Implicit in the term “cycle” is that the real estate market is constantly in a state of flux. Real estate market cycles are specific to a submarket and property type. It is also specific to classification (A, B, C, or D) within a property type within a submarket. So, in most cases, it’s not adequate to simply state that the industrial market is increasing, or the office market is decreasing. Office demand could be increasing in a suburban submarket and decreasing in an urban submarket, for instance. National trends rarely perfectly reflect what is happening in a given submarket, so it’s important to be critical of the information we consume and apply to the markets we serve.

Why is it important to know where we’re at in the real estate market cycle? As appraisers, our job primarily includes market analysis. Therefore, identifying where we’re at in the cycle is at the crux of our profession. Other reasons why identifying where a market is at in the cycle include:

• How long a valuation may be relevant or reliable
• Absorption rate for new or current vacant supply
• Where future competition may come from
• What capitalization rate may be applicable to current income
• What yield rate may be applicable in discounted cash flow
• What rent growth (or decline) to expect during holding period
• How much demand is there for space? How much is that space worth?

There are many external influences on property value included, but not limited to:

• Interest rates
• Overbuilding or underbuilding
• Changes in tax laws
• Population shifts
• Job creation or loss in a local or regional economy
• Changes in effective buying power
• Market participant (buyer) psychology

In many ways, market psychology is likely the most impactful on value and it is essentially what drives markets through the four phases of the cycle. There are unique characteristics to real estate – such as the ability to force appreciation through operator expertise – that are not necessarily present in other investment markets such as bonds or stocks. This makes real estate a particularly attractive – but more risky – investment vehicle compared to those alternatives, in most cases.

There are two markets that influence the cycle: the physical market and the capital market. The physical market analysis answers the question How much demand is there for space among users? The capital market analysis answers the question How much demand is there for leased properties among investors?  

The physical market is influenced by changes in employment, population growth, and effective buying power. It is the interaction between users (demand for space) and developers/owners (supply of space) in an individual market. With exception to residential property types, the physical market is influenced by specific business needs – which may or may not be consistent with the overall market trend for that property type in that submarket. For instance, office may be overbuilt in a submarket in which multiple companies are breaking ground on an office development during a recessionary or recovery period whereby building is not financially feasible.

The physical market for commercial real estate is incredibly inefficient as a lack of transactional data precludes our ability to discern where we’re at in the real estate cycle in real time (see also price discovery). Simply put, in commercial real estate, there are typically not an abundance of sales of a particular property type in a given submarket during a short period of time to assert with a high degree of certainty where the property type is trending in pricing. Conversely, residential market cycle identification is typically more distinguishable in real time as there are more transactions of similar properties in a submarket during a short period of time. Despite the theoretical principles of the physical market, it’s important to remember that in practical application, most commercial real estate transactions arise out of a business need which are most times influenced by motivations related to specific operating requirements – not necessarily influenced by where the market is at in the cycle.

Real estate investment competes with bonds, stocks, mutual funds, venture debt, hedge funds, among other vehicles. It uniquely benefits from depreciation write-off and is uniquely diversified in that the return of and on capital can come from increasing net operating income (physical market) or price appreciation (capital market), respectively. The capital markets are typically much more volatile and unpredictable than the physical market for real estate. We have seen this recently with the rapid increase in interested rates. Conversely, supply sometimes takes years to develop, for instance.

The physical and capital markets do not always work in tandem. For instance, there may be historically low office demand and historically low interest rates which translates into historically high office pricing. It should be noted that each of these markets are also influenced by consumer confidence which is difficult to assert and difficult to predict at any point throughout the market cycle. Differences of opinion make the market and perceived value is sometimes more important than the fundamental relationship between supply and demand. Ultimately, as appraisers, we are trying to measure human behavior which is unpredictable in nature. Nevertheless, it is important to analyze trends to provide more sound counsel to our clients – even in the face of the most chaotic markets.

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