How Much Longer Will the Cycle Last?

DALLAS—Many in the commercial real estate industry have experienced repeated real estate cycles. As the current real estate expansion approaches its ninth year, a common question that professionals, investors and lenders are asking is how much longer will this current expansion period last or is history going to repeat itself?

For insight, it is important to understand the phases of real estate cycles and how to recognize them. Chris Burrow, founding partner and CEO of Range Realty Advisors LLC, says this is essential to making informed decisions related to real estate investments. To begin, the four phases of the commercial real estate cycle mirror the phases of the broader US economy, Burrow says.

The recovery and growth phase occurs after the market hits bottom and is the lowest point in the trough. The period from mid-2009 to 2010 is the most recent example. Valuations are attractive during this phase and sophisticated real estate investors start entering the market. Occupancies are at or near a low point and there is minimal leasing activity. There is very little or no new construction in most markets. Rents begin to rise later in this phase as does GDP. Job growth also starts to pick up as the overall business outlook starts to turn and economic indicators begin looking up. Overall, market sentiment begins to switch from negative to neutral.

During the expansion phase, where the US has been since 2010, the economy is clearly on the upswing, typically growing at a healthy 2 to 3% annual rate. There is also growing demand for commercial space, as well as increasing interest in investment assets. During expansions, GDP growth is typically moving back to normal levels and job growth is strong. Rents continue to rise, development activity typically surges and cap rates move down. As this phase begins to come to an end, valuations may hit historic highs.

During the hyper-supply/crisis phase, there is typically an oversupply of many asset types. This is the peak when the economy may be growing at a rate of more than 3%. Sellers begin to dominate the market and inflation may begin to heat up. During the later stage of this phase, new development activity starts to lag at first and may drop precipitously. Asset values begin to decline and leasing concessions become more common. Oversupply may result from overbuilding or a sudden drop in demand caused by the sudden economic shift.

The recession phase features a period of industry consolidation. The Great Recession of December 2007 to June 2009 is the most recent example. There is a return to a focus on fundamentals as the economy contracts. Real estate assets are often recapitalized during this period. Government intervention may be required, such as bailouts of financial institutions or specific industries. Supply far outweighs demand for many real estate assets. Rent growth is stagnant, while concessions and in some cases, rent reductions are on the rise.

In addition to those phases, many believe US presidential cycles often have a direct impact on economic activity, Burrow says.

“The belief is that presidents tend to pull whatever economic levers they can get their hands on during their first term in office, particularly during the two years leading up to their run for a second term,” he tells GlobeSt.com. “The hope is that a strong economy will encourage voters to support them at the polls. Likewise, if a president is at the end of his second term, he will typically use every option available to keep his party in power.”

So at what point is the current real estate cycle and how much longer will this expansion period last?  The current expansion period is the second-longest post-war boom period on record and may become the longest. This would indicate that the cycle may be close to a peak, Burrow says. This argument is supported by the fact that the average economic expansion period since 1945 lasts about six years and the average contraction about 11 months. Based on a recent analysis by Wells Fargo Investments, a turn in the business cycle typically occurs 12 to 18 months following some excess evidenced by a peak or trough.

“To that end, we need to look at key indicators and determine if we are currently in a period of excess in order to predict the occurrence of the next recession,” Burrow tells GlobeSt.com. “In effect, we need to peel back the layers of the economy. On close inspection, key economic indicators today lack much similarity to periods that historically preceded US recessions. These include household spending, which is a reflection of consumer confidence, business investment and job growth.”

US consumer confidence actually rose more than expected in October to the highest level in almost 18 years as Americans grew more confident about the economy and job market, as measured by the Conference Board.

“Jumps in the Conference Board’s measures of the present situation and expectations signal Americans are becoming more upbeat about the economy and employment as the labor market improves. Improvement in household confidence helps underpin their spending, the biggest part of the economy,” according to Bloomberg’s response to the latest data.

Indeed, retail sales are a strong reflection of consumer confidence. Total retail sales have grown year-over-year every month since November 2009.

Business investment is another key indicator of US manufacturing and services sector sentiment, and it is currently very strong. But spending levels are lower than during the cycle ending in 2007, suggesting that business investment is not yet at excessive levels.

National companies have ramped up hiring. This suggests the US economy can continue without overheating, forcing the Fed to adjust with aggressive interest rate increases. In fact, Fed chairman Jerome Powell noted that unemployment is at the lowest level since December 1969 and inflation is close to the central bank’s 2% target.

But many economists argue that the causes of the next crisis are beginning to emerge now, even if it is a few years before those causes fully develop and tip the economic balance. For example, the United States is currently piling on debt at an alarming rate with no long-term debt reduction plan in place. The prospect of a trade war is a more recent concern among economists and has led to acute stock market volatility of late, along with a fairly sudden drop in oil prices. Concern has also been raised about the potential impact of a tightening labor market. The high employment rate could force companies to pay higher wages that could lead to higher inflation, Burrow says.

The Fed has already implemented a policy of interest rate hikes in order to hold down inflation. If inflation rises and the Fed expedites increases in interest rates, economic growth could slow.

Given the current status of economic indicators and the apparent lack of economic excesses, it appears unlikely that a recession is lurking in the near future; however, the indicators point to the likelihood that the US is in the later stage of the current expansion, says Burrow. Fortunately, most economists see few threats to the recovery in the short term, saying it would take a big hit to set the economy off of the current course.

While tax cuts and spending increases may boost inflation, they also provide a cushion to any economic hits. Considering these factors, economists surveyed by the Wall Street Journal recently put the odds of a recession in the next year at 15%.

But even when a position of peak excess appears to be at hand, based on historic economic trends, it will likely be 12 to 18 months after that point before the end of the current expansion occurs. Given that the next 24-month period coincides with the build-up to a major presidential election, the current expansion could well last through 2020. At that point, the current expansion would be the longest in the post-World War II era.