Real Estate Cycle Factors

My book “ Essential Data to Create Financial Success with Real Estate”, states that market knowledge is a determining factor to succeed in property business. People who follow us regularly know, that each article contains valuable information derived from variety of accredited sources to educate you towards financial success with Real Estate.

 As so many of you replied with investment concerns, asking for portfolio review, or assist in analyzing potential investment projects, due to scarcity of time I could answer only to few of you. One email” requesting for core elements that dominates in real estate cycles” draw my attention and I decided to expand this subject further. This narrative contains valuable information, which is not easy to swallow or digest, but is used within real estate funds as cornerstone for lucrative decision-making.

“Property cycles are recurrent but irregular fluctuations in the rate of all- property total return, which are also apparent in many other indicators of property activity, but with varying leads and lags against the all- property cycle.” (RICS, 1994).

 The real estate cycles are a reflection of various distinct components of property industry: occupier market, the development industry and investment markets. On one had it is a classic supply and demand market driven by economic growth and influenced by inelasticity of property supply on the other property cycle feeds directly off the economic cycle at various key points. Fluctuations in output and employment drive the occupier markets through the demand for space; changes in the financial climate impact upon property yields and investment allocations.

·      Occupier markets and Rental Cycles. Rental values are the outcome of balances between demand and supply in competitive markets. A feature of occupier markets, which distinguishes them from straightforward competitive markets, is the time required for total supply to adjust to changes in demand, due to the development lag and inflexibility of the built stock. Demand side is pro-cyclical with economic growth indicators, but inelasticity of supply means that even highly regular demand cycles can generate irregular rental cycles. Barras (1994) identified potential cycle overlaps: Short cycles of 4-5 years, the classic business cycle operating on occupier demand; Long Cycles of 9-10 years a tendency for severe over supply to feed part of the next cycle; Long swings of 20 years, associated with major phases of urban development; Long waves of 50 years, associated with technology change.

·      Development Industry and New Supply; Real Estate Development is a profit driven process. As in any industry, developers should be expected to set their production in response to the profits they expect to achieve. Indicators to follow: Supply Side (volume of construction work, construction new orders, construction commencements), Demand Side (GDP, consumer spending, financial and business services, manufacturing activity, employment trends, interest rates, yields (property and other investments). These indexes are used in specifically designed investment models for each real estate sector. Example: Model For Retail Development Activity Positive Influences; Current Retail Capital Values; Negative Influences; Retail Capital Values 2 years ago; Rise in Building Costs over 2 years; Interest Rate 2 years ago.  Development is volatile not because it is tossed about by building manias or waves of purely speculative finance. Building booms and slumps can be explained simply by developer’s responses to current market signals, and the development lag. It is the rate of profit being achieved on developments currently being completed which is the dominant trigger for additional building.

·      Investment Markets, Yields; An analysis of investment markets opens out the field of view, bringing into play the influences from other asset classes and financial markets. Yield movements over the last thirty years have been related to some financial factors; gilt yields, interest rates, anticipated property returns a short time ahead, and inflation. The investment markets are another source of instability. But, in practice, over the last thirty years, any tendencies for yields or investment allocations to exaggerate the cycle have been damped by two factors. First, a small measure of foresight: yields have mostly anticipated the major swings in the rental cycle a year or so ahead. Second, there are offsetting and balancing forces: yields are pushed up by major building booms; and rapid capital growth in upswings itself curtails investors’ appetite for property.

There are very strong but flexible links between swings in the economy and those in property markets. Economic cycles which have much in common may be associated with property cycles that differ in character. Marked peaks and troughs in the rate of all-property return (TOT return, yield movement and rental growth) are, however, sensitive to leading indicators of economic activity: property does not, looked at in these terms, lag behind the rest of the economy.

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