The Real Estate Cycle and What it Means for a Post-Pandemic Market

In 1918-19, the world was focused on the end of World War I and the H1N1 influenza pandemic (1918 Pandemic). As with the COVID-19 pandemic, some parts of the country shut down, and many people wore masks. But an estimated 50 million people died, about 675,000 of those in the United States.

The music community of the day responded to the 1918 Pandemic by writing music. Rag pianist Malvin M. Franklin included one of the better-known Influenza Blues songs in his three-act comic musical, A Lonely Romeo, which was performed on Broadway in 1919. Robert B. Smith’s lyrics sing the lament of a man who was so lonely he feared catching the flu for remaining outdoors in the rain while others partied inside.

Other 1918 Pandemic compositions were more humous, perhaps to provide respite from the challenging times. Arkansas crossword and word puzzle author Helen Lyle Pettigrew wrote her only musical composition, “Oh You Flu,” which was written during this time. And ragtime pianist Walter A. Moloney of Altoona, Pennsylvania, wrote “The Influenza Blues,” a lively “syncopated one step” for piano.

A less positive view of the 1918 Pandemic was reflected in 1919 Influenza Blues, which included lyrics saying the 1918 Pandemic was God’s judgment on rich and poor alike. The author and lyricist of the 1919 Influenza Blues are unknown. The song was recorded starting in the 1960s by another female Arkansas native, African-American singer and pianist Essie Ray Jenkins.

Some compare the 1918 Pandemic to the COVID-19 pandemic. If history repeats itself, and so do musical themes. Well before 1918, during the 17th-century bubonic plague in Italy, residents of Milan, taking the church bell as their cue, sang outside to show solidarity with those who were quarantined. And today’s musicians, like those of 1918, have responded to the COVID-19 pandemic through song. In May 2020, the Chicago Tribune published links to songs about the COVID-19 pandemic from 40 musicians and groups, including Jon Bon Jovi, Gloria Estefan, Avril Lavigne, Alicia Keys, and Cardi B.

Music isn’t the only aspect of society that repeats itself. The economy is cyclical, with periods of growth followed by a recession. And there is the real estate cycle, which, although primarily tied to the economic cycle, has its own indicators and opportunities. This article discusses the real estate cycle and predicts what the future might look like for commercial real estate.

The Real Estate Industry

There’s a reason real estate lawyers sometimes are called “dirt lawyers.” It’s not a pejorative term. Instead, the term comes from the fact that real estate law governs the ownership and use of land (dirt) and what’s above and below the land’s surface.

The real estate industry isn’t as complicated as, for instance, the computer or healthcare industries. Yet, despite real estate’s simplicity, nearly all other industries need real estate to function.

A big-box retailer needs real estate for its stores, that a manufacturer needs real estate for its factories, and that an online retailer needs real estate for its distribution centers. Even industries that people think of as not being location-based, such as shipping, space, and virtual call centers, couldn’t operate without real estate to house their people, equipment, and computer servers.

The Real Estate Cycle

Although real estate can be a terrific investment to diversify a portfolio. Real estate is a risky investment. And every private placement memorandum I prepare reminds investors of those risks.

To succeed, a real estate investor must understand the real estate cycle. Sophisticated investors often can optimize returns by timing their acquisitions, dispositions, refinancings, and development based upon the real estate cycle.

Historical real estate cycle statistics show a predictable 18-year real estate cycle for 125 years from 1800 until 1925. What’s impressive is that the cycle ran like clockwork when there was no government regulation.

The following 54 years (from 1925-1979) should have been three cycles, but there were only two cycles. This period also was when government economic regulation skyrocketed in the wake of the Great Depression. Not that regulation is a bad thing. It may have prevented additional depressions. But government regulation sometimes disrupted the previously predictable real estate cycle.

There was a 48-year cycle that included the post-WWII era of homeownership growth, ushered in by government home mortgage programs. This was followed by a truncated 1970’s cycle due to the Federal Reserve’s 1979 doubling of interest rates.

The real estate cycle has four main stages: Recovery, Expansion (or Growth), Hyper Supply (or Over Supply), Recession. Vacancy rates, rent increase rates, and new construction rates are some factors that determine what stage the cycle is in:

How Investors Value Real Estate

Return on investment (ROI) drives real estate prices. Much of the time, investors calculate value by applying their desired return to net operating income (NOI).

For example, if an investor wants a ten percent ROI and the real estate generates $100,000 per year in NOI, the investor will likely value that real estate at $1,000,000. Other factors beyond this article’s scope might incentivize an investor to buy that example property for more or less than $1,000,000, but ROI is the primary driver of price.

This basic ROI calculation is based upon NOI. Most real estate has significant fixed costs, such as taxes, insurance, staff, maintenance, and utilities. Often, the most significant variable is revenue, which is almost entirely rental income.

How Supply and Demand Drive the Real Estate Cycle

The rental market determines how much rent an owner can charge. Because investors value real estate based upon ROI, rental and vacancy rates determine real estate prices.

Supply and demand drive the rental market. If vacancy rates are low like they are in the Recovery phase, there is likely to be more demand than supply. Absorption rate (how quickly vacancies are filled) will be high, and rents will increase. In response to the short supply and rising rents, developers will construct additional inventory, moving the cycle into the Expansion phase.

That additional construction from new construction causes supply to approach demand. As supply outstrips demand, the real estate moves to the Hyper Supply phase. Absorption rates slow and vacancies increase, causing rent increases to be sluggish.

When supply outstrips demand, there may be a Recession. Vacancies may soar, and rents will remain low or may even decrease. Gradually, the excess supply will be absorbed, and the cycle will start the Recovery phase again.

Where Are We Now and What Does it Mean for the future?

Not surprisingly, to learn that the market now is in the Recession phase. The last recession was in 2008 (ushered in by the mortgage loan crisis). So, following the 18-year cycle, we should still be in the Hyper Supply phase.

We can blame the COVID-19 pandemic for ushering in the Recession phase early and shortening the cycle. However, if we can hold on, things will get better, and the cycle will once again move into the Recovery phase.

I’m not an economist, just an attorney and real estate broker with more decades of experience in real estate than I’d like to admit. With that disclaimer, I believe that predict that we are likely to see signs of a Recovery phase by mid-2022 and that the market once again will peak around 2030.

The wild card in this forecast is interest rates. Rates have been kept low for years. They are due to increase. The Federal Reserve will probably attempt to control the interest rates, so they increase gradually and don’t slow recovery. If they don’t, the real estate cycle could be disrupted like it was in 1979.

The last real estate cycle, triggered by mortgage loan abuses, prompted new consumer safeguards. As I discussed in Reimaging Real Estate for the Pandemic and After, the current recession will change the real estate industry.

Recovery occurs in a historical context. Music that emerged from the 1918 Pandemic was blues and ragtime because those were popular styles of the day. Today’s pandemic music, which includes styles ranging from rock to R&B to Latin dance-pop to rap, also reflects its times.

Frequently, the real estate cycle’s Recession phase serves as a call to action for the industry to examine itself and correct weaknesses and make improvements. So the recession only hastens changes that should have occurred eventually anyway.

In 2019, the real estate industry was already addressing the needs of an aging Baby Boomer population, Millennials' needs, and technological developments. The current recession is likely to move these changes to hyperspeed

For instance, some developers, noting Millennials’ delayed home and car ownership, were already moving to mixed-use projects where people could live, work, shop, and enjoy leisure activities without getting into their cars. And other developers were creating similar projects where Baby Boomers could live, dine, enjoy fitness, and receive healthcare.

As technology allowed people to work anywhere, retailers and restaurants added comfortable places where people could meet and work. And for those who eschewed formal offices, shared workplaces, such as those developed by WeWork, offer a less public place to work and have meetings.

For sector-specific ideas about how these trends might continue post-pandemic, read my previous articles: How the Retail Real Estate Sector Must Change to Survive, How the Pandemic Will Change Multifamily Real Estate, and How the Pandemic Will Change Office Leases. And, as we approach the market peak in another 15-16 years, remember that it may be time to position holdings for the Recession phase in that real estate cycle.

© 2021 by Elizabeth A. Whitman

Any references clients and their legal situations have been modified to protect client confidentiality.

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