Understanding Commercial Real Estate: How Different from Housing Is It?

Abstract

On the one hand, urban economics suggests that commercial real estate and owner-occupied housing are driven by common fundamentals, which should make them perform similarly. On the other hand, stronger limits to arbitrage in housing suggest that wider swings in prices, which are unrelated to fundamentals, are feasible in that property sector. And wider swings in fundamentals could be expected in the commercial sector due to the longer lead times for commercial buildings to be permitted and delivered, leading to a greater possibility of a temporal mismatch between supply and demand. Yet, the author finds many more similarities than differences across the two real estate sectors. The simple correlation between appreciation rates on owner-occupied housing and commercial real estate is between 40% and 60%, depending on the data source. Both sectors also exhibit similar time-series patterns in their price appreciation, with persistence across individual years and mean reversion over longer periods. In this article, Gyourko explores the various linkages between these two huge sectors, including the cost of land and materials, cost of capital, lender optimism, and access to the productivity and amenities of a given labor market area. With the recent dramatic declines in house prices, the strong similarities between the two sectors are foreboding given that the commercial real estate capital structure looks weak and a strong mean-reversion process in prices may still be underway.