By John Loos, Property Strategist, FNB Commercial Property
In a downturn, property market values can deviate dramatically from the market ‘equilibrium’ value, which can be lower in recessionary times due to strong resistance by the market to dropping values in order to sell. The result can be a significant oversupply in the market and subsequent weakness.
Property values typically adjust very slowly to changes in economic fundamentals.
In general, there is a strong resistance in the property market to price drops in order to sell. A property can often be a major investment, either household or for business, with the reluctance to accept that it may not be worth as much as what it was once believed to be. There may also be a strong anchoring of value perceptions to recent price levels, or even to the prior purchase value a number of years back.
Valuations of properties, whose methodologies often rely heavily on existing data, cannot be expected to move instantly to a sharp lower level when no new historic data, on which to base such an adjustment, exists. Therefore, market values move slowly and battle to keep up with market reality.
So, when data shows negative capital growth in the property market, such as the -5.9% decline that MSCI data showed for all commercial property average capital value / square meterage between 2019 and 2021 for example, this is by no means the end of the full weakness story.
An example: in an economic shock, expect a noticeable move both in demand curve (left) and the supply curve (right), the latter shifting due to a flood or stressed properties entering the market. Initial price decline from point ‘0’ to the market disequilibrium point ‘1’ is moderate and often seen only in real terms while disequilibrium build-up is seen in increasing difficulty in selling properties in an oversupplied market, and an increase in the average time that properties stay on the market prior to selling. Mounting stress, in a recession, can start to cause a more rapid price drop or adjustment to new equilibrium at point ‘2’.
While equilibrium value or price drops instantly from 50 to 20 when the demand and supply curves shift, a market average value of 20 will only be reached later on – or never reached, should fundamentals recover before the market passes too far past point ‘1’, with demand and supply curves shifting back to D0 and S0 positions.
When an economic downturn hits, the downward inflexibility in values forces market values to remain well above the new lower demand-supply equilibrium value initially, and the market becomes oversupplied.
At this stage, the bulk of market weakness may not yet be witnessed in a drop in a price or valuations index. It may be seen in a time series showing an increase in the average time of properties on the market, prior to being sold – an increasing oversupply of properties sitting on the market for longer with the built in resistance to dropping prices or valuations holding for long periods of time.
Very often, during and after an economic and property market recession, the market values never drop as far as a recession period’s lower ‘required’ market equilibrium value. Instead, the economy sometimes recovers before prices or values complete the downward adjustment, property demand starts to recover, and declining market values meet a rising or recovering market equilibrium value somewhere in between.
During an economic and market downturn, it is often said that “this is the value of the property, but the market is dead and nothing is selling.” This is when market valuations are unrealistic, given the economic fundamentals and which reflect a market in a demand-supply disequilibrium. This imbalance can remain for long periods of time. We have been witnessing significant disequilibrium positions in the commercial property market in recent years (FNB Property Broker Survey) and some are still intact, most notably in the office sector.
Between 2019 and 2021, MSCI annual property data showed average capital value or square meterage declining by -6% in the retail market, -9.2% in the office market and -5.4% in the industrial market.
However, when reviewing the FNB Commercial Property Broker Survey, major oversupplies were reported by the majority of brokers in both the office and retail markets with only the industrial market having seemingly managed to recover to demand-supply balance.
The demand-supply survey response
Property brokers are asked whether they perceive ‘demand far exceeds supply’, ‘demand exceeds supply somewhat’, ‘the market is in balance’, ‘supply exceeds demand somewhat’ or ‘supply far exceeds demand’.
A significant portion of the group within the retail and office sectors still point to ‘supply exceeding demand’, either ‘somewhat’ or ‘far’ when compared to those pointing to ‘demand exceeding supply’.
The oversupply is particularly severe in the office market, but the property brokers perceive ‘demand exceeding supply’ in the industrial market i.e., 57.1% versus 33.4% perceiving ‘supply exceeding demand’ (9.5% perceiving a balance). By comparison, 52.1% perceive ‘supply to exceed demand’ in retail and a massive 84.6% in the case of the office market.
In short, the property brokers still perceive the retail and office markets to be oversupplied, but the industrial market undersupplied relative to demand. The office and retail markets have been perceived as constantly oversupplied ever since the survey launched at the beginning of 2019, with the office market still perceived to be far from demand-supply equilibrium, providing an idea of how long it can take values to fully correct. The corrections to date have been insufficient in the area of retail and especially office, to bring the market back to balance.
In conclusion, during an economic and resultant property market weakening, due to the slow pace at which property values adjust downwards, demand-and-supply typically moves away from equilibrium with market values and prices often remaining well above the equilibrium value for long periods of time, adjusting only gradually.
The full weakness of a market cannot always be gauged merely by viewing capital value growth or decline. A major part of the weakness lies in the oversupplied nature of a market, with actual valuations being out of line with market equilibrium values, the current office market being a good example.
General economy-wide inflation can assist the valuation correction process, with most of this correction taking place in ‘real terms’. Actual values may not always decline, but also not keep pace with general inflation in the economy, correcting slowly in what economists call ‘real’ terms.
In this case, inflation conceals, in part, the full extent of the value correction, creating something of an illusion that a property has held its value, which is what is happening to a significant degree since the commercial property market began its multi-year correction around 2016.
Property average capital value or square meterage was 2.4% higher than the 2015 level in 2021, in real terms, it was -26% lower and still with oversupply in place.
