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Real estate cycles strongly impact real estate markets and the success of real estate investments (and professionals).  This chapter reviews the factors that influence real estate cycles, providing a better understanding of how real estate cycles can be forecasted.


Real estate cycles are prolonged periods of property supply and demand imbalance, which eventually gravitate towards relative market balance.  Real estate cycles play out gradually due to the slow nature of demand growth, long-term leases, and the fixity (permanence) of supply.  Thus, it generally requires many years for this balance to occur.  Vacancy rates indicate whether markets are improving (falling vacancy) or weakening (rising vacancy), and net absorption statistics tell us how much vacant supply was leased relative to how much was vacated over a specific time period.

The lagged timing of supply is a major factor in the success of a development. Developers often initiate projects in a very strong market when demand for new space is high.  However, due to the prolonged nature of real estate development, projects often come online after demand for the product has weakened, or alternatively, after competitive new supply has already been delivered.  Such conditions often make it difficult for a developer to find new tenants for the project while existing tenants in the area are already committed to long-term leases in neighboring buildings.  Thus, a newly developed building can often remain poorly leased, while an older, inferior building is fully occupied at above-market rents.  The shift in occupancy to newer buildings will eventually occur as existing leases terminate, but developers will often incur substantial losses in the early years due to the poor timing of the project.

Demand growth will eventually close the supply/demand gap, but it is important to understand that demand grows slowly, as it is directly linked to (and lags) job creation in the market.  The chapter reviews the case of office development in the U.S. during the dotcom era.  At the end of the 1990s, the tech bubble created high expectations for extensive U.S. job growth and, in fact, from 1999 to 2000, 6 million new jobs were created.  As a result, a surge of office development began, creating an excess supply of new space.  However, as the tech bubble burst in 2000, the market was flooded with a surplus of newly developed office buildings in the face of negative job growth.  In fact, during 2001-2003, the U.S. economy lost approximately 2 million jobs, bringing office vacancy rates to an astounding 18%.  Only by mid-2007, after 5 years of strong demand growth and little new supply, did vacancy rates fall below 10%.

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A major source of delay in real estate supply is the development regulatory process. Development projects require many permits, certificates, and approvals before construction can begin.  A delay in getting through the regulatory process can infringe on the timing of delivery of a development and on its feasibility and success.  Often, developers have equity and many hours tied up in the future project and will continue despite weakening market conditions, when supply already exceeds demand.  Thus, markets will take a long time to absorb the supply mistakes, leading to prolonged periods of market imbalance.  A source for developers’ confidence is partial pre-leasing of a new development, but keep in mind that even pre-leasing can backfire, as many of the pre-leased tenants may go bankrupt before construction is complete.

Real estate capital availability is another important factor in real estate supply.  It is an eternal truth that if developers get money, they will build, and if debt is cheap and plentiful, many real estate owners will overpay and over-leverage.  Hence, when cheap capital floods the market, real estate prices rise, and as capital becomes scarce, there may be plenty of opportunities to purchase property at bargain prices.  The Linneman Real Estate Index measures capital market balance by calibrating commercial real estate debt relative to the driver of space demand and economic activity, and is a useful tool to track the supply of real estate capital.

The 2008-2009 Financial Crisis was triggered by the massive growth in subprime residential mortgage borrowing from 2002-2006 by speculative homebuyers, and subsequent defaults, which rippled through the global financial system by subjecting institutional investors to margin calls on their positions.

To better understand cycles, gather information and monitor trends in local and national markets, for different property types.  Look to local brokers and publications such as The Linneman Letter to get information on vacancies, net absorption, and market forecasts to form your opinion on where the market is currently in the real estate cycle.


These are the types of questions you will be able to answer after studying the full chapter.

1. What is more volatile, the demand for space or the supply for space, and why?

2. Given the following data, calculate the net absorption over a year in a market, and the year-end occupied square footage.

Occupied space at the start of year: 1M square feet
During year: no new supply; tenants move into 250K square feet and vacate 300K square feet

3. Given the following data, calculate the market’s year-end vacancy rate.

Total space at start of year: 1.12MM square fee
Occupied space at start of year: 1MM square feet
Occupancy at start of year: 89.3%
During year: 200K in new supply delivered; tenants move into 200K square feet and vacate 100K square feet

Audio Interviews

Real estate cycles and local sub-market correlations (3:41)


BRUCE KIRSCH: Real estate cycles or this constant quest for equilibrium between supply and demand of real estate are a reality of the business in the US and overseas. And cycles make real estate unique and one could argue that on a macro basis an asset class whose fortunes are relatively predictable as a whole. But the fundamental problem is that there are no quote, unquote, “national” real estate markets or quote, unquote “regional” markets.

But rather, every geographic market is a reflection of the micro level submarkets that comprise that geography. And every micro level submarket has its own set of dynamics and particularities that impact its performance. Why is it hard for some people to understand this, and how can we disabuse them of that notion of a national or regional real estate market that moves as a whole?

PETER LINNEMAN: It’s very hard. Everybody believes their building is special. Everybody believes their region is special or their submarket is special. One of the things I’ve learned about real estate over the years is a rising tide does lift all boats a lot. And a falling tide does lower all boats a lot. And some can weather the ups and downs better than others, some submarkets.

We have some of the– there’s a supplement in the book that talks about how different markets have higher or lower betas– that is correlations with national. But they all have positive correlations with the national, and they’re very high positive correlations. And in fact, some over respond to national movements. That is they thrive when the US economy thrives, and they really desperately struggle when the US economy struggles.

State capitals, in contrast, go up when the US goes up, but not nearly to the same extent. There’s a stability of a state government or big universities or things like that in the market. So while each market is the same, if you look in the supplement, you’ll see all of them are highly correlated with the US. And you’ll find the same thing in other countries. All the markets in Germany are highly correlated with Germany’s economy and so forth.

I’ve said people have an amazing ability to lie to themselves and delude themselves. It’s how some of us get through the day in a funny way. I don’t know why it is.

But I started out as a young person believing it when people told me theirs is different. Their sub market is different. And as I’ve gone through the years, it’s different, but not a lot. We’re in a weak economy still. You give me an economy that would add 5 million jobs a year instead of 1,000,005 jobs a year– trust me. Every market will do a lot better. Some will do a lot better, but everybody will do a lot better.

It’s just one of those things. People convince themselves that they’re special. Garrison Keillor has had this radio show that focuses on Lake Wobegon where everybody is above average. And everybody tries to convince themselves they’re above average. But you can’t be above average on average.

Three real estate cycles examined (8:06)


BRUCE KIRSCH: The last three real estate market crashes in the US were all caused for different reasons. What were the causes of the last three? And the next one is going to be caused for a new reason, or are we going to start to cycle back into those three from before?

DR. PETER LINNEMAN: If you took the last three hits, you would characterize it, hit at different geographies a little different timing, but the recession in real estate that was generally viewed as 1988 through 1992 depending on where you’re at geographically was a way overproduction, massive overproduction, and you could see that in that the vacancy rate for office buildings, for example, was running 17% and 18% even when the economy was really good.

So you had a vacancy rate running 17% and 18%, and demand was good, and people were still building enough space to keep the vacancy rate at 17% or 18%. And when the economy slowed and you were building space that was keeping a vacancy rate already at 17 or 18, it was a nightmare.

And there was a situation of some strange tax laws had created an incentive for people to build a lot. Those got eliminated. Around the same time, cheap and stupid money kept flowing to keep the machine going a bit longer to create supply. And then, when the economy did slow, it was pretty clear the emperor had no clothes. You can’t have an 18% vacancy rate and justify construction.

And suddenly, the vacancy went to 22%. And it was a economic downturn. It wasn’t even that severe an economic downturn, but it revealed the emperor has no clothes. And it was ugly in that there was huge vacancy to start with. It got even worse. Lots of new buildings came online on top of that and financing disappeared. It was ugly.

Then you go to the recession of 2001 shortly after 9/11, and that was a different kind in that there were some markets, the dot com markets, were massively overproducing space. But most of the rest of the economy was not overproducing space. And to that point, hotels in most of the country were not being massively overproduced.

But a recession hit, demand fell, and 9/11 happened when the World Trade Center and the Pentagon were attacked, Flight 93 goes down, and nobody traveled. Well, that was a demand shock, a huge demand shock, especially on the hospitality side. And demand just fell off a cliff.

And it was in a fairly healthy market, a somewhat overbuilt market in the dot com markets, but the rest of the country not wildly overbuilt. But if no one is traveling, literally no one is traveling for six, eight months– remember, after 9/11, it was two weeks until anybody was allowed in the air. You are going to have a demand shock.

And so that was a demand shock from a recession meeting in some markets excess production associated with the giddiness of the dot com was going to create millions of new companies that would take a lot of space. And I had a student back in the dot com days who was in the tech space.

And they called me one day and said, do you think we should take 50,000 feet in Chicago or 30,000 feet in Chicago? And I said, you only have five employees. I mean, what are you talking about, 6 versus 10,000 per employee? And he says, yeah, but we’re going to hire a lot of people in the near term. We just did a $50 million raise, and we’re going to hire tons of people.

Well, they went out, and they ended up taking 60,000 feet, and they were out of business six months later. And of course, since they were out of business six months later, they burned through their 50 million. They were out of business. Nobody was going to finance them any further.

Some landlord signed a lease at really high rates for a lot of space that was never occupied, and when those companies disappeared, there was a big drag on the market. They were leased, but they weren’t occupied. So that was some combination of irrational exuberance being fueled by dot com on the demand side that disappeared on the recession, super, super shock on the demand side temporarily and a bit of oversupply in certain markets.

Then you go to the recession we’ve just been through, and that’s a pretty simple one in the sense that there was not massive overproduction. We were producing about enough space to deal with normal economic growth. There was not wildly overproducing commercial space and multifamily space. Single family was a different story.

Well, if instead of growing at a normal pace, if instead of adding 1.8 million jobs a year– so imagine you’re building enough space to accommodate a growth of 1.8 million for each of the next couple of years, and it takes a couple of years to build a building. You’re building space for that, and instead of adding, say, 3.6 million jobs over the next two years, two years at 1.8 million, you lost 9 million and about 13 months. Wow. Yes, I overbuilt a bit, and yes, there was a demand shortfall, and I didn’t get the growth I thought, but I never thought I’d lose 9 million out of 136 million jobs, never.

And so that was almost all demand shock. And the difference with real estate in most businesses is the space stays. It doesn’t go away when the demand doesn’t show up. I talk about pumpkins versus the holidays in the book where I might overproduce pumpkins, but they rot, and then you get on with it whereas real estate doesn’t rot. It sticks around and competes and competes and competes.

So those were the three. The next one will be something different. All of them have capital market implications on top of the demand side. Namely, not only do I have less space being absorbed and new space coming online with nobody to take it, but people lose confidence in financing real estate until they see where things shake out. And it’s a very capital intensive business, and when capital loses its confidence, a capital intensive business is really going to suffer.

You saw that in the last go round where even companies with very strong balance sheets, if they had a loan coming due, had a very hard time getting a new loan at all, not a loan big enough to refinance, just a loan they couldn’t get because everybody was already overcommitted. And the last thing you need when you’re overcommitted is another loan.

So each was a shock. There’ll be another one. I do believe they all have as part of them, though, a demand element. There’s a demand shortfall, and the demand shortfall will either make it clear that the emperor has no clothes– that is, you’ve been building buildings that are empty– or that you were building buildings rationally, but with the demand shortfall, there’s just a lot of empty space that’s going to shock things and confuse capital markets.

Why commercial lags residential in the real estate cycle (4:50)


BRUCE KIRSCH: Why does the commercial real estate market tend to lag the residential market, at least in the US, both in terms of when it booms and when it busts?

PETER LINNEMAN: It really has to do with the production cycle. And in fact, if you come within commercial real estate, you’ll see it follows a logical pattern. A single family home is you’re talking about a couple of thousand square feet. In the South where the weather allows you to easily build homes year round, you can put up a single family home pretty easily in four months if you want, five months, six months from start to finish. You don’t have to get way out ahead of demand.

And remember, demand shortfalls, surprises, demand shocks are one of the problems. So the fact that there’s a short cycle says when the demand falls, you see it immediately. Nobody comes out to buy a new home. Nobody comes out because it’s a big ticket item.

They’re hesitant to go out and get a big ticket item. Demand falls very quickly, and it’s felt very quickly on the negative side in the single family. But the good news is production slows down pretty rapidly because the pipeline is short. Only have like, four month pipeline. So yes, there’s some more supply comes on line, but it’s a pretty short pipeline, and therefore, supply doesn’t keep running.

The exception to that are high rise residential. High rise residential is, once you’re pregnant, you basically have to have the baby unlike a single family home. If I’m on the third floor of a 30-story building, I have to complete it.

Suddenly, I now have a building that takes 2 and 1/2 to three years to build. And secondly, I can’t just stop after the second floor. I have to keep going to get it enclosed and get the systems installed, et cetera. So that leads to the other distinction, which is, how long does it take to produce something, and is it bite-size?

So high rise office buildings, for example, tend to be late in the cycle feeling negatives. Why? Because I’ve already got most my space leased. The building’s built, it’s almost all leased, times are good. I just signed a bunch of leases for five to 10, 15 years.

So, OK, demand weakens a little bit, but come on, I only have 2% of the building up for lease this year and 94% of the building is already leased. So yeah, I feel a little softness, but it’s only on 2% of my income. The rest my income’s OK.

That’s also why it lags on the upside, though, because then, it means that for four years on the way we’re heading down and on the bottom for three years or so, I’m leasing at low rates, and those low rates keep me pulled down. Namely, yeah, now people are really starting to lease, and they’re leasing at higher rates, but I’ve locked up 15%, 20%, 30% on my building for the next five to 10 years at below the kind of rents I could rent out today. So long leases and the fact it takes a long time to build commercial means they’re later in the cycle.

Apartments, apartments tend to be– garden apartments tend to be more like single family. You can’t build them in three months, but you can build them in nine to 13 months. A three-story walk up wood frame, you can build it in nine to 13 months.

So the supply cycle is relatively short. People still sort of come out. And in fact, in a down economy, you may even get a few more renting rather than buying, so it buffers a little bit the demand shortfall because people lost their jobs.

And on the upside, there are short leases. So when the market turns, I haven’t tied my building up with a lot of my income coming from low rents, a turnover in a year or so. Hotels, the same way. Hotels show the pain early in a cycle, and they show recovery soon in a cycle because they have very short-term leases. Not quite as soon as the single or multi because it tends to be a high rise product, takes a little longer to build. So you can kind of go through the different property types and each one has their own business characteristics that would suggest when it comes out of the market, reflecting length of lease and the time it takes to build a building.

Reduced office square footage per employee: cyclical or secular trend? (5:27)


BRUCE KIRSCH: Currently in the office sector there is a trend wherein office tenants, big tenants, are aggressively making changes to use less space per employee as opposed to more, which is a reversal in the trend of the last several decades. And this in the last year, in 2012, has made a really serious impact in Washington DC coupled with some other coincidental bad timing elements. And DC is historically one of the most stable office markets.

And so we might see this happening in other markets as well. And so I guess the rule of thumb is roughly for corporate Class A space, the square footage per employee is, let’s say, 200 square feet. Do you see this starting to decline in these major markets around the world?

PETER LINNEMAN: Well, it’s clear that people are using space more efficiently. And it’s clear that they’re using space in different ways, more shared space, less private space in an office building. That’s happened in every downturn I’ve seen during my lifetime. And the question is, it cyclical or secular?

Every time in the past, people have said it’s secular. That is it’s a fundamental change. And it turns out it’s been cyclical every time in the past. Namely, yes, people are using space differently. But in the long term as things improve, they go back to larger space usage, more private space, more amenities space as the business recovers. It’s too soon to know.

My own view is that the change in the way space is used is fundamental, but so was moving away from large secretarial pools. But at the same time, as we moved away from large secretarial pools, all the law partners required a window, which they didn’t used to have. And so yes, one reduced the amount of space you need. The other increased it.

The next one was not all my workers have to have windows, just my senior workers. I’m going to put the junior workers on the interior. That reduced the amount of space in the next cycle. But as we came out and the economy roared, they said, yes, but I need a whole lot more conference rooms. Because I want conference rooms available and meeting space available when people need it. Because they can’t conduct meetings in their cubicles.

So the down part was obvious. The up part reversed it. And the total amount of space kind of neutralized back to where it was. My own view is on a down cycle, you look to save money. And it’s obvious to save money by reducing space. But also, you make people fly coach. You make people stay in cheaper hotels. You send fewer people to the conference.

And everybody says each time, this time it’s secular. They’ll never change those policies. And then on the up cycle, when companies are making a lot of money, they go back to flying up a class. They send more people to the conference. They have bigger travel budgets, bigger entertainment budgets, conferences again. And I think that it’s natural.

And if you think about office space, it’s where people spend more of their life than in their home almost. Therefore, it’s important. It’s part of their identity. And if you think about it, if I save 20 square feet per worker and the rent is $30 a year, I’m only saving $600 on that employee by cutting down their space. If in a down cycle, $600 per worker is the difference between me being profitable and not, I’ll downsize.

Now think of the up part of the cycle. During the up part of the cycle, it costs me much more than $600 to replace a dissatisfied worker who leaves me because they don’t like their work environment. And so on the up part of the cycle, you give them back the space. You give them back the amenitization of the space.

It may not be a private space. It could be climbing walls or a gym or conference rooms or a kitchen. There’s different how it’s done each cycle. So my expectation is yes, we’ve downsized use during this down part of the cycle, but I think on the up part of the cycle you’re going to see space usage increase back towards the norm. Because it’s just another employee prerequisite that you’re giving them as part of making it a better and more attractive working environment.

And to lose talented and productive workers over $600 a year is not good business. And when people don’t have a choice of where to work, you can press them and take away their benefits. When people have a lot of choices of where to work in the upside of a cycle, you give them those benefits back. And I think space is one of those benefits. But we’ll see.

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Key Terms


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Text for accomplishing cushion.

To view the definition, click or press on the term. Repeat to hide the definition.

Prolonged periods of property supply and demand imbalance.

The total amount of square footage tenants newly occupy over a given period of time.

Measures the difference between the total newly-occupied square footage and the total square footage vacated over the same period.

Non-pre-leased or non-pre-sold real estate development.

A type of mortgage that is normally issued by a lending institution to borrowers with low credit ratings.

A floor plan layout that makes use of large, open spaces and minimizes the use of small, enclosed rooms such as private offices.

Investors who purchase single family residences with the intent to sell them quickly (“flip them”) for a profit.

A tradable security that is collateralized by mortgages on single family residential properties.

The immediate requirement for a securities holder to produce a significant amount of cash to offset the loss of value in accounts in which they purchased securities using borrowed funds.

Chapter Headings

  • What Are Cycles?
  • Contractual Obligations and Market Frictions
  • Demand Adjustments
  • Structural Office Demand Headwinds?
  • Permits and Regulations
  • Capital Cycle
  • What Led to the 2008-2009 Financial Crisis

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