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.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.