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Thursday, 23 January 2014 20:43

How to achieve lucrative returns in Commercial Real Estate – Part 1.

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Price and yield behaviour during
Recovery, Prosperity, Recession and Depression phases.

How to profit from the property marketHow to profit from the property marketWhen it comes to real estate investment, the majority of people blindly rely on property market gossip and anecdotal “professional” opinion on how the market is performing and how that performance is reflected on property price and yields.  I plan to publish this article in two parts:

The first intention is to raise awareness on property market economics with emphasis to supply, demand, price and yield behaviour;

The second focus is on market performance barometers, analysis and their importance within investment decision making.

First and foremost, real estate is cyclical and closely related to the business cycle, as they feed off the same drivers, e.g. taxation and fiscal policy, and is also connected to the global economy. Secondly it is a 'lumpy asset class' with slow response adjustment mechanism and lastly – real estate prices almost never decline in nominal terms.

Economic events or “shocks” like severe oil price changes, natural disasters or wars, will trigger economic imbalance through changes in stock exchange markets and real estate performance in the long run. Cyclical market behaviour has been observed since early 1800 and since then, the cyclical pattern has been identified in all the following crises of: 1920, 1960, 1980, 1990, 2000 and 2008. The difference between all of them was the degree of detrimental effects countries had to cope during the crises periods.  During extensive literature review and referring to Barras 2009, four business cycle phases were identified with property performance gauges and market player behaviour to each;

Recovery.

for-sale-signsfor-sale-signsThe process starts with fiscal policy incentives and emerging technologies that push new demand for space and consumption. Investment into new capital goods introduces improved techniques into production boosting labour productivity and construction methods. Existing building stock is forced to accept changes for corporate social responsibility policy in order to avoid government burdens, to become second best in the market and to satisfy demand for quality space. (Crove, Rabanal, 2013)  Expanding businesses seek larger modern premises and relocations increase. Building stock that was empty from previous building cycles becomes occupied therefore vacancy rates falls below its equilibrium level.  

Occupier demand and accelerated obsolescence of existing building stock multiplied by capital investments into new stock will accelerate property price growth.  Rents start rising as less space becomes available on the marker due to rising demand and lag time for new property to be completed. Development risks are reduced through rising rents, reduced vacancies and rising property prices.  These conditions strengthen development profitability and new development schemes will emerge.

Prosperity.

Strong economic growth will maintain property demand due to limited availability of suitable sites.  Rising building and labour costs will inflate property prices and rents further.  Speculative developments will emerge with optimistic behaviour in order to maintain profits. As property prices surge, companies gain more confidence on their property assets and increase borrowings for business expansion against them.

First round developments were a prime response to market demand coming into completion.  As also are increasing supply of available space, easing the upward pressure on rents and prices, and boosting productive capacity of the economy. When the number of completions increase, market supply exceeds demand leading to market saturation.  As a result, there is a decline in rents, property prices and flow of funds into the sector.

As profitability falls, investors and financiers will withdraw from the market: investors will shift investments to less risky asset classes e.g. government bonds and guilds, where financiers have to seek to diversify their property loan portfolios.

Recession

Overoptimistic consumer demand drives inflation to the highest level, which in turn calls for macro prudential control measure implementation to mitigate the overheated market. Loan to value ratios will increase.  Capital costs and supply become more stringent, leading to a slowdown in borrowing and a decline in new construction commencements.

Due to lag times in building space, delivery projects that are underway to be completed will face weaker investment demand.  With an increasing vacancy rate, profit margins have to be reduced in order to dispose of completed properties. A reduction in rents will accelerate as more space becomes available on the market.  Yields will rise in proportion to rising interest rates. A combination of high interest rates and weakening rental growth will erode property asset values over time leading to more stringent lending against property collateral. Eventually new supply of buildings will cool off leading to vacancy rate stabilization and further price decline. 

Depression.

out-of-businessout-of-businessDramatically reduced property demand forces liquidation of secondary building stock that is obsolete and cannot compete with new building stock. Renovation activities will be most common in depression stage financed by well capitalised developers or private investors.

Depending on their location, property values will fall below their replacement costs and actual purchase price, leaving investors to cope with negative equity. Developers that were highly lending geared must face losses and cope with volumes of vacant stock.

Due to a lack of economic activity, building owners are forced to renegotiate lease terms in order to cover their loan and rent payments. Banks foreclose on non-performing loans.  The prices that assets can be disposed of on current market conditions will not be sufficient to recover their investments. As a result there will be wide spread loan defaults, bankruptcies and repossessions will occur.

Capital rich investors will enter the property market to acquire sites and prime properties, taking advantage of distressed market conditions and low investment competition. Low construction costs and tender prices combined with emerging technologies, low interest rates and optimistic future rental growth will form a basis for new property cycle phase to emerge.

Conclusion of the article content can provide twofold value.  It can serve as informative literature for new market entrants or act as a guideline for more advanced market participants to follow. Understanding market dynamics and following the main property gauges can result in the market cycle stage being identified and tailored for individual investment strategy.

 Graph 1: Property price fluctuation through various cycle phases around its equilibrium price Graph 1: Property price fluctuation through various cycle phases around its equilibrium price

Graph 1: Property price fluctuation through various cycle phases around its equilibrium price

Read 24377 times Last modified on Thursday, 23 January 2014 21:25
Gintautas Matukaitis

Gintas is a real estate professional with strong planning, analytical and financial management skills primarily related to commercial real estate, development and property management sectors.

He has hands on experience with project planning, investment analysis and decision making techniques with a strong focus on achieving accuracy and efficiency in any projects that he works on.  

He also has experience as an estimator and quantity surveyor.

Gintas is in the final stage of a Masters Degree in Property Management and Investment from Napier University in Edinburgh.

You can contact him on gintas2511@gmail.com

His LinkedIn profile is here

 

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