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Unraveling the Real Estate Puzzle Amidst Economic Uncertainty

Amidst the debate surrounding a potential US debt default, persistent inflation, a looming recession, the credit crunch, banking consolidation, global de-dollarization, high interest rates, the high cost of insurance, a housing shortage, and a growing affordability crisis, it is challenging for investors to predict what the future holds!!

However, it’s important to recognize that the world we live in today is highly interconnected, overly political, and therefore excessively complicated. In contrast, real estate is a long-term investment and a relatively straightforward business. 

The simple business of real estate

Real estate offers a single product—space rented out by the unit. Moreover, real estate is geographically constrained, creating a micro market with limited customers and competitors. This localized nature of the business makes it easier to analyze, track, and operate within. 

Compared to large national and global enterprises, real estate is relatively simple. When we strip away everything else and consider each property as its own business operating in its own distinct market, it becomes much easier to answer the questions “Do I want to buy this business?” or “Do I want to own this business long term?” 

As long as you are purchasing quality, well-located, cash-flowing real estate in a market that supports long-term sustained growth, and you are willing to hold onto the real estate indefinitely, the answer is always “yes”.

A more challenging question can be around determining when to sell the business. Not all market eviroments are conducive to selling real estate, given shifts that can occur in the market. Understanding black swan events, market cycles, and broader economic trends is crucial to determining investment success in all market conditions.

Shifts driven by Black Swan Events

Black swan events are unforeseen and non-cyclical occurrences that lead to a sudden market shift. These events can be triggered by the adoption of highly disruptive new technologies. For instance, the introduction of cell phones in the mid-1990s completely disrupted the telecommunications industry, causing the prepaid phone card business to collapse while creating a brand-new market with its own infrastructure, sales, manufacturing, and customer support jobs. 

More recently, we experienced a black swan event with the 2020 COVID-19 pandemic, which prompted the government to inject trillions of dollars in stimulus money into the economy. Coupled with low-interest loans and extremely cheap variable-rate bridge debt at the time, this led to a surge in rents and real estate values nationwide. 

Real estate is hyperlocal, and its performance is directly influenced by the economic conditions of its surrounding submarket. However, since real estate is often acquired through debt, it is also affected by credit markets and monetary policy. 

While some argue that the implementation of quantitative easing (QE) and modern monetary policy has become somewhat cyclical and self-reinforcing since QE1 in 2008, black swan events like COVID-19 are non-cyclical and nearly impossible to predict. 

Consequently, having a specific time horizon for an investment with a defined exit date is not advisable. Although establishing a target exit date can assist in projecting investment returns, being forced to sell at an exact date could result in poor market timing when values are low. This is the exact predicament investors are currently facing today. 

Although most real estate investments do not have a fixed exit date, real estate investors are confronted with the expiration of debt terms. Over $1.5 trillion dollars of commercial real estate debt is set to expire between now and 2025, necessitating refinancing at a time when higher interest rates are pressuring investors to either conduct a cash-in refinance or sell. 

Moreover, commercial real estate values have declined due to high interest rates, increased insurance costs, and rising expenses caused by inflationary pressures. Cap rates have expanded by 75-125 basis points in the past 12 months. Additionally, low transaction volume and an escalating affordability crisis are beginning to impede rent growth, while an imminent recession could bring about higher unemployment, further dampening rents. 

Although the impact of low transaction volume and higher unemployment will vary depending on each property and market, it’s essential to recognize their negative influence on rent growth when estimating the future value of commercial real estate. While many owners of commercial real estate are struggling to navigate these turbulent times, this does also present a rare “buying opportunity” in the real estate cycle, where investors seeking commercial real estate can find attractive discounts that will yield substantial returns in the future.

Understanding where we are in the market cycle

Generally speaking, in a laissez-faire economy, market prices are self-regulating and determined by supply and demand. When supply is low, prices tend to rise, incentivizing more competitors to enter the market and increase supply, eventually leading to lower prices. 

The real estate cycle follows four phases of fluctuating prices driven by supply and demand. We discussed the real estate cycle in a previous blog post. See article link (here).

Typically, the real estate cycle spans 3-5 years. Ideally, an investor can identify the transition from recession to recovery, purchase real estate at the bottom, hold it until the cycle moves from Phase 2 to Phase 3, and sell at the peak. Since the cycle is driven by supply and the transitions between phases are determined by occupancy levels and vacancy changes (which can be easily measured and tracked), one might assume that timing the bottom and peak of the real estate cycle would be relatively simple.

However, this assumption overlooks the fact that demand fluctuates and there are multiple classes of real estate with varying levels of demand. Additionally, the aggregate demand for housing in a market change with population and demographics. While it is nearly impossible to precisely determine the bottom and peak prices, it is relatively easy to assess whether prices are trending upward or downward and to identify the current phase of the cycle. 

Keep in mind that the real estate cycle varies from one market to another and is specific to the property class. Generally, if occupancy is still above the long-term average and there are new deliveries and permits in most major markets, a decreasing vacancy rate would indicate the expansion phase, suggesting prices are still below the peak. 

On the other hand, if vacancy rates are increasing, it indicates the hyper supply phase, which would lead to declining prices. In either phase, if occupancy is approaching the long-term average, it could be a favorable time to buy. If you are in Phase 2 and occupancy is significantly above the long-term average, you are nearing peak pricing, and it may be a good time to sell or prepare for another cycle. If you find yourself in Phase 3 with occupancy well above the long-term average, you likely bought near the peak and should be prepared to weather the cycle again.

Other trends play important roles too

Aside from cycles, which are a series of repeating, self-reinforcing, self-perpetuating, and self-regulating economic forces that influence asset values and economic growth, there are trends that contribute to long-term sustained growth. 

Trends like population growth, net migration, increasing barriers to home ownership, housing affordability, and housing supply shortages have been supporting real estate appreciation for decades, and these trends are still relevant today. 

The housing supply shortage persists due to rising construction costs, expensive financing, a shortage of skilled labor in the trades, and the time required to build new housing. Net migration to the Southeast and Texas continues to drive housing demand in these areas, leading to higher rents, increased real estate values, and stronger local economies. 

In the current economic environment, where the debt cycle is causing asset values to decline and economic growth to slow, investing in markets with emerging and sustainable growth can offer short-term growth potential that outperforms the overall market. Real estate, being highly localized, can sometimes operate independently from the broader economic landscape. This has always been one of the advantages of real estate investing – the ability to find opportunities regardless of market conditions, as long as investors are willing to put in the effort to seek out new opportunities in various markets.

While the current conditions pose challenges for existing asset owners and may not be ideal for selling real estate assets, I believe the next 6-12 months will present a great opportunity for investors to purchase quality real estate at a significant discount. 

Although identifying these opportunities may be challenging in the current landscape, Warren Buffet’s well-known quote encapsulates this opportunity best: “Be greedy when others are fearful, and fearful when others are greedy.” The best time to acquire assets is when others are not actively pursuing them, and the confusion and uncertainty of the current environment have led many investors to remain on the sidelines.

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