Market Cycles on Leasing and Valuation -Part 1

"It's tough to make predictions, especially about the future." - Yogi Berra

This will be the first part of a series dedicated to de-mystifying some of the aspects on market analysis and how it affects financial analysis. We see many Offering Memorandums and flyers with wild assumptions about future cashflows relating to market rents, vacancy and expenses. Obviously these all have major implications for investments as we are purchasing future cashflows. Understanding market movements and the factors influencing them is both a science and an art.

First, let's begin to understand what market cycles are and what are the drivers of these cycles. Dr. Glenn Mueller from the Burns School at Denver University publishes a Market Cycle Monitor quarterly. Report can be found here: https://daniels.du.edu/burns-school/ by scrolling towards the bottom of the page. This report shows the natural progression of real estate cycles and their affects on rent growth, construction, and vacancy.

He breaks down the report into both the major asset types and larger MSA's (Metropolitan Statistical Areas) to show where assets lie on the demand/supply spectrum. The x-axis compares those assets to the long-term occupancy and how that affects rental growth (undersupplied vs. oversupplied). Yet to truly understand this report, you also need to understand the drivers of demand and how that affects supply overall. That leads to a basic understanding of the capital markets...

Commercial real estate is constantly trying to get to equilibrium, meaning that supply and demand for space are equal with a given vacancy rate. Yet the markets never actually get there for many of the reason outlined in a previous post about lagging factors. Businesses expand and contract, properties become obsolete, and construction lags demand. To further complicate the story, demand for space and the demand for capital are sometimes misaligned. A good video explanation is below. It's kind of dry, but really helps explain how capital flows can influence construction outside of space demand. We saw this occur in certain sectors as historically low interest rates and a thirst for yield drove construction and supply in markets as capitalization rates compressed.

These constant fluctuations in the space and capital markets help influence changes in the overall market cycle and subsequently creates changes in both rental pricing and valuations for commercial real estate.

Remember the formula for real estate values:

Market value = Net Operating Income

Capitalization Rate

Market values can increase (or decrease) by either increasing the NOI (space markets) or decreasing the market cap rates (capital markets).

The big takeaways here are that market cycles are created from imbalances in the supply/demand equilibrium. Supply (and subsequent stock) can be influenced by both demand and capital drivers. If we can begin to determine where we are at approximately in the market cycle, then we can begin to understand where demand and rental rates may be heading. Looking at Dr. Mueller's report above, would it make sense to project rental increases for the next couple of years if we believe the asset and market are in the 14th position (recession)? Likely not or there should be a good explanation. Yet we see offering memorandums and flyers show exactly that. Investors, General Partners, and brokers should have a good answer for why they choose rate trends. Remember, you are purchasing FUTURE cashflows; not what has already occurred.

Ok, so demand for space is key. But how do we understand and calculate future demand. That will be coming in Part 2!