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Surprising Truths Regarding Gateway and Non-Gateway Market Pricing and Liquidity

Investor Insight ​​

Contrary to popular opinion some of the largest, most sought after markets exhibit the greatest pricing volatility​

Investor Application

Investors can dampen pricing volatility in their portfolios by combining non- gateway markets with gateway markets

In​​vestor Insigh​​t

Contrary to popular opinion gateway markets offered no advantage in “crisis liquidity” levels​

Investor Application

Investors can secure higher yields in non-gateway markets without sacrificing higher levels of “crisis liquidity”​
 
Many office investors continue to pay premium prices in the traditional gateway markets of Boston, Los Angeles, New York City, San Francisco and Washington, DC. They view these markets much like stock investors view blue chip stocks – stable and highly liquid. However, other investors are increasingly venturing into non-gateway markets. The average 2011 sales volume for non-gateway markets was 6.5 times their 2009 levels while the average 2011 gateway market sales volume was four times their 2009 levels.
 

Change in Sales Volume: 2009 to 2011

 

 

 

Source: Real Capital Analytics 

So while the five gateway markets alone continue to account for 64 percent of the sales volume in our sample the greatest rate of sales growth is clearly occurring outside of the gateway markets. Are these two groups of investors getting what they are paying for? Or are they entering certain markets expecting one thing and leaving with something quite different?

It is commonly held wisdom that investments in gateway markets benefit from superior pricing stability and greater liquidity. Conversely, commonly held wisdom is that investors venturing into non-gateway markets are accepting more price volatility and reduced liquidity in return for higher yields. Are these widely held beliefs supported by the facts? Let’s first examine the pricing behavior of gateway and non-gateway markets. To do this I will use the Moody’s Commercial Property Pricing Index (“CPPI”). The CPPI is a repeat sales pricing index. The graph below shows the annual, indexed pricing movements of New York, San Francisco, Washington D.C., the 10 largest office markets and national office market beginning in 2000 and ending in 2011. Is pricing in the gateway markets really more stable? The graph below reveals a
different reality.

 

Surprisingly Volatile Gateway Market Pricing

 

 

 
Source:  Moody’s CPPI
 
*Top 10 Office includes:  Atlanta, Boston, Chicago, Dallas, Houston, Los Angeles, New York, San Francisco, Seattle and Washington, D.C.
 
Next let’s look specifically at the pricing volatility from the market peak to market trough, the very time investors would expect to benefit from being in gateway markets.
 

Pricing Index Decrease: Change from Market Peak Pricing to Pricing Trough

 
New York City ​-39%
​San Francisco ​-39%
​National Office ​-31%
​D.C. ​-28%
​Top Office​ ​-22%​​
 
Source:  Moody’s CPPI
 
Clearly the gateway markets did not provide the superior pricing stability they paid for.
 
Next let’s evaluate liquidity in gateway and non-gateway markets. To fairly evaluate this I will break liquidity into two phases that roughly reflect the expansion and contraction phases of an economic cycle. I will focus on liquidity levels during the contraction phase and more specifically on liquidity levels at the height of the most recent financial crisis, the “crisis” period. I will call this liquidity “crisis liquidity.”   
 

Liquidity Decrease: Change in Annual Sales Volume from Peak to Trough

 
​​​Los Angeles ​-100%
​San Francisco ​-98%
​New York City ​-93%
​Top 10 Office ​-93%
​Non-Gateway -93%
Boston ​-92%
​Washington D.C. ​-81%
 
Source:  CoStar, Office, $10M and greater
 
Now we have some idea why prices in gateway markets did not fare as well during the contraction phase of the most recent commercial real estate pricing cycle. At the very time investors most needed the liquidity they paid premiums for “crisis liquidity” was largely non-existent in these markets.
 
While gateway markets may have not delivered the expected price stability or liquidity at the height of the financial crisis how has their pricing performed subsequent to the financial crisis? Subsequent to their pricing nadirs NYC and San Francisco saw pricing increase an impressive 44% and 51% respectively. Comparatively, pricing for Moody’s Top 10 Office Markets and the national office market increased 16% and 2% respectively from their market low points. Clearly the Gateway markets have “bounced back” much more quickly. But where does that leave them relative to their market highs? As the chart below shows the gateway markets of New York, Washington, DC and San Francisco are closer to their market highs than the national office market.
 
Gateway Markets Rebounding Faster
 
Source: Moody’s CPPI

Disappointing crisis liquidity levels and surprisingly volatile pricing in no way makes gateway markets a poor choice for investors. To the contrary, if investors combine the relatively stable pricing of the Top 10 Office markets with gateway markets, and adjust financing strategies to take into account actual “crisis liquidity” levels, investors will create a more efficient portfolio than if they were to invest solely in gateway or non-gateway markets.
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