Effective Commercial Real Estate (CRE) investing has two key requirements – capital and opportunities to invest the capital. Both are equally important and one without the other doesn’t work. And hence an investor has to constantly look for opportunities to invest if they have the capital. Where does one find real estate investing ideas or opportunities? How does an investor validate their real estate investment ideas and thesis? The purpose of this article is to answer these questions.
A Real Estate (RE) investor has to look at the right places to get RE investment ideas in today’s information overload age. Some good sources are market studies, reports, and research done by academia, government agencies, and consulting companies. We’ll look at one great source – Real Estate Market Cycle reports – to answer our questions around RE investment ideas. We will see if we can validate investment ideas at the property or portfolio level according to the investor type and their risk tolerance. We’ll summarize investor takeaways based on the three major investor types – conservative, moderate, and aggressive.
Real Estate Market Cycle Introduction
You may have heard about economic/business cycles or credit cycles. The Real Estate Market Cycle can be viewed as the business cycle for the real estate industry. It is based on the fundamental belief that real estate goes through sequential cycles. A given cycle also goes through multiple phases. Real Estate Market Cycles are long, like credit cycles, and can last 10-20 years and so the investor needs to think and plan long-term.
One of the popular US real estate cycle report comes from Professor Mueller at the University of Denver. Professor Mueller publishes a quarterly Physical Market Cycle Analysis of four Property Types in 54 Metropolitan Statistical Areas (MSAs). The Real Estate Market Cycles are based on the long-term occupancy average as it is a key factor for rental growth rates, income, and thus property values. The market cycle phases or quadrants within the real estate cycle are illustrated in the graph below:
CRE property types have different risk/reward profiles. Accordingly, Real Estate Market Cycles covers the following property types and sub-types:
- Office – Suburban, Downtown
- Industrial – Warehouse, R&D, Flex
- Retail – Neighborhood/Community, 3rd Tier Regional Mall, Factory Outlet, PowerCenter
The chart below shows the National Property Type Cycle Locations in Q3 2020. In summary, Office and Industrial warehouses are in the expansion phase. Apartments, Industrial R&D and Neighborhood Retail are in the Hypersupply phase. Retail, except for neighborhood stores – is in the recession phase.
How to leverage the Market Cycle and invest?
How does an investor leverage the market cycle for her investment decisions – Buy, Hold, or Sell? Before we analyze this further, it is important to remind ourselves that COVID-19 has caused major dislocation in the CRE industry. CRE industry is in a state of flux and it will cloud the picture for investors in 2021-2023. The Real Estate market cycle can be one data point for investors, but not the sole data point or factor. Keeping this in mind, an investor has a couple of ways to leverage the real estate market cycle:
Portfolio strategy is the overall asset allocation amongst the major asset classes – stocks, bonds, and real estate. The Real Estate Market Cycle gives an investor the opportunity to validate or make updates to her long-term portfolio strategy. Should an investor increase or reduce her exposure to real estate? Compared to stocks and bonds what should the real estate allocation be in the years going forward? Real estate investing, in particular, takes a lot of portfolio planning and long-term thinking as the execution can run into quarters.
New and Existing Investments
When it comes to investing in new real estate deals, an investor can look at the Real Estate Market Cycle for the given property type and location to determine the potential risk and upside. For e.g. if the investor buys during the hyper supply phase, the returns are going to be lower than when buying during the expansion phase. On the flip side, the investor can expect more upside when she buys during recovery/expansion and sells during the hyper supply phase. The investor can follow a similar approach to see if an asset should be sold or held.
Our opinion for all investor types
As we saw in the last section, an investor can prepare herself and plan for her portfolio based on the Real Estate Market Cycle. It is important to keep in mind that the progression along the market curve is not always smooth and sequential. It is possible for a property type and location to fall back on the curve.
An investor can look at the property type and location combination and see where they are in the market cycle. In the following sections, we review the Real Estate Market Cycle by property type and give our opinion for various investor types.
Multifamily property type for various locations is either in the hyper supply phase or close to it, as in the Multifamily Real Estate Market Cycle shown below. Multifamily has been resilient in 2020 with expectations for it to continue the next few years. Deal activity came to a halt for most of 2020 and it is expected to pick up in 2021. An investor will have opportunities to buy, hold, or sell but the asset prices will remain elevated in the hyper supply phase.
Those looking to buy will be faced with high asset prices and thus low returns and cap rates. The key macro-trend to watch is the outward migration from urban and coastal areas to the sunbelt and the limited supply of housing stock.
Our opinion: Multifamily will provide opportunities for all investor types – conservative, moderate, and aggressive. But, investors need to do due diligence at the market, company/operator, and deal level.
The industrial real estate market cycle looks very similar to the multifamily market cycle. Similar to multifamily, industrial properties have been resilient in 2020 and the eCommerce acceleration has only increased industrial demand. The trends in play are not going to slow down anytime and actually can be expected to increase in the coming years.
Our opinion: Industrial will continue to provide opportunities for all investor types – conservative, moderate, and aggressive. But, investors need to do due diligence at the market, company/operator, and deal level.
The office property type is usually the domain for institutions, but there are some individual investors who invest in smaller suburban offices. Per the Office Market Cycle Analysis, most of the markets are in the expansion phase. This may come across as a surprise to many as offices were hardly occupied in urban areas. Most of the office leases are long-term and hence there hasn’t been a drastic impact on economic occupancy as tenants have continued to pay the rent.
The upcoming quarters need to be carefully watched as many of the urban offices may move into hyper supply or recession. Though the Office Market Cycle looks favorable, we believe it is clouded due to the long term leases. In addition, there are major macro-trends at play like work from home and employer migration to sunbelt states, that makes it risky for conservative and moderate individual investor types.
Our opinion: We do not recommend investing in office for conservative and moderate individual investor types. Aggressive individual investors may leverage distress, adaptive reuse, or contrarian opportunities.
Retail Maret Cycle has been clouded with the underlying macro-trend of the retail “apocalypse” over the past few years as well as COVID-19. Simply put, investing in Retail is for professional and aggressive investors only. It is for the institutional players who can make use of the adaptive reuse opportunities (i.e. convert retail into warehouses or apartments etc.). Quality institutional investors have the scale, capital, and wherewithal to execute adaptive reuse. We can expect some breakthrough innovation and associated rewards in retail, but it is not for the faint of the heart. Retail is not for conservative or moderate investors.
Our opinion: We do not recommend investing in retail for conservative and moderate individual investor types. Aggressive individual investors may leverage distress, adaptive reuse, or contrarian opportunities.
We introduced Real Estate Market Cycle as a great resource to generate or validate CRE portfolio and investment strategy. We looked into the Market Cycle for each property type and our opinion for different types of investors. The following table captures the key takeaways based on the type of investor. Conservative and moderate investors can consider multi-family and industrial property types but stay away from office and retail. Nevertheless, all investors need to do the market, sponsor, and opportunity due diligence.