What’s ahead for private real estate? While no one has a crystal ball, there are several smart ways to address the question, including real estate market cycle analysis.
Real estate market participants of all types—from individual investors and developers to sponsors and institutional asset allocators—can benefit from cycle analysis. By seeking to understand the different risks and opportunities present in each cycle phase, savvy players can make informed decisions and likely achieve better outcomes over the long run.
Here we take a high-level look at commercial real estate cycles, relying on the work of Glenn Mueller, a professor for the Burns School of Real Estate and Construction Management at Denver University. A well-known researcher and subject matter expert, he publishes a quarterly real estate market cycle monitor that many industry professionals consider a must-read. Current and historical editions are available in the “Real Estate Market Cycle Report” section toward the bottom of this Burns School website.
Real estate cycles 101
We’ll focus here on the physical real estate cycle, which studies the interaction of supply and demand as it translates to occupancy levels—or the inverse, vacancy rates—and rental rate growth. This is distinct from the financial cycle, which examines capital flows into real estate and their relationship to real estate prices.
Physical real estate is cyclical due to the lagged relationship between demand and supply for space. Historically, full cycles have lasted approximately 16-18 years. The physical commercial real estate cycle has four phases:
- Recovery – We start at the bottom in a state of oversupply with occupancy at its lowest point. As we move through the recovery phase, demand begins to grow and excess space is absorbed. Rental rates stabilize and begin to increase. Eventually, occupancy levels reach the long-term average, where rent growth is equal to inflation.
- Expansion – Occupancy is above its long-term average, new construction is beginning, and rents are rising rapidly. Long expansionary periods characterized by strong, tight markets are possible. The cycle peaks when demand and supply are growing at the same rate, creating an equilibrium point.
- Hypersupply – Markets can reach peak occupancy and be in equilibrium until demand begins to decline due to a slowing economy or recession, or until developers begin to build more than is needed. In either case, supply is growing at a faster rate than demand, pushing the cycle into the hypersupply phase. Occupancy rates decline and rent growth is positive but declining.
- Recession – If new supply grows faster than demand once the long-term occupancy average is passed, the market falls into a recession. The severity is determined by the differential between market supply and demand growth rates, with the worst case being massive oversupply in conjunction with negative demand growth. The cycle reaches a bottom as new construction and completions halt, or as the demand growth rate climbs above the rate at which new supply is added to the market.
Please, review the chart below to learn how recovery, expansion, hypersupply and recession affect occupancy rates, new construction and rental rate growth.
|Rental rate growth||Negative/low||Moderate/high||Moderate/low||Low/negative|
Where are we now?
It’s critical to recognize that the commercial real estate cycle doesn’t play out uniformly across asset classes and geographic markets—determining where we are now and what comes next depends on the property type and location.
In Q4 2021, for example, Mueller’s national-level report classified regional malls in the recovery phase while office properties were in the expansion phase. Looking at specific markets for office properties, classifications for major metro areas spanned all four phases, ranging from Houston and Los Angeles in recession to Miami and Orlando in expansion.
How can individual investors use cycle analysis?
Some individual investors may try to surf the cycle using tactical allocation shifts within their portfolios—for example, investing in more aggressive, opportunistic real estate strategies in anticipation of an expansionary phase then shifting to more defensive strategies as the market appears to move toward a recession.
It is, however, quite difficult for individuals to successfully time the market by moving in and out of real estate investments. For many individual investors, the optimal path to durable wealth creation may be a thoughtfully constructed portfolio of long-term investments with appropriate risk-return characteristics, managed by experienced sponsors who can make active adjustments within their strategies in light of shifting cycle dynamics.
Depending on their cycle analysis, portfolio managers develop and implement optimal strategies for acquisitions, dispositions, holding periods, leverage, lease structures, capital expenditure plans, and operating policies—all with an eye toward meeting targeted risk-adjusted returns across a full cycle.
Stephen Pyhrr, Stephen Roulac, and Waldo Born provide an example in their comprehensive review “Real Estate Cycles and Their Strategic Implications for Investors and Portfolio Managers in the Global Economy”:
If an industrial market is ‘hot’ today but a downturn is expected in two years, leases can be structured on seven- to ten-year terms and designed to attract credit tenants who are not likely to default during the downturn. Using this strategy, current high rent rates at the top of the cycle can be locked in, allowing the investor to ‘leapfrog’ the market downcycle and recovery period. In addition, the investor might also refinance this low-risk property at its ‘top of the market’ value with a 75% non-recourse loan with a ten-year term, then use the refinancing proceeds to establish a substantial liquidity fund for use during the downturn when distress properties can be purchased at distressed prices.
A grasp of commercial real estate cycles should help individuals better understand the investment landscape—including the opportunities today and what may lie ahead—and assist in positioning their portfolios for long-term success, ultimately enabling them to generate lasting wealth.
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The information contained herein is general in nature and is not intended, and should not be construed, as accounting, financial, investment, legal, or tax advice, or opinion, in each instance provided by Caliber or any of its affiliates, agents, or representatives. The reader is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances, desires, needs, and requires consideration of all applicable facts and circumstances. The reader understands and acknowledges that, prior to taking any action relating to this material, the reader (i) has been encouraged to rely upon the advice of the reader’s accounting, financial, investment, legal, and tax advisers with respect to the accounting, financial, investment, legal, tax, and other considerations relating to this material, (ii) is not relying upon Caliber or any of its affiliates, agents, employees, managers, members, or representatives for accounting, financial, investment, legal, tax, or business advice, and (iii) has sought independent accounting, financial, investment, legal, tax, and business advice relating to this material. Caliber, and each of its affiliates, agents, employees, managers, members, and representatives assumes no obligation to inform the reader of any change in the law or other factors that could affect the information contained herein.
 Journal of Real Estate Research, February 1999