Real estate, a diverse and intricate asset class, defies a single, definitive measure of pricing. The intricacies of the market and the multitude of factors influencing buyer behavior make it challenging to gauge property-market values accurately. Each market-level metric encompasses a wide array of buildings, each possessing unique qualitative attributes. Nevertheless, by examining various approaches, we can piece together a more comprehensive understanding of market pricing.
Real Estate Pricing: Approaches from transactions
In a recent analysis of the U.K. office market’s downturn in the past year, a range of market pricing, valuation, and liquidity metrics shed light on the situation. While all indicators display some degree of deceleration, the extent of this slowdown varies, and each metric contributes a valuable fragment to the narrative of how U.K. offices have been affected under the new regime of higher interest rates.
One avenue of assessment stems from transaction-based approaches. The RCA Commercial Property Price Indexes (RCA CPPITM) and RCA Hedonic Series, which measure transaction prices, demonstrate a modest decline over the 12 months leading up to March 2023. The CPPI utilizes a repeat-sales regression methodology, while the Hedonic Series models transaction prices by factoring in variables like a building’s age, size, and location.
These declines remain moderate, partly due to the highly illiquid nature of the transaction market. The limited number of assets being traded tends to consist of higher-quality properties, thereby restricting the scope for significant price drops. To observe a more substantial decline, a broader range of assets would need to enter the market, possibly through distress situations or refinancing challenges.
Two measures quantify market illiquidity, as indicated by the orange bars. The liquidity score, measuring the depth and breadth of active capital acquiring assets, experienced a nearly 20% decrease for U.K. offices over the 12-month period leading to March. Additionally, a modeled bid-ask spread, estimating the disparity between buyer and seller reserve prices using transaction data, reveals a significant mismatch between the perceived market pricing by buyers and the actual willingness of sellers to engage in transactions.
By combining the modeled bid-ask spread with the CPPI, a spread-adjusted transaction price index was created, illustrating a more substantial decline compared to the actual CPPI. This approach unveils the market clearing price that would emerge if prices adjusted based on buyers’ reserve prices. Notably, it highlights that buyers currently require a more significant discount than what is currently available to re-enter the market and restore liquidity to its long-run average. The persistence of such a price gap underscores the illiquidity and imbalance between buyers and sellers.
Another piece of the puzzle stems from valuation data provided by the UK Quarterly Property Index. This data reveals a drop in asset values exceeding the indications from transaction-price data. Valuers, grappling with rapidly rising interest rates and elevated capital costs, tend to adopt a more aggressive downward adjustment of asset values.
Examining the performance of listed property companies offers an additional perspective on property-market pricing. The listed sector often serves as a leading indicator for the direct market. Over the past 12 months, the UK IMI Core Real Estate Index, capturing all asset types, experienced a significant decline. Listed markets exhibit greater volatility compared to private markets, resulting in more pronounced pricing fluctuations. For instance, during the onset of the pandemic in February and March 2020, the listed index witnessed a decline of over 40%, a drop not mirrored by direct market pricing or valuations, which remained relatively stable.
This heightened volatility can be attributed, in part, to the embedded leverage employed by listed real estate companies to finance their assets, as well as their exposure to broader equity market beta. To mitigate these impacts, the UK IMI Liquid Real Estate Index methodology was designed. In the 12 months leading up to March, the drawdown in this index was less pronounced than the core index but still exceeded the decline observed in the liquidity-adjusted CPPI.
Real Estate Pricing: A global perspective
Taking a global perspective, similar pricing trends emerge in other developed office markets. Broadly, hedonic and CPPI series utilizing transaction data demonstrate a smaller adjustment in prices compared to valuation data and measures of liquidity, such as capital liquidity scores and modeled bid-ask spreads.
One notable exception is the United States, where the hedonic prices experienced a substantial drop over the past 12 months, exceeding the magnitude indicated by the bid-ask spread. This disparity suggests a wider range of assets sold in the U.S. compared to countries like the U.K. or Germany.
As we unravel the complexities of real estate pricing, it becomes evident that no single metric can fully capture the nuances of this multifaceted market. Instead, by piecing together these various fragments of information, we can approach a more holistic understanding of the intricate dynamics shaping property-market values.
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