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An Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle by Glenn R. Mueller, Ph.D. Real Estate Research Group Head at Legg Mason Wood Walker, Inc. and Faculty member of the Berman Real Estate Institute at Johns Hopkins University internet GRMueller@leggmason.com and Anatole Pevnev Vice President, Real Estate Research Legg Mason Wood Walker, Inc. internet APevnev@leggmason.com 111 S. Calvert Street, P.O. Box 1476 Baltimore, MD 21203-1476 410-539-0000 presented at The American Real Estate Society Meetings Sarasota, Florida April 16-19, 1997 Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle 2 Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle Abstract Real estate markets go through both physical (demand and supply) cycles and financial cycles (capital flows and price movements). (Mueller 1995) If asked when a market cycle last peaked, real estate professionals will give different answers that use demand, supply, vacancy, rental growth or price trends. This lack of standard definition is confusing and leads to both research and investment problems. A growing body of research literature on real estate market cycles have examined the potential uses and understanding of real estate physical and financial cycles. This paper develops a rental growth hypothesis and then examines historic rental growth and the distribution of rent growth during different physical market cycle phases for 54 office and industrial markets in the U.S. The data confirms that rental growth rates are quite different in different physical market cycle phases, yet the distribution of rental growth among markets that are in the same position in their market cycle can be quite wide. Thus while rental growth rates should be generally predictable during different cycle phases, the exact amount of rental growth will vary greatly by market. This paper is only a first step at understanding the localized nature of demand and supply basics and the impacts they have on rental growth, which is the first step in the complex process of understanding price movements and ultimately investment returns. This calls for further research as to determinants of rental growth at different points in the physical market cycle. Introduction While vacancy rates indicate the balance between demand and supply in a real estate market, rental growth helps to determine the profitability of investments in the marketplace over the long term. This article examines rental growth rates in 54 different markets across the U.S. in both office and industrial properties. This paper examines rates of gross asking rents in different real estate market cycle phases in a different markets. Asking rents are the method used by building owners to signal to renters their desired terms. The growth of asking rents may also help to determine investment pricing over the long run, but history has shown that capital flows also have a major impact on property pricing and therefore investment returns. This paper does not examine capital flows or total property returns, as the complex set of interdependencies between the physical markets and the capital markets is not yet well understood. This paper is only a first step at understanding the localized nature of demand and supply basics and the impacts they have on rental growth, which is the first step in the complex process of understanding price movements and ultimately investment returns. Literature Review Real estate cycles were first discussed by Homer Hoyte in 1933 in his analysis of the Chicago marketplace, and received scattered attention over the years. Pritchett (1984) theorized that there is a national real estate market cycle, but that each property type's cycle was not exactly coincident. He stated that supply growth and decline always lagged demand growth and decline and that turning points in the top and bottom of any cycle could be determined when supply and demand growth were moving in opposite directions, however recognition of turning points was less useful to investors than anticipation of such points. He applied these ideas by stating that the most advantageous buying opportunities generally exist during late declining, bottom, and early rising portions of the real estate cycle. Witten (1987) stated that every city had its own property cycles which will be unique in length of time and degree of change and this comes from the internal dynamics of each market. He also stated that new supply while being cyclical is somewhat more volatile than demand, as supply is often determined by the availability of financing rather than by market need. He also observed that markets seldom move as smoothly as the classically drawn curves, but instead move in "fits and starts" causing investors to hesitate and wait for clear signs as to market changes. Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle 3 Brown (1984) described cycle modeling as a simplification of the complexities of reality which hopefully capture the crucial features of the economic sector or system being studied. He believed that time series should be used to determine the length and breadth of cycles as it seeks to measure movement over time. Also the longer the period of time the better the understanding of the movement. A key to cycle credibility is the identification and removal of trend and seasonal components inherent in time series data. He concluded that if feasibility analysts, investment advisors, and principals or lenders are to give credibility to cyclical behavior, much more research needs to be done. There are currently no uniform measurement procedures making it difficult to agree on the length and breadth of cycle rhythms. Because the downside of cycles creates extreme economic obsolescence, real estate professionals need to maintain the perspective of cyclical timing. Wheaton (1987) estimated the national office market cycle to have a length of between 10 and 12 years by using a sample of 10 cities. He found that these 10 cities had turning points in their own series that are within one or two years of the combined average series. He studied the causes of market movement that make the office market cyclical. One of his findings was that the tenure structure of office leases was usually long term (e.g. 10-15 years). His explanatory model found that expected employment growth has a strong significance in determining cycle behavior thus creating an adaptive demand model and concluded that supply responds more readily to the state of the economy (as developers adjust their expectations) than demand and can actually help curtail the magnitude of the cycle. He concluded that both supply and demand respond to changes in the economy although supply is definitely more responsive than demand. Wheaton & Torto (1988) studied rent and vacancy rate cycles and found that there was a market rental adjustment mechanism that caused real office rents to drop approximately 2% annually for every percentage point of excess vacancy in the market. They also found that the average office vacancy rate was trending upward over the 1968 to 1986 time period studied. Mueller and Laposa (1994 and 1995) discussed the difference between overall market and submarket cycles. Their research found that submarkets can move differently from the overall market in the short run, but will typically trend toward market movements as locational advantages get appropriately priced in the marketplace. Mueller 1995 stratified real estate market cycles into a physical cycle that looked at only the demand and supply of physical space and a financial cycle that looked at the capital flows into real estate for both existing properties and new construction. This separation between physical and financial cycles helps to explain the lag that appears to exist between market movements and real estate prices. Economic literature addresses price dispersion under various search models. Butters (1977) postulated that imperfect information on the consumers part alone is insufficient to support price dispersion. Others have shown that heterogeneity among producers explains price dispersion [Carlson and McAfee (1983), MacMinn (1980)]. Nitzan and Tzur show that price dispersion can exist even when fully rational economic agents on both sides are homogeneous. Fershyman and Fishman (1992) present a dynamic search model which accounts for cyclical patterns of prices and demand. Thus, the behavior, strategies, and expectations of landlords and search behavior of tenants at various points in the real estate cycle may be explained by search theory models and price dispersion theory when we examine the rent price distributions in real estate markets. Cycle Theory Real estate market cycles can be broken into four distinct phases based upon the combination of supply and demand characteristics. Markets have a combination of either under or over supply and more or less demand than necessary for the existing supply. Market equilibrium is defined as that point in the cycle when supply and demand are in balance (with enough vacant space to accommodate the next tenant move or the next marginal tenant to enter the marketplace.) The interaction of supply and demand above and below the equilibrium point is very different. While impossible to pinpoint accurately, this equilibrium point in the cycle can be most easily identified by a long term average vacancy rate calculated over a number of historic cycles. Exhibit 1 helps to identify the supply and demand interaction. Starting with Phase one (recovery) at the bottom of a cycle, the marketplace is in a state of oversupply due to previous oversupply (new construction) or negative Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle 4 demand growth. At this bottom point vacancy rates hit their peak (or occupancy is at its lowest level in the cycle). Typically the market bottom is when the excess construction from the previous cycle stops. As the cycle bottom is passed demand growth begins to slowly absorb the existing oversupply and supply growth is non- existent or very low. As the excess space is absorbed, vacancy rates fall allowing rental rates in the market to stabilize and even begin to increase (typically at below inflation levels). As this recovery phase continues, positive feelings about the market allow landlords to increase rents at a slow pace. Eventually the market reaches equilibrium where supply and demand are in balance and the only excess space is that which will fulfill future expected demand. Graph 1 Market Cycle Quadrants Declining Vacancy New Construction No New Construction Increasing Vacancy Declining Vacancy Increasing Vacancy More Completions New Construction Phase 1 - Recovery Phase 2 - Expansion Phase 3 - Hypersupply Phase 4 - Recession Equilibrium In Phase two of the cycle (expansion) demand growth continues at increasing levels causing the need for additional space. As vacancy rates fall below the equilibrium level, signaling that supply is tight in the marketplace, rents begin to rise rapidly (above inflation levels) until they reach a "cost feasible" level that allows new construction to commence. In this period of tight supply, rapid rental growth can be experienced which some observers call rent spikes (as landlords demand higher prices and tenants agree to pay them due to lack of alternatives in existing supply). Some developers may also begin speculative construction in anticipation of "cost feasible" rents if they are able to obtain financing at this point in the cycle. Once cost feasible rents are achieved in the marketplace, demand growth and supply growth may continue at similar rates for some period of time. Long expansionary periods are possible and many historic real estate cycles show that the overall up-cycle is a slow uphill climb. At some point in time the peak in the cycle is reached. This peak can be described as the "inflection point" in the demand and supply growth curves where the rate of demand growth drops below the rate of supply growth. At this point the space market is tight and rents are high. The peak is passed when the marginal rate of change in supply becomes higher than the marginal rate of change in demand. Phase three of the real estate cycle (hypersuply) commences after the demand/supply inflection point, however most participants do not recognize this peak as vacancy rates are below equilibrium, thus the market is still in tight supply and looks good. During phase three supply growth is higher than demand growth and vacancy rates rise back toward the market equilibrium level. While there is no oversupply during this period, new supply completion’s compete for tenants in the marketplace and rental growth slows from a high point at the Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle 5 peak of the cycle when space is most difficult to find Eventually market participants realize that the market has turned and commitments to new construction should slow or stop. If new supply continues to grow once the equilibrium point is reached, the market will move into phase four. Phase four begins as the market moves past the equilibrium demand/supply level with high supply growth and low or negative demand growth. The extent of the market down-cycle will be determined by the difference (excess) between the market supply growth and demand growth. Massive oversupply coupled with negative demand growth in the late 1980s sent most U.S. office markets into the largest down-cycle ever experienced. During this phase landlords realize that they will quickly loose market share if their rental rates are not competitive and they lowered rents to capture tenants, even if only to cover their building's fixed expenses. Market liquidity is also low or non-existent in this phase as the bid ask spread in property prices is too wide. The cycle eventually reaches bottom as new construction and completions cease or as demand growth turns up and begins to grow at rates higher than any new supply added in the marketplace. Rental Growth Theory This theory assumes that asking rent growth is a function of the market’s position in the real estate cycle phase. Therefore during the recovery phase of the cycle vacancies are at their highest and demand (absorption) is just beginning to increase, rents will begin at negative levels and increase as the cycle moves toward the equilibrium point, but still stay below the level of inflation. In the growth phase of the cycle rents will increase at higher than inflation rates, reaching the highest rate at the market peak (highest occupancy or lowest vacancy). In the hyper supply phase rents will continue to grow but at declining rates until the market reaches equilibrium on the way down. In the recession phase rents will continue to decline and growth will be below inflation levels or even negative as the bottom of the cycle is reached. The distribution of rental growth rates should also vary during different points in the cycle, being very wide at the bottom of the cycle and narrowing as the market improves, all the way to the peak of the cycle. This distribution tightening should be the result of the market becoming more efficient as landlords take control for the tenants and look to their competition for pricing. As the market goes through a down-cycle the rent distribution should steadily increase as landlords fight for tenants and tenants are able to demand lower rents. At different points in the down-cycle some landlords will try to hold out for higher rents while others will drop their prices to obtain tenants at any cost, causing the distribution of asking rents to widen until the market reaches the bottom and the cycle. When the market finally bottoms all landlords finally resolve themselves to the situation and distributions may narrow. Then the cycle starts all over again. Thus the apriori expected change in rent variance is one of narrowing as the market improves in an up-cycle to the market peak, then widens in the oversupply and recession phases of the cycle and then potentially consolidates at the bottom of the cycle. Data Market information was used from Torto Wheaton Research including demand, supply, absorption, vacancy and gross asking rent growth data for 54 office markets and 54 industrial markets. The time period for each market varies and begins as early as 1967 and concludes with the 4th Quarter of 1995. Each gross asking rental growth rate is the average rental growth rate for all buildings available in a given market. Thus if one building has three spaces available at $15, $16, and $ 17 respectively, the average asking rental rate of that building will be $16 - not size weighted or value weighted. Methodology The following steps were completed for each market: 1. An equilibrium vacancy rate was calculated according to the Mueller-Laposa methodology (1994). Actual vacancy rates for the market were compared to the equilibrium vacancy rate in order to identify specific time periods corresponding to cyclical phases. Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle 6 2. The market cycle was broken into 16 positions and each year of each market was assigned to a market cycle position one through sixteen. (Graph 2) 3. Market cycle positions were connected to the growth rates for each year and for each market, then the aggregate average growth rate for each cycle position was calculated and the distributions examined. Graph 2 3 Cycle Position Labels 4 Equilibrium 1 2 5 6 7 11 10 9 8 16 15 14 13 12 Cost Feasible Rents Level Hypothesis to be tested include: 1. Rental growth rates vary by physical cycle position. Increasing during an up-cycle and declining during a down-cycle 2. Rental growth distribution varies by cycle position, with distributions narrowing during an up-cycle and widening during a down-cycle. Then consolidating at the market bottom. Results Summary tables, graphs, and general descriptives are presented in Exhibits 1-8. Office vacancy rates started at a high of 22.8% at the bottom of the cycle (position 1) and the standard deviation of vacancy rates was 4.8%. (see exhibit 1) Office vacancy rates reached their lowest point of 4.4% at position 11 the peak of the cycle. The standard deviation of vacancy rates steadily declined throughout the up-cycle to a low of 2.5% although the standard deviation at the peak was 2.9%. Vacancy rates rose during the down-cycle back to 19.3% in position 16 and standard deviations grew back to 4.3%. Average office absorption also grew during the up-cycle from a low of 2.2% to a high of 8.7% and then fell during the down-cycle back to 4.4%. The standard deviation of absorption did increase in the up-cycle and decline in the down-cycle (see exhibit 2). Office completion rates were high at the bottom of the cycle 7.7% then dropped to 3% on average in position 2 and stayed low through the recovery phase and into the first position of the expansion phase (position 7). From the cost feasible point, completion rates rose to a peak of 8.9% in position 13 (already over the top and into the hyper supply phase) and stayed strong through the rest of the down-cycle. (see exhibit 3). Office rental growth was negative in cycle positions one and two then was low but positive through the rest of the recovery phase of the cycle. Beginning at the equilibrium level rental growth jumped to 4% (above inflation levels) and increased to a high of 13.8% in position 10 (just before the cycle peak). Rental growth then steadily declined during the Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle 7 hypersupply and recession phases of the down-cycle . Growth dropped below inflation in the recession phase and became negative again in position 16. (see exhibit 4). Industrial vacancy rates started at a high of 13.1% near the bottom of the cycle (position 2) and the standard deviation of vacancy rates was 4.2%. (see exhibit 5) Industrial vacancy rates reached their lowest point of 4.5% at position 11 the peak of the cycle. The standard deviation of vacancy rates steadily declined throughout the up-cycle to a low of 1.3% although the standard deviation at the peak was 1.9%. Vacancy rates rose during the down cycle back to 10.5% in position 16 and standard deviations grew back to 3.1%. Average industrial absorption also grew during the up-cycle from a low of -0.3% to a high of 3.6% and then fell during the down- cycle back to 0.1%. The standard deviation of absorption did increase in the up-cycle and decline in the down- cycle (see exhibit 6). Industrial completion rates were low at the bottom of the cycle 0.9% then dropped more to 0.3% on average in position 5. From the cost feasible point (position 6), completion rates rose to a peak of 2.9% in position 11 the top of the cycle and stayed strong through the down-cycle. (see exhibit 7). Industrial rental growth was low but erratic in the recovery phase being positive in cycle positions one and two then negative in cycle position 3 (due to some strong outliers). Growth became strong and positive in position 5 and through the rest of the growth cycle peaking in position 10 at 9.8%. Rental growth then steadily declined during the hypersupply and recession phases of the down-cycle. Growth dropped below inflation in the recession phase and became negative again in position 16. (see exhibit 8). Conclusion Physical market cycles defined by demand and supply variable interaction (which leads to occupancy level cycles in all markets) are relatively stable in their trends. The dispersion of demand, supply and vacancy levels does decrease in up-cycle and increase in down-cycles. Market rental growth rates behaved as hypothesized, being low and negative at the bottom of the physical cycle, improving rapidly above equilibrium and growing at high rates near the peak of the physical cycle. Rental growth then steadily declined during the hyper-supply and recession phases of the down cycle. Rental growth dispersion also behaved as expected, narrowing in the up-cycle and widening in the down-cycle. There did not appear to be consolidation in growth rates at the bottom of the market cycle though as hypothesized These results point to the continued use of cycle research in projecting rental growth rates in office markets. Industrial markets showed similar results in the demand, supply and vacancy levels with slight variations. Industrial rental growth rates were less homogeneous, being low negative and low positive in the recovery phase, then going through sporadically increasing rates during the up-cycle and smoother declining rates during the down-cycle to low and negative rates in the recession phase. Thus industrial rental growth rates appear to be relatively predictable except during the recovery phase of the cycle. These results lead to the conclusion that local supply and demand characteristics do play a major role in rental rate growth in markets. These results can be used for making investment decisions, as more accurate rental growth rates can now be entered into the discounted cash flow programs used by real estate investors. The next step in research is to look at the correlation of prices to rental rate growth to see how much influence rental growth has on prices, followed by research on the capital market factors (interest rates and capital flows) impacts on prices. 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Torto, "Vacancy Rates and the Future of Office Rents," AREUEA Journal 16(4): 430-455, 1988. Wheaton, William C., Torto, Raymond G., Southard, Jon A. “Flight To or From Quality” paper presented at the 1995 ARES meeting Witten, Ronald G., "Riding the Real Estate Cycle," Real Estate Today, 42-48, August 1987. . compete for tenants in the marketplace and rental growth slows from a high point at the Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle 5 peak of the cycle when. historic rental growth and the distribution of rent growth during different physical market cycle phases for 54 office and industrial markets in the U.S. The data confirms that rental growth rates are. the cycle peak). Rental growth then steadily declined during the Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle 7 hypersupply and recession phases of the