The buy early and build later strategy commonly practiced in the real estate sector may not always be the most advantageous path, according to an analysis of historical market data by Hines Research.
Theoretically, buying assets early in the real estate cycle when asset prices are lower and developing them later in the cycle when prices tend to rise is an effective investment strategy. However, the firm’s analysis revealed that returns might be greater early in the cycle and diminish in later phases. In addition, the analysis found that absolute returns on development tend to shrink later in the cycle and fall below returns needed to account for risk levels. Hines quantifies risk as the probability that market prices will be lower in five years than they are today.
The acquisition and development cycle includes eight phases: early buy, buy, strong buy, late buy, prepare to sell, sell, late sell and hold/monitor. High vacancy rates, falling rents, and weak tenant demand typically characterize the early phase. Market prices are generally low during this phase as well. The risk that prices will be lower in five years is low, but most buyers in this part of the cycle are private high-net-worth investors and family offices. Many U.S. office markets are currently in this phase.
Fundamentals strengthen as the cycle progresses, and by the prepare to sell phase, capital market enthusiasm for assets is higher. Prices tend to be high, which boosts risk levels. Then, as fundamentals and capital markets cool, risk again declines and a new cycle begins, said the report.
The analysis shows that returns are higher earlier in the cycle and fall once the markets enter the sell phases.
“In practice, this means that while investors and developers probably would not want to break ground in the earliest part of the cycle, this may be an opportunistic time to option land for the invariable improvement in market fundamentals that tend to occur as the cycle progresses,” said the report.
Market participants in the early buy phase typically see attractive valuations, and competition for sites is likely to be lower, giving negotiating leverage to sellers.
In the later phases, strategic development can be structured as build-to-core projects with longer-term holds to help alleviate low returns that could result from a merchant-build structure, said the report.
“We believe that our research helps to debunk the idea that buying early in the
cycle and building later is the best path forward,” said Hines Research. “So, regarding the question of whether to buy or to build, we believe that the answer lies in a flexible, data-forward approach that spans market conditions, geography, and property sectors — as opposed to any preconceived notions of market behavior.”
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