Chapter 25 | Real Estate Cycles

Overview

Real estate cycles strongly impact real estate markets and the success of real estate investments (and professionals).  This chapter reviews the factors that influence real estate cycles, providing a better understanding of how real estate cycles can be forecasted.

Summary

Real estate cycles are prolonged periods of property supply and demand imbalance, which eventually gravitate towards relative market balance.  Real estate cycles play out gradually due to the slow nature of demand growth, long-term leases, and the fixity (permanence) of supply.  Thus, it generally requires many years for this balance to occur.  Vacancy rates indicate whether markets are improving (falling vacancy) or weakening (rising vacancy), and net absorption statistics tell us how much vacant supply was leased relative to how much was vacated over a specific time period.

The lagged timing of supply is a major factor in the success of a development. Developers often initiate projects in a very strong market when demand for new space is high.  However, due to the prolonged nature of real estate development, projects often come online after demand for the product has weakened, or alternatively, after competitive new supply has already been delivered.  Such conditions often make it difficult for a developer to find new tenants for the project while existing tenants in the area are already committed to long-term leases in neighboring buildings.  Thus, a newly developed building can often remain poorly leased, while an older, inferior building is fully occupied at above-market rents.  The shift in occupancy to newer buildings will eventually occur as existing leases terminate, but developers will often incur substantial losses in the early years due to the poor timing of the project.

Demand growth will eventually close the supply/demand gap, but it is important to understand that demand grows slowly, as it is directly linked to (and lags) job creation in the market.  The chapter reviews the case of office development in the U.S. during the dotcom era.  At the end of the 1990s, the tech bubble created high expectations for extensive U.S. job growth and, in fact, from 1999 to 2000, 6 million new jobs were created.  As a result, a surge of office development began, creating an excess supply of new space.  However, as the tech bubble burst in 2000, the market was flooded with a surplus of newly developed office buildings in the face of negative job growth.  In fact, during 2001-2003, the U.S. economy lost approximately 2 million jobs, bringing office vacancy rates to an astounding 18%.  Only by mid-2007, after 5 years of strong demand growth and little new supply, did vacancy rates fall below 10%.

A major source of delay in real estate supply is the development regulatory process. Development projects require many permits, certificates, and approvals before construction can begin.  A delay in getting through the regulatory process can infringe on the timing of delivery of a development and on its feasibility and success.  Often, developers have equity and many hours tied up in the future project and will continue despite weakening market conditions, when supply already exceeds demand.  Thus, markets will take a long time to absorb the supply mistakes, leading to prolonged periods of market imbalance.  A source for developers’ confidence is partial pre-leasing of a new development, but keep in mind that even pre-leasing can backfire, as many of the pre-leased tenants may go bankrupt before construction is complete.

Real estate capital availability is another important factor in real estate supply.  It is an eternal truth that if developers get money, they will build, and if debt is cheap and plentiful, many real estate owners will overpay and over-leverage.  Hence, when cheap capital floods the market, real estate prices rise, and as capital becomes scarce, there may be plenty of opportunities to purchase property at bargain prices.  The Linneman Real Estate Index measures capital market balance by calibrating commercial real estate debt relative to the driver of space demand and economic activity, and is a useful tool to track the supply of real estate capital.

The 2008-2009 Financial Crisis was triggered by the massive growth in subprime residential mortgage borrowing from 2002-2006 by speculative homebuyers, and subsequent defaults, which rippled through the global financial system by subjecting institutional investors to margin calls on their positions.

To better understand cycles, gather information and monitor trends in local and national markets, for different property types.  Look to local brokers and publications such as The Linneman Letter to get information on vacancies, net absorption, and market forecasts to form your opinion on where the market is currently in the real estate cycle.

Questions

These are the types of questions you will be able to answer after studying the full chapter.

1. What is more volatile, the demand for space or the supply for space, and why?

2. Given the following data, calculate the net absorption over a year in a market, and the year-end occupied square footage.

Occupied space at the start of year: 1M square feet
During year: no new supply; tenants move into 250K square feet and vacate 300K square feet

3. Given the following data, calculate the market’s year-end vacancy rate.

Total space at start of year: 1.12MM square fee
Occupied space at start of year: 1MM square feet
Occupancy at start of year: 89.3%
During year: 200K in new supply delivered; tenants move into 200K square feet and vacate 100K square feet

Additional Multimedia

Key Terms

To view the definition, click or press on the term. Repeat to hide the definition.

Prolonged periods of property supply and demand imbalance.

The total amount of square footage tenants newly occupy over a given period of time.

Measures the difference between the total newly-occupied square footage and the total square footage vacated over the same period.

Non-pre-leased or non-pre-sold real estate development.

A type of mortgage that is normally issued by a lending institution to borrowers with low credit ratings.

A floor plan layout that makes use of large, open spaces and minimizes the use of small, enclosed rooms such as private offices.

Investors who purchase single family residences with the intent to sell them quickly (“flip them”) for a profit.

A tradable security that is collateralized by mortgages on single family residential properties.

The immediate requirement for a securities holder to produce a significant amount of cash to offset the loss of value in accounts in which they purchased securities using borrowed funds.

Chapter Headings

  • What Are Cycles?
  • Contractual Obligations and Market Frictions
  • Demand Adjustments
  • Structural Office Demand Headwinds?
  • Permits and Regulations
  • Capital Cycle
  • What Led to the 2008-2009 Financial Crisis

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