The real estate cycle and what it means for a post-pandemic market | Whitman Legal Solutions, LLC
How investors value real estate
Return on investment (ROI) drives real estate prices. Most of the time, investors calculate value by applying their desired return to net operating income (NOI).
For example, if an investor wants a 10% ROI and real estate generates $ 100,000 per year in NOI, the investor will likely value that property at $ 1,000,000. Other factors beyond the scope of this article may cause an investor to purchase this example property for more or less than $ 1,000,000, but return on investment is the primary driver of the price.
This basic ROI calculation is based on the NOI. Most real estate has significant fixed costs, such as taxes, insurance, personnel, maintenance, and utilities. Often the most important variable is income, which is almost entirely rental income.
How supply and demand drive the real estate cycle
The rental market determines how much rent a landlord can charge. Because investors value real estate based on return on investment, rental and vacancy rates determine real estate prices.
Supply and demand stimulate the rental market. If vacancy rates are low as they are in the recovery phase, there will likely be more demand than supply. The absorption rate (how quickly vacancies are filled) will be high and rents will increase. In response to insufficient supply and rising rents, developers will build up additional inventory, pushing the cycle into the expansion phase.
This additional construction from a new construction brings supply to approach demand. As supply exceeds demand, real estate moves into the Hyper Supply phase. Absorption rates are slowing and vacant units are increasing, slowing rent increases.
When supply exceeds demand, there can be a recession. Holidays can skyrocket and rents will stay low or even go down. Gradually, the excess supply will be absorbed and the cycle will begin the recovery phase again.
Where are we now and what does this mean for the future?
Not surprisingly, to learn that the market is now in a recessionary phase. The last recession dates back to 2008 (triggered by the mortgage crisis). So after the 18 year cycle, we should still be in the Hyper Supply phase.
We can blame the COVID-19 pandemic for ushering in the recession phase early and shortening the cycle. However, if we can hold on, things will get better and the cycle will go back into the recovery phase.
I’m not an economist, just a lawyer and real estate broker with more than decades of real estate experience than I would like to admit. With this warning, I think it is predicting that we will likely see signs of a recovery phase by mid-2022 and that the market will peak again around 2030.
The wild card in this forecast is interest rates. Rates have been kept low for years. They must increase. The Federal Reserve will likely try to control interest rates, so that they gradually rise and do not slow down the recovery. Otherwise, the real estate cycle could be disrupted as in 1979.
The latest housing cycle, sparked by mortgage abuse, has created new guarantees for consumers. As I mentioned in Reimaging Real Estate for the Pandemic and After, the current recession is going to change the real estate industry.
Recovery occurs in a historical context. Music from the 1918 pandemic was blues and ragtime because they were popular styles of the time. Today’s pandemic music, which includes styles ranging from rock and R&B to Latin dance-pop and rap, also reflects its time.
Often times, the recession phase of the real estate cycle serves as a call to action for the industry to take a look at itself and correct weaknesses and make improvements. So the recession only accelerates changes that should have happened anyway.
In 2019, the real estate sector was already meeting the needs of an aging baby boomer population, the needs of millennials and technological developments. The current recession is likely to shift these changes towards hyperspeed
For example, some developers, noting the delay in Millennials’ home and car ownership, were already moving towards mixed-use projects where people could live, work, shop, and enjoy. leisure activities without getting in their car. And other developers were creating similar projects where baby boomers could live, dine, exercise, and receive health care.
With technology allowing people to work anywhere, retailers and restaurants added comfortable places for people to meet and work. And for those who avoided formal offices, shared workplaces, such as those developed by WeWork, offer a less public workplace and meeting place.
For industry-specific ideas on how these trends might continue after the pandemic, read my previous articles: How the Retail Real Estate Industry Must Change to Survive, How the Pandemic Will Change Multi-Family Real Estate, and How the Pandemic will change office leases. And, as we near the top of the market in 15 to 16 years, remember it may be time to position holdings for the recession phase in this real estate cycle.
This series draws on Elizabeth Whitman’s experience and passion for classical music to illustrate creative solutions to legal challenges faced by businesses and real estate investors.