Where are we in the latest real estate cycle?

With the current economic expansion moving ahead in 2005, the key issue for real estate is: will the normal relationships between overall economic activity, demand for space, increasing demands for money, and rising levels of property development prevail as in past cycles?

Or will be unusual curt flood of capital into real property markets cause different cyclical outcomes?

In the normal business cycle, as the economy moves out of recession into expansion, growing levels of business activity raise demand for both money and commercial space. These increases put upward pressure on interest rates and occupancy levels in commercial space. Rising interest rates, plus current high vacancy rates and lower rental rates, continue to inhibit new commercial property construction. Also, investors are drawn away from real estate investments into competing asset forms such as stocks of successful companies.

These conditions produce only gradual absorption. Vacancies are falling and rates are stable or rising, but neither holding far enough to justify a new development, especially since interest rates rise along with other competing investments.

With the accelerating general expansion, increased competition for existing space drives vacancies lower and rates higher. Eventually, these changes stimulate developers to start a new construction proects, in spite of higher interest rates. This starts the development phase of the cycle. New projects start just as the overall business cycle peaks. Then with the expansion of available space, combined with an economic slowdown, the result is another overbuilt phase just as the economy slips back into a recession.

Presently most commercial markets are in the gradual absorption phase, with high levels of vacancies declining and rents stabilizing. Downtown office vacancy rates have dropped slightly while national industrial vacancy rates remain unchanged. However, bold office and industrial vacancies are more than double the lower rates they had in late 2000.

Consequently, new office construction dropped off. New industrial development also fell on. However, the demand to buy well-occupied properties of all types remain very high because of the flood of money going into real property investment.

Most experts predict this situation cannot last. Some claim rapidly rising interest rates will make a real estate less attractive to invest in and cause some values to fall. Others think with so much money still trying to invest in real estate that rising interest rates will not dampen investor enthusiasm.

Still others believe that the demand for property will not drop off unless the stock market makes dramatic increases. Enough uncertainty remains about world economic conditions to inhibit investor enthusiasm to get back into stocks. In addition, underlying market conditions are slowly improving, supporting positive investor attitudes toward real estate.

The flood of money has not stimulated a massive move into new property development which in the past would have happened if funds were available so easily. Also, the ability of real estate to pay cash incomes that are much higher than most stocks or bonds make property increasingly attractive to pension funds that are facing rising payouts and retiring baby boomers in need of good incomes.

Therefore, there may not be a near future call apps of real property values except in some condominium housing markets were speculative purchasing could lead to sudden shrinkage of occupancy. Today’s huge investor appetite for properties make this an ideal time to sell real estate. But these conditions will not last forever.

Interest rates will certainly increase in the near future with the Federal Reserve’s desire to raise rates combined with an increasing expansion in the overall economy. If current favorable borrowing conditions continue, more developers will be tempted to start building new projects that lead to another boom. That would undermine improving market conditions, as it has in the past, and may dampen investor demand for properties.

The moral: when the sun is shining, you better make hay.

Good luck to you,

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