Market Cycles on Leasing and Valuation -Part 2

"Prophesy is a good line of business, but it is full of risks. " - Mark Twain

In the last episode we talked about the market cycles and how it is constantly attempting to reach equilibrium but never quite getting there. Like Sisyphus pushing his boulder up a hill and never reaching the top, we can never achieve a perfect balance of supply and demand due to many factors, such as illiquidity, development lead time, and external market pressures. The best we can do is attempt at forecasting future demand and seeing if the current real estate stock is under or oversupplied.

Here is the thought process in what is called Economic Base Analysis:

Basic export jobs --> Service sector jobs --> Population --> Disposable income

Basic (export) jobs are sectors that create goods and services above and beyond whatever the local economy can consume. These jobs export their products nationally and internationally and bring new dollars into the local economy. Examples of this could be manufacturing, distribution, financial services and many more. Each local economy could specialize in certain sectors. Think Detroit for automotive or Silicon Valley for computer technology. Whenever one of these jobs is created, there are several non-basic jobs that need to be created to service the growing economy. Non-basic employment could be local retail, teachers, firefighters, doctors and more. These are important jobs but really only service the local economy and don't contribute much to economic growth. We can actually quantify this phenomenon by looking at labor statistics and determining the basic vs. non-basic jobs, which is called an Economic Base Multiplier (EBM). There are several tools available to help you find this number. Both types of employment have real-world implications for both office and industrial demand, depending upon the types of jobs being created.

If we take this a step further, we begin to understand that as job growth occurs, so does the population. Economic vitality in a region spurs in-migration and workers typically bring with them spouses, children and other family members who can create a multiplying effect on the local community. This has real-world implications for housing and apartments.

Lastly, if we can determine the ratio of population to disposable income within a community, we can once again use a multiplying effect to determine how much new disposable income may be created in an area which has real-world implications for retail sales and service.

So how does this translate to commercial real estate demand? If we can begin to understand changes in demand and can find out what our local stock is, then we can perform a gap analysis. It looks something like this:

Forecasted demand

- Current supply

= Under or over-supply

An undersupply means that we could be in a period of rising rental rates as more competition vies for less space. Conversely, an oversupplied marketplace would mean that there could be softening in the market and perhaps drops in rental rates, longer vacancy periods, or increased concessions to tenants. This gap analysis starts to help clarify how we forecast rental increases or decreases. Our analyses will then begin to paint a clearer picture to either support or challenge our cashflow assumptions. For example, if we are looking at a proforma for acquisition and see 5% rental growth for the next five years, but notice a clear oversupply in the market, then we would push back or want further clarification as to why these numbers were used. There could be a valid reason or it could be a broker throwing darts. Either way, we want to challenge these assumptions.

It is not only important to understand job growth in your local economy, but also what types of jobs are being created (or eliminated). Having an understanding of the labor markets can give you a competitive advantage into finding opportunities or knowing when to pass on them. Know your market and don't take anything at face value.