Re Market Fundamentalks and Asset Pricing

Real Estate Market Fundamentals and Asset Pricing

Petros S. Sivitanides, Raymond G. Torto, and William C. Wheaton

I

PETROS S. SIVITANIDES is a senior economist at Torto Wheaton Research in Boston (MA 02110). psivitanides@ tortowheatonresearch.com RAYMOND G. TORTO is a managing director at Torto Wheaton Research in Boston (MA 02110). rtorto@tortowheatonresearch.com WILLIAM C. WHEATON is a professor of economics at Massachusetts Institute of Technology in Cambridge (MA 02139). wheaton@mit.edu

SPECIAL ISSUE 2003

n the last year we have heard much discussion of a disconnect between the commercial real estate capital and space markets. We see declines in the cap rates (yields) of property transactions, while a weakened economy has generated deteriorating real estate market fundamentals (Gordon [2003]; Kaiser [2003]). Corcoran and Iwai [2003] argue that such a pattern could be just what an efficient asset market should produce if the space market is always mean-reverting. If fundamentals are temporarily depressed, an efficient market will keep prices firm and hence produce lower cap rates—in anticipation of a recovery. If the space market is strong, cap rates should fall in anticipation of eventual new supply and market softening. Our objective in this discussion is an econometric examination of the historical movements in office space market fundamentals (vacancy and rental rates) in order to compare them with a similar history of office market capital movements (prices and yields). This comparison supports three conclusions: 1. In examining how market fundamentals influence asset pricing, it is crucial to control for interest rates. In fact, a better way to measure how the asset market views the space market is to look at real estate spreads over Treasuries. 2. The behavior of both spreads and cap rates— controlling for interest rates—suggests that the real estate asset market does not look forward, but rather looks myopically at current conditions.

THE...