Loss aversion and the Liquidity of Real Estate Markets

Investors in the business property market often exhibit a phenomenon known as "loss aversion," where they strongly prefer not to witness their investments incurring losses. Typically, property owners tend to retain underperforming assets while selling off profitable ones, primarily to avoid realizing losses on their investments.

This aversion to losses becomes particularly significant when property prices begin to decline, substantially impacting the market's liquidity. It can shed light on the current lack of liquidity in global property markets and why this liquidity shortage varies from one city to another.

The Confluence of Rising Interest Rates, Reduced Transaction Activity, and Plummeting Property Values Since the first half of 2022, the swift increase in interest rates has resulted in a sharp decline in transaction activity. Moreover, valuation and pricing metrics in many of the world's major property markets are still undergoing adjustments. Through a "mark-to-market" assessment, we can gauge the proportion of properties that may now be valued lower than their original purchase prices. This evaluation is accomplished by examining price fluctuations up to June 2023 using the RCA CPPI (Commercial Property Price Index) and factoring in the duration of property ownership.

An alarming situation has emerged in London and Hong Kong, where over half of the assets are currently valued below purchase prices, marking the lowest among all global cities studied. MSCI transaction data reveals that commercial property prices in London have plummeted to levels last witnessed in 2017, prompting a surge in acquisitions by opportunistic buyers. Conversely, cities like Sydney, Seoul, and Melbourne have fared better due to rapid price appreciation throughout the economic cycle, experiencing compound annual growth rates (CAGR) of 10.5%, 8.2%, and 7.4%, respectively, until June 2023.

Liquidity has been more significantly affected in markets where more assets incur losses.

We can employ MSCI Capital Liquidity Scores and data on the percentage of properties expected to be in a loss position in each city to analyze the impact of loss aversion on market liquidity. While there are exceptions in the global markets examined, it is generally observed that less liquid markets tend to have a higher number of properties experiencing losses. For instance, London's Capital Liquidity Score has plummeted by over 20% since its peak in 2015 and by 15% in the past year. Conversely, fewer assets are anticipated to be in a loss position in cities like Sydney, Melbourne, and Boston, contributing to better overall liquidity.

The MSCI Price Expectations Gap further underscores the reluctance of individuals to incur losses. This gap, most pronounced in cities like London, San Francisco, and German A-cities, signifies the disparity between what buyers are willing to pay for a property and what sellers are willing to accept. In situations where uncertainty prevails, buyers rapidly adjust their price expectations, creating challenges for sellers in finding willing buyers.

Divergent Perceptions of Property Value Between Buyers and Sellers

Expanding upon the study of loss aversion, we can assess how the number of properties in a loss position would change if property prices declined further. For example, a 15% price drop in Washington, DC, could leave over 80% of property owners with properties valued lower than their purchase prices. In the case of a 25% drop, this scenario would affect 99% of assets, given that property values in DC have seen limited growth since the conclusion of the global financial crisis 2008, with a meager 10-year CAGR of just 2.5%. Similarly, a 13% price drop in New York could result in over half of the assets being valued below their purchase prices.

Varied Vulnerability to Price Declines Based on Specific Scenarios

It is essential to recognize that this study calculates price changes at the metropolitan level, obscuring differences at the individual property level. Various factors influencing property values can have disparate effects on each asset. For instance, while property sellers in London may achieve double-digit returns, those in Seoul or Sydney might experience single-digit returns or losses.

Considering the Prolonged Period of Low Liquidity

Investors should contemplate the possibility that the current period of low liquidity may persist longer than usual due to individuals' aversion to realizing losses. Ongoing uncertainties surrounding inflation and interest rate trajectories necessitate clear pricing signals in direct property investment markets.