Real estate market cycles provide clues to commercial real estate developers and investors as to when to buy and when to sell.
Therefore, understanding commercial real estate market cycles is essential to making smart investment decisions, at the right time. Commercial real estate market cycles can be extremely complex and nuanced, so it’s important to get the basics right.
What is a Market Cycle?
‘Market cycle’ is a term used to describe a phenomenon that’s found across all types of markets.
These cycles are characterized by a consistent pattern of ups and downs in the price of whatever is traded in that particular market.
Cycles in price occur because of the underlying long-term changes in supply and demand which itself occurs because of human behavior and environmental forces.
You’ll see these cycles in practically every market you can imagine
- Stock Market
- Credit Market
- Labor/Employment Market
- Real Estate
- Goods/services markets from gas to groceries
The Four Phases of a Market Cycle
The most popular perspective on market cycles is that they consist of four major phases (sometimes described using different terms): expansion, hyper-supply, recession, and recovery.
Each phase is characterized by changes in supply and demand during that phase which affect prices in a particular way.
- Expansion: Increasing demand relative to supply causing prices to increase.
- Hyper-Supply: Too much supply relative to demand causing prices to begin going back down.
- Recession: Still not sufficient demand relative to supply causing prices to continue down further.
- Recovery: Finally, where demand and supply get to equilibrium, demand begins to slowly pick up and so prices slowly rise.
Every cycle has a different typical length. It depends on the market. It can be as short as a single year or as long as 100 years. But most common market cycles range from 10 to 20 years.
Lastly, trying to predict market cycles can be very difficult because all markets are connected, and changes in one market will affect another in a large, tangled web of markets that create the overall economy.
The Four Phases of a Market Cycle Applied to Real Estate
This four-phase market cycle can be applied to any single real estate market.
Expansion
As the economy grows, consumers buy more goods and services. This means an increased demand for office space, shopping centers, and other commercial properties such as restaurants, hotels, and gas stations.
In addition, companies need additional office space to accommodate new employees. During the expansion phase, most of the available real estate supply has been bought or leased, as vacancy rates fall below long-term average.
Developers invest in new construction to meet rising commercial property demands, and real estate prices rise.
It is the best time to sell a property during the later stages of the expansion phase, as prices have reached an all-time high.
Hyper Supply
The market begins to plateau and then slows down, causing additional supply entering the market to exceed demand.
During this phase the market is often still strong and able to absorb decreasing occupancy rates and unsold assets for a while, but eventually prices start to fall.
Hyper supply could be considered a warning signal that the real estate market is heading into a downward phase. It is also the tipping point at which the market switches from a sellers’ market to a buyers’ or tenants’ market.
Recession
The economy shrinks during a recession. People tend to save more money during times of economic uncertainty which means they are less likely to purchase homes and businesses.
As a result, there is decreased demand for office and retail space, and other commercial properties remain empty. Declining demand and excess supply contribute to falling prices.
It is often deemed too risky to invest in commercial property during this phase because profitability is uncertain, although some smart deals can be made for those willing to take the chance.
Recovery
This phase begins when the market has hit its lowest point after a recession, and is characterized by high unemployment, distressed properties, oversupply of inventory, high vacancy rates, and lack of new construction.
Government usually intervenes by lowering interest rates to drive employment and population growth. This leads the market towards expansion.
The recovery phase is usually the best time to buy a property, as the market begins to stabilize, and pricing is favorable.
Why the Concept of a Generalized Real Estate Market Cycle Might Not Be Helpful
It’s important to note that housing markets and commercial real estate could be in completely different phases of a cycle at any one time. Cycle stages can also vary from one location to the next, or one building typology to another.
Furthermore, while these cycles are linked to the business cycles of the economy, they don’t always have a direct cause vs effect relationship – for example, a downturn in real estate cycles typically coincides with recessions in the greater economy but this hasn’t always been the case.
So, thinking of ‘the real estate market cycle’ as a catch-all generalization is not helpful, unless you capture the nuances of your specific sector of the market.
Understanding the different markets in commercial real estate, how they are connected, and how they cycle, can help investors and developers get a clearer picture of the unique characteristics of the real estate market cycle that applies to their business.
Commercial Real Estate Markets and Cycles
Commercial real estate has three major markets which are connected to each other, but they cycle separately.
1. The Space Market
Also referred to as the ‘rental market’ or the ‘usage market’, this category of commercial real estate revolves around leasing or renting physical spaces to users who pay for the right to occupy them over a period of time.
The space market is divided into property types such as office, retail, industrial, and multifamily residential.
Tenants could be individuals, companies, or institutions who need space to conduct their business processes. They could also be students renting apartments in a multi-housing development.
Leasing and rental prices in the space market are subject to fluctuations of supply and demand in specific locations. Thus, you may find the same type and size of space being leased for a much higher rate in Manhattan for example, than it does in Chicago.
2. The Asset Market
The commercial real estate ‘asset market’ is the market for the ownership of real estate assets, that is, real property. Assets consist of land parcels and the buildings that occupy them.
From an economic perspective, assets represent claims to future cash flows generated for their owners from the rental or lease of land and buildings.
These commercial properties are traded directly in the private property market, but they are also traded indirectly in the stock market through equity shares in REITs and other real estate companies. In 2020, real estate formed two-thirds of the value of investable capital assets, globally (McKinsey).
Demand for the asset market is made up by investors who won’t necessarily ever step foot in the physical space they are investing in.
Thus, the asset market is more integrated than the space market and is more likely to be influenced by national economic shifts, than micro shifts in the real estate market of the building’s actual location.
3. The Development Industry (Construction)
Through the conversion of financial capital into physical building stock by construction, the development industry is the connector between the space and the asset markets.
The development industry is a big driver for entrepreneurial and commercial activity due to the many facets involved in constructing a successful building. Commercial construction activity is driven by the demand for new or added built space only – thus it is typically strongly affected during a recession where demand is low.
The development industry’s market cycle is strongly linked to the macroeconomic business cycle of the country. Over the decades, construction has been shown to typically increase by 40% during an expansion in the business cycle, followed by steep declines.
Final Thoughts on Commercial Real Estate Market Cycles
Understanding real estate market cycles is a necessary skill for any commercial real estate investor. Analyzing the cycle of your specific market, or sub-market of commercial real estate, can give you important clues as to which direction the market will go. This will help you with key financial decisions regarding your property assets.
Curious as to what’s happening in the commercial real estate market right now?
This report from the National Association of Realtors provides some commercial real estate market insights for 2022.
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