What Do Strong Gains In Home Prices Mean For Commercial Property?

question markEven though the commercial real estate sector and the single-family home market are radically different beasts, the fact is they  both driven by enough common fundamentals that rates of price changes in one are significantly correlated with prices in the other.

The most recent numbers indicate the house prices 20 cities are up 10.9% since 2012, which is the largest increase since 2006.  Published by Standard & Poor in their Case-Schiller Home Price Index, a  composite home price index of 20 cities has beat analysts’ expectations of a 10.2 percent annual gain.

As the index’s biggest increase since April 2006, what does this single family home surge suggest for the commercial market?

Price-to-construction-cost tells one tale

We do recall in the last recession the national plunge in home prices was followed shortly by a general plunge in commercial space. the question as to wether the reverse holds is up to locality and to the common fundamentals of the residential and commercial markets.

Evidence that the housing and commercial property sectors are related and move together is available in a few different ways to number crunchers.  One method to expose the connection is by comparing the ratio of prices to construction costs for office buildings and housing over time, one metro area at a time. One statistical model named Rosen-Roback, when applied properly show that booms in one property sector within a metropolitan area should show up in other sectors within the same
market.

Speaking generally, a focus on price-to-construction cost serves to get at the bottom (in more than one sense) of both home and commercial value propositions.   The spread between sales prices and construction costs reflects both the developer’s profit margin and land cost. But while gross profit margins for homebuilders and commercial developers, which are commonly between 15%-20% can vary over the development cycle, land value is expected to be the most volatile factor because it is the residual claimant on project value.  Because of this, changes in the price-to-construction cost ratio are interpreted as primarily reflecting  changes in implied land values.

Well Correlated

Using this approach sets up a glimpse into a correlation between the rates of price change in commercial vs. residential in a metro area.  One National Bureau of Economic Research study from University of Pennsylvania puts the correlation ratio at around 40%, which is one way of saying the patterns of price cycles will follow each other a significant number of times – significant enough to use as a baseline expectation when making the comparison.

Which is leading and which is trailing?  As always, it will depend on local factors in specific markets, but the recent recession had commercial prices clearly in the trailing role.  That does not mean the same thing will always happen, but history has a funny way of repeating itself.  Will it be good news this time around?  We’ll see.