How Commercial Real Estate is Pricing on Yesterday’s Valuations

Issues such as Federal Reserve policies, climate-related risks, and rising insurance costs have been putting pressure on accurate commercial real estate valuations.

This prompted Urban Land Magazine to ask economists: “Do you think commercial real estate values are fully reflecting today’s costs and risks?”

The unanimous response was “no,” but for different reasons.

Michael Acton, managing director and head of research at AEW Capital Management, told Urban Land that valuations should reflect investors’ best assessment of potential risk and return based on available information.

However, “for several years, U.S. commercial real estate investors have operated under a degree of information inefficiency driven by below-average transaction volume and, consequently, less effective price discovery.” As a result, there is a misunderstanding of how and where commercial real estate fits into the economic and capital market cycle.

At the same time, Chad Littell, national director, U.S. Capital Markets Analytics at CoStar Group suggested that investors may be overestimating today’s elevated vacancies and interest rates, rather than considering future growth. “The speed at which property fundamentals can improve once the supply spigot shuts off could surprise the market,” he said.

Kiran Raichura, head of commercial real estate economics at Capital Economics in London, told Urban Land that since the end of 2021, the 10-year treasury has increased by nearly 300 basis points (bps), while the all-property cap rate has risen by 85 bps. This has left the yield spread close to zero.

Josh Scoville, global head of research, Hines, described today’s CRE pricing environment as a “bit like driving while looking in the rearview mirror.” It’s known where the prices have been, but not where they’re going. He added that the question investors should be asking is how difficult it will be to replace an asset five years from now, rather than whether an asset is priced fairly today.

Joseph Crescio, global head of real estate valuation at Manulife Investment Management, agreed with the “future” challenge. He said that the judgment-driven assumptions that determine pricing (growth rates, discount and terminal cap rates) are basically averages, with accuracy depending on the asset, submarket, previous markdowns and a disciplined institutional framework.