Office Market CycleThe office market cycle is an important characteristic of office market behavior. Investing profitably in office property requires an understanding of how office markets are likely to move over the investment horizon.
Furthermore, the potential impact of such movements on the earning prospects of a particular property need to be evaluated thoroughly. Market wide behavior does not affect equally all properties; its impact may vary depending on the strength of location, nature of demand, and the quality/amenities offered by a property. The historical development of the US office market has shown that the intertermporal behavior of the office market is characterized by considerable cyclical instability. Vacancies, rents and new construction fluctuate considerably through time generating cyclical ups and downs in the office property values and medium-term investor returns in this property type. The period 1981-1991 when the vacancy rate moved from considerably below 10% in the early 1980s to above 20% in 1991, when the economy fell into a recession, is indicative of such fluctuations. The real estate market at that point suffered a significant downturn, some characterized it as a crash, as property values were written down considerably. An important characteristic of the cyclical behavior of both new construction and the vacancy rate is the long periodicity of the cycle, which based on the 1980-2001 experience it appears that it is between 8-10 years.
It should be noted that the latest downturn in the real estate market in general, and the office market in particular, after the 2001 recession, was smaller. Some analysts attributed the this shorter cycle to the increasing securitization of real estate through Real Estate Investment Trusts but in my opinion it was the historically low interest rates, that kept consumption and demand from collapsing, thus preventing the market from going through a longer cycle. The historical behavior of the office market shows that the national office market cycle affects most of the major metropolitan markets. However, the timing and strength of upward and downward movements in individual markets varies considerably. For example, office vacancy rate fluctuations in Atlanta have been noticeably more severe compared to Los Angeles. The office cycle may also differ in terms of magnitude and timing across different qualities of office space, such as class A, class B etc. Causes Of The Office Market CycleThe office market cycle is due to the inherent idiosyncrasies of the behavior of this market. In particular, the cyclical movement of the office market is due to: - The sluggish adjustments of office space demand to changes in market conditions (market rents and vacancies) due to long-term leases that prevents office tenants change their consumption of space and location - The sluggish adjustments of supply to changes in demand due to the long time that it takes to plan and complete an office project; furthermore due to the high cost of office development process, projects that are well in this process are rarely remain unfinished despite of unfavorable developments in the market - The sluggish adjustment of rents for already rented space due to long-term leases that not only maintain rents at fixed levels but stipulate mandatory increases, independently of prevailing market conditions and trends in market rents - The high volatility of demand for office space due to unpredictable economic shocks that affect employment growth in service and financial sectors which determines large portion of additional demand for office space
Predicting the Office Market CycleWhen investing in an office market the investor needs to have a good understanding of how office property rents and values will most likely move over the time horizon of this investment, because these movements will determine whether the investment will be eventually profitable at the price for which is bought. That is why predicting the office market cycle is very important for successful and profitable property investing. Scientific forecasting of the office market cycle requires historical data on office rents, office space supply, and vacancy rates. This data can then be used to estimate and calibrate forecasting equations predicting marginal demand or absorption, which is calculated as the change in occupied stock, completions, which are calculated as the change in the existing stock and rents. In other words, a system of three econometric equations needs to be estimated. Once calibrated through econometric estimates using the historical data, it can be used with different economic scenarios regarding employment growth in office-using sectors, to assess how demand, completions, vacancy rates and eventually market rents will move in the local market. Competent forecasting firms specialized in real estate market analysis and forecasting do provide forecasts of major office markets in the US, which can provide valuable insights into future office rental rate movements and potential returns from office property investments.
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