properties to the market at the worst time driving down home valuations.

From the commercial perspective, during a household exodus, retail suffers the most as falling demand for goods causes lost profits and store closures. Store closures translate to higher commercial vacancy rates and, therefore, decreasing valuations of unprofitable commercial properties. The western Canadian city of Calgary has the unfortunate honour of being a great example of this real estate boom and bust cycle – a consequence of its reliance on profits from the oil fields, and OPEC’s bipolar control over global oil prices. Real estate valuations in cities with such economic sensitivity are routinely sky-high or rock-bottom depending on the prevalent market cycle.

Demographic shifts are a more infrequent supply driver as compared to new construction and population migration. Their rarity is caused by the fact that demographics tend to move – if they move at all – in generational waves. In recent memory, at least in Canada’s major markets, demographic shifts have not had much impact on supply in the real estate markets: households have not had much reason to dispose of these assets on mass. A frequently mentioned demographic cohort, the baby-boomers, have yet to make any major shift into smaller housing units, and any resultant supply slack has been easily absorbed by domestic demand and immigration.

Currently, a demographic shift in consumer preference led by advancements in technology is profoundly affecting the supply of commercial retail real estate. As mentioned above, the Millennial predilection for online retail purchasing has increased demand for industrial space and, thus, increased supply of commercial retail space. In the past decade, heightened retail vacancy rates have caused commercial real estate owners to re-purpose their leaseable space, reducing the supply of retail square-footage by converting it into residential units. This is an example of supply in commercial space correlating with supply in residential real estate; keeping in mind that the strategic conversion is secondarily driven by unmet demand – and high valuations – in residential markets.

Speculation

To be certain, buyers and sellers are not typically as rational as economists make them out to be. In reality, speculative behaviour drives both sides of the supply/demand equation with supply-side sellers attempting to capitalize on seemingly high property valuations, and demand-side buyers speculating that property prices will keep going up. As with any subjective sentiment, the quantum of market speculation is difficult to measure; however, it’s safe to say that speculation has always been an elemental factor in prevailing market valuations.

Coming full circle, as to the question of whether commercial and residential real estate valuations are correlated, if prices in both markets are controlled by identical supply and demand drivers, they must be correlated.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s