The Cycle That Commercial Real Estate Markets go Through
The economy (nationally and globally) goes through cycles and so does real estate. Commercial and residential market cycles are completely different because commercial real estate is an investment process while residential real estate (homes) is a production process. Commercial real estate has two separate cycles: physical and financial. The physical market cycle is the interaction between users (demand for space) and developers/owners (supply of space) in an individual market. On the other hand, the financial market cycle deals with the prices of commercial real estate and is driven by the capital markets (the interaction of buyers and sellers of properties) which have evolved from local to national, to public and now global. In this article, the commercial market is discussed.
Commercial real estate moves through the same 4 phases of the cycle as residential real estate but they don't move concurrently as commercial real estate is more complex. For a full breakdown of the four phases of the real estate cycle refer to my previous article and for this article, I will do a brief review.
1 - Recovery
It is at this point in the cycle we have just gone through a recession. We are seeing negative rental growth and below inflation rental growth. Occupancy is starting to rise as we make our way to the next phase, expansion.
phase 2 - Expansion
The expansion phase is met with rapidly rising rents, further declines in vacancy and new construction becomes more prominent.
Phase 3 - Hypersupply
At this point, we have not passed the demand/supply equilibrium point and occupancy is now starting to decline as supply begins to outpace demand. The new construction process takes years to go through so even though we have reached the hypersupply phase there is still new construction in the pipeline that will add to the supply and lead into a recession.
Phase 4 - Recession
The final phase of the cycle, rock bottom. We have below inflation & negative rent growth. Vacancy is increasing as more completions come about. This is the bottom of the market.
Understanding the relationship between the space market (rental market) and the capital market (transaction market) is an important element of market analysis. The space market determines the market rent based on current supply & demand and the capital market then applies a cap rate to the current market rent to establish an asset's value. Net operating income and values are tied together to capital markets through a cap rate. In order to determine value, you divide NOI by the going cap rate for the market to determine value.
Market Dynamics
As the economy strengthens and the demand for space increases, rents rise and the supply of space cannot adjust fast enough to meet the new demand as development is a time-consuming process. Because rents are rising, the increase to NOI is translated via the cap rate into a higher asset value which in turn means that values are greater than replacement costs. When value is higher then replacement cost this gives developers the incentive to begin development as the difference between value and cost represents profit.
In a perfect world, the new supply brought on would be just enough to meet the new demand. Rents would return to the level that produces a value again equaling replacement cost, and equilibrium is restored. Unfortunately, this doesn't happen all the time because one of two things tends to happen: Either value exceeds replacement costs or replacement costs exceed value. In a realistic world, rents increase resulting in an increase to value which signals to developers, let's build. The problem is we live in a free market so any developer or financier can decide they will be the developer to meet this new demand. If the market signals demand for 200,000 sqft of new office you will have three developers develop a building with 200,000 sqft of office and now you have an excess of 400,000 sqft of office which brings rents below equilibrium and values begin to drop. This shift doesn't happen overnight and in a growing market such as the Lower Mainland area of BC where 60,000 new people a year (and in recent years lots of tech companies) are moving to the area this excess of space is met with new demand resulting in a relative balance and at times still not enough. It is when events such as Covid-19 happen resulting in an immediate halt in immigration to the area that we see sudden increases to vacancy and new supply to the market from subleases and completions. The developers 2-5 years ago were planning on consistent growth to fill the space but temporarily that has been halted. It is black swan events such as Covid that can tilt a market over the edge and into a recession if the market is negatively affected for a prolonged amount of time and there is a dramatic decrease in absorption.
When value is less than replacement cost, the incentive to build is gone. Additionally, rents are not high enough for landlords to maintain buildings at peak condition. The markets adjust through a process of filtering, in which some buildings depreciate out of the market. This shifts the supply curve until it reaches equilibrium and the cycle returns to its original point.
This is a snapshot of a typical real estate cycle. It is highly unlikely that real estate cycles will ever go away. Beyond that it is difficult to get developers to produce the correct amount of space. Public real estate markets have led to a broader dissemination of real estate information meaning lenders and developers have a better sense of what they are getting into when they move into a market. Future market cycles likely will be less pronounced than in the past due to this fact.
Physical Market Cycle
The physical market cycle is the demand & supply for space, which is very local in nature. Demand for commercial space is a function of the amount of space needed by businesses to run their operations. Demand for office & industrial is driven by the local economy's total employment which is derived from basic employment. Growth in total employment leads to growth in total population & households which determines the demand for apartments. Total population & household growth leads to an increase in disposable income which determines the demand for retail. The amount of space actually used is a function of both the need for space and the price of that space.
The supply of space is a function of existing space, space under construction, and planned new space. Rent is a function of the current space available (vacancy level) and the future expected space available. If occupancies are low (vacant space available is high), landlords will drop rents (price) to attract tenants and vice versa. Researches have found that historic rental rates are a function of occupancy levels, which has a high correlation with rent growth. Future rent levels are forecasted by analyzing the change from current occupancy to the forecasted future occupancy levels.
A major constraint on new space construction is the cost of building new space. Developers want a reasonable ROI for the investment risk they take building new space. Rents or cost per sqft has to be high enough to "cost justify" building new space.
The real estate cycle is widely considered to be a delayed reflection of the national economic cycle. A basic reason that real estate is a cyclical industry is the fact that the demand side is affected by economic cycles, particularly employment growth and supply response is not immediate or efficient. The lag between demand growth and supply response is the second major cause of volatility in physical real estate cycles as too little space is available when rapid growth is happening and once production has ramped up and completed the demand has slowed due to long development timelines.
Financial Market Cycle
Estimating the space market building cycle is a much easier task than projecting the financial cycle as there is far more data available for the demand and supply-side variables. It's more difficult projecting the financial cycle as the other investment markets such as stocks, bonds and international investments must be considered as they compete for investor's dollars.
The financial market cycle has to do with the flow of capital into and out of a market. As real estate has become much more global in nature there has been an increase in capital moving from country-to-country in order to diversify portfolios and achieve higher ROI's. Countries have different industries that make up basic employment such as China being a manufacturing country and Canada a natural resource and increasingly tech country. Depending on where each market is in its cycle, big money will want to invest abroad to chase the highest & safest returns. When it comes to individual investors who don't necessarily have the resources to invest globally, they will be looking at the cost of capital and returns & horizons commercial investments provide in comparison to other options such as stocks, bonds, MICs, ETFs, REITs, etc.
The flow of capital is a major factor affecting prices in real estate as well as all other investments. In the 1980s, the private real estate capital markets, driven by tax shelter investors, then non-taxable pension funds, then foreign investors created a long 10-year capital flow to real estate that created the largest overbuilding cycle ever experienced in the U.S. Leading into the 1990s the private capital markets moved away from real estate and the public markets moved back in by way of REITs and CMBS vehicles. REITs were first formed in the 1970s but that ended in disaster as the mortgage REITs were externally advised by their sponsor banks who could care less about defaults in the REITs portfolios as the bank wins either way. The 1990s was a different period as there was more available information and the public markets were able to anticipate problems and react to them. Smart data has helped to maintain a relatively balanced demand/supply growth.
Now that the public markets have emerged, real estate finally has access to the five major sources of the capital markets:
- 1. Public Debt
- 2. Private Debt
- 3. Public Equity
- 4. Private Equity
- 5. International Capital
Public capital sources (REITs & CMBS) have different effects on real estate which are positive in nature such as better data, faster access to data, multiple monitoring and reporting sources, and better access to capital. This in turn should provide more balanced long-term capital flows as well as stability to the real estate markets.
An example of how the physical and financial markets can work hand in hand is looking at the traditional real estate market cycle. After a market has gone through a recession and is in the recovery quadrant, it is the introduction of capital that pulls a market out of recovery and into the expansionary phase. It is the implementation of capital that gets projects started, people back to work and people spending money in the economy again.
Real estate capital markets have gone from being local in the 1970s to national in the 1980s to public and global in the 1990s. A combination of volatility & poor performance in the stock market, the security of a physical asset (real estate) and easier access to real estate has led to much more capital being directed towards real estate in turn making it harder to find good deals. As technology advances, access to real estate is becoming easier for the everyday individual whereas previously it was only institutional and savvy investors who would play ball. Now if you have an internet connection you can buy shares of a real estate deal for as little as $1 through certain platforms. As this is a relatively new concept it will take some time to see how it affects real estate moving forward.
References:
Mueller, G. R., Understanding Real Estate’s Physical and Financial Market Cycles, Real Estate Finance, 1995
CCIM 102 textbook. Market Analysis for Commercial Investment Real Estate
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