Economist’s View: Don’t Blame Allocations for CRE Valuations

Accepted conventional wisdom in the commercial real estate industry is that allocations to (and relatedly, interest in) CRE have increased over time. In turn, that dynamic has heightened competition for assets among investors and consequently driven valuations upward. But is that story actually true? As I mentioned in last quarter’s column, interest rates structurally and significantly declined during the last couple of business cycles, by roughly 500 basis points, U.S. Treasury data shows. Our econometric modeling shows that the decline in interest rates primarily drove up CRE valuations, not a change in allocations. But we need a way to address this allocation impact question without getting lost down the rabbit hole of econometrics.

If this narrative about higher allocations were true, we would see signs of it in market data. Start with transaction volume. We are utilizing nominal RCA data on a calendar-year basis going back to 2001 for all property types in the U.S. If increased competition drove up valuations, we would almost certainly see it manifest as increased transaction volume data. It is highly unlikely allocations could have increased to the degree that many assert without a notable impact on turnover and volume. And from a superficial perspective, it seems like this narrative is true. The calendar-year average volume during the previous economic expansion of the 2010s is roughly 58 percent higher than the calendar-year average volume during the expansion of the 2000s, according to data from CoStar. And total volume during the 2010s is higher, but that’s largely a function of the longer duration of the economic expansion last decade, the longest in U.S. history, as per data from the same source.

But we still have to disentangle the impact of rates from allocations (again without the model). For this, we turn to the overall economy. The economy also expanded over the last two business cycles and benefited from the structural decline in interest rates during that period. Yet, when we examine the economic data in conjunction with the transactions data, the narrative about increased competition driving valuations becomes less convincing. During the expansion of the 2000s, the average annual ratio of transaction volume to nominal GDP was 4.2 percent. But during the previous expansion, it fell to 2.3 percent, a 46 percent decline, and almost the mirror opposite of what occurred with nominal transaction volume, according to data from the U.S. Bureau of Economic Analysis. If there were truly a significant shift in valuations due to allocation increases (independent of interest rate impacts) on anything like the scale that many assert, volume surely would have grown faster than the economy whose growth slowed structurally during that period.

What about new development? Could this increase in allocations have simply manifested in net new development, especially if some of that development hasn’t shown up yet in the transactions data? Here things seem a bit more convincing. Over the last two business cycles, physical inventory has increased by an average of about 23 percent, cumulatively, across the major property types, as per data from CoStar. Much of the increase in allocations could have effectively found a home in this new development. But ultimately increasing supply by such a relatively large percentage would have alleviated or fully offset any pricing pressures coming from the increase in investor demand from higher allocations.

So, what’s going on? First, most people making this allocation assertion aren’t doing careful econometrics to discretely account for the impact of the decline in interest rates. Second, they are also likely only thinking about the demand side of the CRE market, and not the supply side. Have allocations increased? Absolutely. Have they had an impact on valuations? Possibly at the margin. But as our modeling shows, the majority of the increase in valuations over the last few decades has come from the structural decline in interest rates and not a higher allocation to CRE.

Read the June 2024 issue of CPE.