EMV 3265: REAL ESTATE FINANCE III
UNIT 5.PROPERTY CYCLES IN REAL
ESTATE DEVELOPMENT & INVESTMENT
Academic Year: 2024-2025
Department of Estate Management and Valuation
University of Rwanda - College of Science and Technology
AGEN DA
Real estate space and asset
markets
The real estate system
The4-quadrant model
Real estate cycles
Using the4-Quadrant model to explain
R.E cycles
READING MATERIALS
Geltner, D. M., Miller, N. G., Clayton, J., Eichholtz, P
(2006 ) Commercial Real Estate Analysis &
Investments. 2ed. Chapter 2: The Real Estate
System, pp 21-35
Mueller, G., R. (2001). Predicting Long-term
Trends and Market Cycles in Commercial Real
Estate. Working Paper No. 388
Lee, C., (2011). Real Estate Cycles, TheyExist and
are predictable. Centre for Real Estate Quarterly
Journal, vol. 5, no. 2.
Investing in real estate without understanding the real estate
cycle is like riding a canoe in the ocean. You’ll be perfectly
happy as long as the weather’s good. But if and when a storm
hits, you’ll experience a catastrophic disaster.
REAL ESTATE MARKETS
⇨ What is a market?
A mechanism for the voluntary exchange of goods
and services among owners and buyers
⇨ Two markets relevant to realestate:
1. The space market
Market for the right to use real estate (space)
Also called “usage market” or “rental market”
2. The Asset Market
Market for trading ownership of real property
Also called the “property market”
T H E R E A L ESTATE SPACE M A R K E T
Supply: Demand:
MARKET
Property Owners Property Users
(Landlords) (Tenants)
Rents(e.g.$/RWF)
Occupancy
T H E R E A L ESTATE ASSET M A R K E T
Supply: Demand:
Investors MARKET Investors
Wanting to Sell Wanting to Buy
Property Prices:
“Cap Rates”
L I N K I N G T H E A S S E T A N D SPACE M A R K E T S
The real estate space and asset markets are
structurally linked over the medium to long run by
the property development industry
Financial
Resources
New
Development Built
Industry
Space
Physical
Resources
8
THE PROPERTY DEVELOPMENT INDUSTRY
Built space is extremely long-lived commodityas
buildings do not wear out fast.
It is only the demand for new built spacethat
supports the development industry.
New space demand results only from economic
growth &/or structural changes.
Therefore, development is the mostcyclical of
all branches of the real estate industry
T H E R E A L ESTATE SYSTEM
Three major components of the real estate system:
The space market
The asset market
The development industry
INTERACTION OF T H E SPACE MARKET,
ASSET MARKET, & D E VELO PMENT
INDUSTRY
INTERACTION O F T H E SPACE MARKET ,
ASSET MARKET, & D E V E L O P M E N T
INDUSTRY
⇨ Space market
Usage demand interacts with the current stock of
physical space supply to determines current rents and
occupancy levels
⇨ Asset market
Space market activity determines the operating cash
flows produced by real estate assets
Operating cash flow interacts with cap rates to
determine property market values in the asset market
⇨ Development industry
Current development costs compared against current
asset values. If asset vaslues ≥ development costs, dev’t
proceeds
NEGATIVE FEEDBA C K LOOPS IN
T H E R E A L ESTATE SYSTEM
These are mechanisms within a system that tendto
dampen the changes in the system, helping to keep it in
control, preventing it from spiraling out of control. Eg.
Thermostat
Principal negative feedback loop in RE system is the
ability of the asset market to regulate the flow of
financial capital to the development industry
If supply or demand were to get out of balance in the space
market, the resulting effect on assets’ operating cash flows
will trigger a pricing response in the asset market with
further implications for the development industry…
THE FOUR QUADRANT M O D E L
⇨ A graphical illustration of the real estate system
developed by Dipasquale and Wheaton in 1992
⇨ The model is really nothing more than 4 simple
graphs shown with a dashed rectangle linking them
together.
THE FOUR QUADRANT M O D E L
THE FOUR QUADRANT M O D E L
⇨ The model addresses four mainissues:
⇨ How are rents determined in the space market?
(NE quadrant)
⇨ How are properties valued in the assetmarket?
(NW quadrant)
⇨ What determines the amount ofnew
construction? (SW quadrant)
⇨ How is new construction related tothe
existing stock of space? (SE quadrant)
THE 4 Q M OD E L EXPLAINS REAL
ESTATE CYCLES
⇨ The 4-Quadrant model helps explain Boom and
Bust Cycles in Real Estate Markets.
⇨ Boom means that space markets see an extended
rise in occupancy and rents.
⇨ Bust means that space markets see an extended
period of falling occupancy and rents.
⇨ Similarly, property prices (in the asset market)
tend to exhibit periods of rising and falling prices
corresponding to ups and downs in the space
market
But what do we mean property cycles?
REAL ESTATE CYCLES
⇨ The real estate industry is traditionally characterised
by a cyclical business
⇨ …We mean that space markets have exhibited
extended periods of rise in building occupancy and
rents followed by extended periods of falling or low
occupancy and rents.
⇨ A cycle is generally defined as “an interval of time
during which characteristics, or often regularly
repeated events or a seq uence of events occur.”
⇨ The real estate cycle refers to the recurrence of
fluctuations that characterize the equilibrium of
the real estate markets
TYPICAL REAL ESTATE CYCLE
Construction
begins and Vacancy
accelerates as you increases yet
move up the curve construction
while vacancy continues unable
continues to to stop
decline
Vacancy Vacancy increases at
a decreasing rate,
declining and no
some completions
construction
PHASES OF THE REAL ESTATE
CYCLE
OCCUPANCY & RENTAL GROWTH
R E L A T I O N S H I P AT D I F F E R E N T P H A S E S O F T H E C Y C L E
PHASE 1 -RECOVERY
⇨ The recovery phase is characterised by:
Market in a state of oversupply due to excessive construction or
negative demand
This is where excess supply from the previous cycle stops
Passing the trough of the cycle, demand growth begins to
slowly absorb the existing oversupply and new supply is usually
non-existent
Negative rental growth occurs at points near the cycle trough.
As the excess space is absorbed and the recovery continues,
increased occupancy allows landlords to increase rents, but less
than inflation
As the market reaches its long term average occupancy level,
rental growth rates are roughly equal to inflation.
PHASE 2 -EXPANSION
⇨ The expansion phase is characterised by the ff:
Occupancy rates rise above the long-term occupancy
average
Available space becomes scarce and rents rise faster
than inflation until cost feasible levels that allow new
construction are reached
The market often experiences rent spikes due to
growing demand and low supply
Once cost feasible rents levels are reached, demand
growth rate continues to outpace the supply growth
rate because new construction cannot be completed
instantly
PHASE 3 – HYPER SUPPLY
⇨ The hyper supply phase of the estate cycle
commences after the peak point.
The peak is passed when the supply growth rate
exceeds the demand growth rate.
Participants do not recognize this peak turning point
since occupancy rates are high and the market is still
above its LTOA
Rental growth begins this phase very strong, but not
as strong as at the market peak
As this phase progresses demand growth continues
to be lower than supply growth, resulting in falling
occupancy as the market moves toward the LTOA
PHASE 4 -RECESSION
⇨ The recession phase begins when the market
occupancy declines below the LTOA
⇨ Driven by excess development, primarily from
completions started in the hyper supply phase
⇨ Landlords lower rents to retain existing tenants whose
leases are expiring and to capture new tenants
⇨ The cycle eventually reaches its trough as new
construction and completions cease and demand
increases faster than supply
IMPLICATIONS OF R.E. CYCLES
FOR ENTRY A N D EXIT
⇨ Good time to Exit - 6–12 months before or 6
months after the peak of the Plateau Period.
⇨ Good time to enter - the recovery period
⇨ Good time to be very cautious - near the end
of the expansion period
USING THE 4 QUADRANT M O D E L
TO EXPLAIN R.E. CYCLES
EFFECT OF D E M AN D G R O W T H IN SPACE MARKET
Rent
$ Space Market:
Asset
Rent
Market:
Determination
Valuation
D0 D1
R
*
Price P* Q* Stock
$ (SF)
C
Asset *
Market:
Construction
Space Market:
Stock
Adjustment
Construction (SF)
EFFECT OF D E M AN D G R O W T H IN SPACE MARKET: FIRST PHASE…
Rent Can this be a
$ Space Market: long- run
Asset
Rent
Market: equilibrium
Determination
Valuation result?…
D0 D1
R Doesn’t form
1 a rectangle.
R
*
Price P1 P* Q* Stock
$ (SF)
C
Asset *
Market:
Construction
Space Market:
Stock
Adjustment
Construction (SF)
EFFECT OF D E M AN D G R O W T H IN SPACE MARKET: LR EQUILIBRIUM…
Rent
$ Space Market:
Asset
Rent
Market:
Determination
Valuation
D0 D1
R1
R**
R
*
P**
Price P1 P* Q* Q** Stock
$ (SF)
C
Asset *
Market:
Construction
C** Space Market:
Stock
Adjustment
Construction
(SF)
EFFECT OF D E M AN D G R O W T H IN SPACE MARKET: LR EQUILIBRIUM…
Rent
$ Space Market:
Asset
Rent
Market:
Determination
Valuation
D0 D1
R1
R**
R
*
P**
Price P1 P* Q* Stock
$ (SF)
C
Asset *
Market:
Construction
C** Space Market:
Stock
Adjustment
Construction
(SF)
EFFECT OF D E M AN D GR OW T H IN ASSET MARKET…
Rent
$ Space Market:
Asset
Rent
Market:
Determination
Valuation
D0
11%
OAR
D1
R*
8%
OAR
R**
S
R
L
P1 R Q**
P* Q*
Price $ P** Stock
(SF)
C*
Asset
Market:
Construction
Space Market:
C** Stock
Adjustment
Construction
(SF)
F I N A L NOTES
Real estate cycles are relevant and will
become a more important decision
variable for investors and portfolio
managers in the future
There is only one certainty with cycles
— they exist, and they ultimately will
have a significant impact on success or
failure. The key is to not try to control
but to take advantage of the cycles
