Analyzing Market Cycles

All markets are cyclical including real estate cycles. As the old adage goes, “What goes up, must come down” and vice versa. Knowing that, if investors had a crystal ball and could time the market so that they were always buying when the market is depressed and selling when things are hot, imagine the money which could be made.

We are all hearing on the news about how the economy is slowing and the housing market is depressed and people are losing their jobs. But that generalized viewpoint is too macro. Real estate is local and it is better analyzed from a microeconomic viewpoint. That sounds like a simple statement but it is important to understand. While it is true that many markets are depressed, other markets are bustling with activity and appreciating.

What is true in Los Angeles is not necessarily true in Oklahoma City. And what is true in apartments in Chicago may not hold true for retail property in Chicago. It is important to look not only at the “metro” but also the property type. It is important to forecast not only the demand for real estate but supply as well, both of which effect vacancy, pricing and value.

Let’s review a concept with which we are all familiar, namely supply and demand. Obviously when demand is greater than supply, prices go up. Here’s an illustration. Imagine there are two of you in the middle of the desert and you are both dying for a drink of water and I have the only glass of sparkling cold H20. If I offer to sell it to you for $1.00 and the other person wants it bad enough, he will offer me $1.25 for that same glass. Seeing that you will lose out on that much desired glass of water for your parched body, you will be inclined to offer me $1.50 for example. And so the bidding goes until one of you simply can’t afford to increase the price further. So again, when demand is greater than supply, prices go up. That is true not only for property values but rents and occupancy as well.

Conversely, as we know, when supply is greater than demand, prices go down. Using our example, let’s say that I and another person are in the arctic and we are both selling ice cold drinks. Now this other person and I must sell our drinks in order to earn enough money to feed our family. Here you come along all bundled up and not very thirsty. I offer to sell you my drinks for $1.00 each.

Realizing that he is about to lose a sale, this other person offers you the drinks for $.75 and I reduce my price to $.50. Now remember that you aren’t very thirsty so despite the falling prices, you’re still not enticed to buy. We reduce our prices further until at some point you say to yourself, “Wow, I’m not very thirsty but these prices are so low I just can’t pass up a bargain. Maybe I won’t drink them now but I’ll buy them at these low prices and stock up for summer. At some point, when price is low enough it will create demand and a sale will be made.

Obviously I incorporated both supply and demand in this example. Your demand for a cold drink wasn’t very high since you weren’t thirsty and the supply was more than you needed even if you were. But at some point, you bought anyway. When price gets low enough demand increases causing supplies to shrink again. And this is what causes those market swings.

Now you may be wondering why I am repeating a concept with which you are already familiar. The reason is this. Because cash flow is so critical in commercial real estate, it is not enough to only forecast current cash flows but also to forecast cash flows into the future with as much accuracy as possible. To do this, we must forecast supply and demand now only in the present but also into the future. In commercial real estate we use concepts like gap analysis and location quotient along with forecasting basic employment to assist us with these forecasts. We use these advanced tools to determine at what point supply and demand shift.

As an example, if you decided to buy a piece of land now and build a 35 unit apartment complex, you need to know the demand for those units when those units are going "online". In other words, by the time you go through design, the Planning Commission and the construction phase it could be 2 years into the future before your units are ready to be rented.

What if in the interim a large REIT with multimillions (and often billions) came in and built 500 units just around the corner from your building. And what if the demand indicated that only 200 units would be absorbed (rented) per year. When there were only going to be 35 new units in the area, your new construction was only going to serve a small percentage of the demand and your units (if priced reasonably or even slightly aggressively) would be easily and quickly absorbed (rented). But now that there are 535 new units for these 200 people to choose from, imagine the scenario. Think arctic because it’s going to feel like a very cold market!

With only 200 units being absorbed per year, assuming all things equal (supply and demand don’t change), it will take a little more than 2 ½ years after construction has finished to rent all 535 units. Obviously this could devastate your cash flow and if you haven’t planned for this, you could lose your shirt.

Similarly, if you buy a C-Class Building in an area where a new Class A building is being built, what is going to happen to your rents? Why would someone rent a unit in your Class C building when for the same price they could live in a luxurious Class A building? You will have to lower your price to entice renters. Again, if you hadn’t planned for this in your cash flow projections, this could be devastating.

By now you may be saying to yourself "I can’t plan for everything, especially if I don’t know about it." One way to combat this concern is to invest where economies are expanding and therefore demand is increasing and of course to do your due diligence. One strategy is to "Follow the Big Boxes." This means where major retailers go, you go. If WalMart is expanding into an area and building a new store it is because their staff of highly paid experts have determined that population is growing and there is growing demand in that area. Rather than hire your own highly paid experts, just piggy back on their expertise and go where they go.

Now I’m sure that all you engineers, scientists and accountants are squirming in your chairs. After all this is not very scientific. There is no complicated formula. And so it is for you that I will follow up with Part 2 of this article as there are some scientific methods by which to measure the market both presently and in the future with a great degree of precision. Now breathe.