Evaluating whether or not a particular office property is a good value depends on several factors. But beyond the CAP rate, the IRR, and the estimated appreciation, the value of an office property is also greatly affected by the commercial real estate cycle active at the moment of purchase.
The commercial real estate market is closely tied to the state of the economy, and just as the economic cycle through ups and downs, so does the CRE market.
There are four stages to the commercial real estate market: recovery, expansion, hyper supply, and recession. Each one is characterized by different investor behaviors and has a distinct effect on supply and demand and price of investment properties.
These cycles drive the rental price of an investment property and are entirely driven by the local market. Understanding the four cycles in commercial real estate can mean the difference between a successful investment, and a losing one.
Phase 1: Recovery
Recovery follows the tail end of a period of decrease in demand and oversupply of inventory. Deciding where recovery begins is actually arbitrary, but it is essentially at the bottom of the cycle that recovery begins.
The main characteristic of this stage is that the excessive construction of the previous period has finally stopped. Demand is very low, and occupancies are at their lowest point. Rental growth is also negative or very low, only picking up later in the phase. The low market threatens most non-investors, and even some investors adopt a wait-and-see strategy for what some still confuse for a recession.
Smart investors will realize that this phase present offers the best chance of acquiring opportunistic properties at excellent prices. These properties may be suffering from low vacancies, but they can be repositioned for maximum equity growth which will take place in the next phase. Once the next cycle is underway, the property can be sold for a significant income gain.
Value-add properties, on the other hand, present more risk during this phase. Due to a need for renovations and or re-purposing, investors should be prepared with a plan to manage the initial negative cash flow.
Core properties offer the best opportunity during the recovery phase for coaxing profit from an underachieving property. If an investor can purchase a property with an excellent location, they can simply hold on to the property until the next phase, where both lease renewals and decreasing vacancies will rapidly increase profit once the property is sold in the next phase.
Phase 2: Expansion
The expansion phase is much more optimistic. The economy is stronger, and confidence in commercial real estate is growing. This phase is still an excellent time to invest in commercial real estate. Although you may not find the bargain basement properties that were ripe for the picking in the previous phase.
As demand grows, the supply decreases, which causes the price of commercial real estate to increase. Businesses also begin hiring again, which creates a shortage in office and retail space. This leads to developers building new commercial properties or re-purposing old ones in order to keep up with demand.
Unfortunately, the increase in demand also attracts other investors who are less experienced in commercial real estate. These spectators buy property left and right, hoping to cash in on the gold rush, but ultimately causing the commercial real estate market to enter into the third phase of the CRE cycle.
Most opportunistic properties are gone by this stage. However, investors can still see good results from value-add investing. While this may require investors who are particularly adept at making capital repairs and then repositioning the property as a premium property, experienced investors will be able to turn these opportunistic properties into sales easily.
Phase 3: Hyper Supply
The third phase of the cycle is known as hyper supply. In this phase, developers are still busy churning out new construction, but demand has already begun to fall. Some investors ignore the signs and continue to purchase income properties; they are convinced prices will continue to rise, and they will still be able to make a profit.
Instead, this results in increased occupancy rates and lowered rents, which if it is not stopped in time, leads to the next phase: recession.
Phase 4: Recession
In this phase, there is a tremendous oversupply of property.
Development companies, having overbuilt, are not able to sell properties. The same investors who bought during the hyper-supply phase and ending up paying too much for too little are either forced to foreclose or to hold onto a property with a negative cash flow.
Those who bought core products and leased up during the previous period will be able to hold out since their lease rolls are full and the buildings are in good shape.
As in the recovery phase, the recession phase presents an additional opportunity for profit by purchasing heavily discounted properties. Although the wait time will be longer than for properties acquired during the recovery stage, a detailed and well-financed business plan will allow investors to hold the property until the recovery or expansion phase.