So Megan McArdle has a post up talking about the failure of a commercial real estate project in Stuy-Town.  I read McArdle a lot, and whenever she talks about New York and D.C. I’m much like an ignorant savage with a bone through my nose being told about far-off Albion.  I’m so Southern that I think anything north of the Red River is like one of those old Christopher Columbus maps (“Here there be dragons!”) and I’ve always read the comment threads of her posts about big city vs. suburban living with a bit of wonderment (walking home to your apartment with bags of groceries?  WTF?).

Megan attributes the price appreciation of commercial real estate during the bubble to animal spirits.  Megan:

But about half was just that buyers, suddenly and for no apparent reason, became willing to pay more for a given stream of projected rents.  Where previously, buyers might have wanted a price-to-rent ratio of ten or eleven to one, by the height of the bubble, they were willing to pay 14 or 15 times rents.

I think Megan’s wrong to characterize the change in the prices being paid as tied mainly to expectation of appreciation or to claim that it happened “suddenly and for no apparent reason.”  One of the possible reasons (and what I would think would be the most important reason) for the decrease in the ROI for commercial real estate is the general trend in 2000-2009 of decreasing interest rates.  The principle of substitution applies to real estate as well as other investments.  If, because of a low interest rate environment, a security with risk A is priced at a yield of 6%, a real estate investment with risk A isn’t going to be priced at a yield of 10%.  Prices will clear at a level where yields on equivalent risk are at least similar.

To the extent that a small premium was being paid above and beyond the risk-adjusted yield on real estate at the height of the bubble, I think you also have to factor in the fact that in 2005-2006, interest rates were at (what was thought at the time) to be historic lows.  So, absent a catastrophe or Black Swan event, it was rational for commercial real estate investors to price in some amount of appreciation to the extent that there is a lower bound on how low interest rates can go.

Here is a graph of the Interest Rate Composite.  Notice the magnitude of the decline from 2000 – 2005.  I think that, coupled with the fact that rates were pushing up against a lower bound, goes a long way towards explaining the change in price-to-rent ratios (and, thus, the yields) in commercial real estate in the run up to the peak in 2007.

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