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Why CRE Lags Behind the Business Cycle?

We're out of the woods, right? RIGHT?

We have seen investors in the past point to commercial real estate's resilience during economic downturns, only to get slapped by the markets shortly thereafter. And it repeats similarly through each cycle. Why is that? Commercial real estate lags the overall business cycle by anywhere from 6-24 months depending upon the duration and severity of downturns (or upturns). I explain to investors that while equities can behave like a Ferrari, commercial real estate acts like a tractor-trailer with three flat tires. But why does commercial real estate lag and what can we learn from past cycles?


The lag effect comes from several reasons but really originates from demand factors and the nature of the asset type. We can try to explain this in four key categories: employment demand, leasing duration, illiquidity, and bad data. Let's dive into each of these:


Employment Demand


Commercial real estate is space for workers (excluding apartments here). Employment increases and decreases have real implications for overall demand, especially for office and industrial product. Yet employment is a lagging factor when taking into account the overall business cycle. Rises or declines in interest rates affect housing and consumer demand, which in turn affect business orders, which in turn affect profits and eventually lead to either increases or decreases in employment. Businesses are either increasing production (more workers) or decreasing (less workers) from demand-side factors. Employment already lags an economy for this reason. Commercial real estate follows employment and income demand, which takes time during a cycle and leads into the next reason...


Leasing Duration


Commercial leases are typically contracted at longer durations than residential, 3-5+ years in most instances. Just because new orders and production decrease, doesn't mean businesses can just pack up and go, or scale down their overall square footage overnight. Businesses continue to be on the hook for leasing liability despite contraction or expansion pressures. As leases expire or options become available, businesses are forced to make decisions based upon where demand and production is in the business cycle but that occurs after a good deal of time.


Illiquidity


Stocks and bonds can be sold nearly instantaneously, particularly now with online trading. Therefore these markets tend to be more volatile and more closely correlate with the changing business climate. Real estate in general doesn't work like this, especially commercial. In order to move a piece of commercial real estate you need time for marketing, negotiations, due diligence, and closing timelines. Add in closing delays due to zoning, environmental, legal issues, and more and you can look at 1-6 months or more of lead time. Brokers who have been in the business long enough see closing times sometimes lasting years! To make matters worse, commercial real estate has a limited pool of buyers compared to residential because of equity requirements and operating knowledge. Which leads us to one of the final reasons...


Bad Data


Not all participants in commercial real estate are equally informed. Except for publicly-traded REITs, operating data is very difficult to come by and often incorrect. In many states, sales data is public but that's not necessarily always helpful when valuing properties as those are lagging factors. Contracts could have been negotiated months ago or properties were mispriced. This happens all the time. More difficult is finding accurate data that affects returns and valuations such as capitalization rates, leasing data, and expense ratios. Institutional investors have access to some of the is data and are more sophisticated in general, but 'mom and pop' investors don't usually have access or rely on brokers to provide this data, with questionable results. Data takes a while to filter down through the industry and changes do not happen overnight. Sellers in a downturn want pricing from 6-12 months ago. Buyers are buying future cashflow and looking at lower leasing rates or increasing vacancy. This bid/ask spread increases during inflection points in the cycle and further delays any pricing correction in the market.


Economies, cycles, and capital market movements are incredibly complex and no one has a crystal ball. The recommendation is to gather as much data as possible and make fact-based decisions. Also, no two investors are the same. Each has different business plans and risk tolerances. If you need help, Duckridge Realty Advisors is here. Just be aware of the lagging effect and what it could mean for your investments in the future.


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