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Real Estate Market Fundamentals

In this post I’ll tell you what fundamentals to look for in real estate, and give you my two cents in an analysis of today’s market.

I’ll write a post in the future on the specifics of underwriting & beneficially structuring real estate deals.  But the first step is knowing the market.  Basic economics – what do supply and demand look like?  And what factors are changing that in the near and distant future?

Real estate is not nearly as efficient as stocks or bonds.  I believe that someone with a critical eye who puts the effort to collect the information can produce outsized returns compared with the averages.  REIT dividend yields are plus or minus 3% – I’d certainly hope we can aim a little higher.

In an inefficient market, you can find deals if you know how and pay attention.  It’s worth examining the fundamentals.  Understand the overall market dynamics, apply them to your local market, be patient, and after a while you’ll uncover a gem.

What Sort of Fundamentals?

Suppy-demandAt its most basic, real estate is built on supply (buildings) and demand (building renters).

Demand all starts with employment base & trajectory.  Job growth creates bigger companies and office space demand.  It also leads to population growth, which drives residential (for-rent & for-sale) demand.  More/larger companies use more hotel rooms, and the new employees/residents shop & dine more.  So before investing in real estate, understand the jobs picture in your region & city.  Invest in a growing job-market.  Don’t fight it out in a weak/declining market.  Not in real estate, especially if you are a beginner.

Demand drivers have structural changes from time to time.  Much retail can be bought on the internet.  Housing demand seems to have shifted somewhat towards rentals/apartments.  Office space seems to be headed in a more open floor plan with a higher headcount density per square foot.  Understand the implications of structural changes in your product type.

Then move onto supply.  Understanding supply is understanding:

  1. What do comparable assets cost?
  2. What other options are out there?  What is in the pipeline?
  3. What rents do they get?
  4. What are prevailing vacancy rates?
  5. What are the new trends in this asset class?

The internet is a good start here.  Lots of analytical data.  Get yourself some qualitative data too.  Brokers are good resources in this department.  Whether you are planning to hire one or not, take a few out for coffee.  They’ll let you pick their brains – it’s business development to them.  Go to speakers/panels through real estate networking groups. (some groups’ acronyms: ULI, NAIOP, ICSC, NMHC)

With this fundamentals analysis, you aren’t really looking for a silver bullet, or some secret formula.  You just want to understand: what’s the lay of the land?  Are things generally good or bad, and moving which direction?  Write it down; organize your thoughts.  Map out some comps, or neighborhood attributes & price points.

My Take on Real Estate Fundamentals Today

My job is in commercial real estate development across several markets in the Southeast US.   Here is my example for an analysis of the current market dynamics, including several of the local asset classes.

National Picture

The macroeconomic picture nationally has been and continues to be decently solid, but recently some dark clouds have been moving in.  Jobs have been created steadily for several years since the downturn at a slow but steady rate.  Companies have stayed cautious, but relatively comfortable with the economy.  And with the jobless rate’s steady decline (now below 5%), consumers have also become comfortable (not celebratory).

Interest rates continue to stay very low which has helped real estate.  I don’t know where the 10 year interest rates are headed in 5 years (likely up some, I guess), but a huge spike in the near term seems unlikely.  Given so much debt in real estate, interest rates can do a lot of help or hurt in the real estate market.

Local Picture

My local market has reflected somewhat the national picture, with some tweaks.  We were a little late into the downturn, and a little late out.  Less severe down, and steady up.  We’ve seen a below-average jobless rate due to the growth of several of our employment sectors.  We are a highly educated market.  With large government, university/research, healthcare, and tech sectors.   People continue to move here rapidly.  The weather, availability of jobs, and pace/quality of life seems be hitting the mark.

Steady growth would be the overarching theme for this market over the last 2-3 decades.  And seems to have some decent runway yet left.  We don’t have the overbuilding problem of some of the larger metros.  It seems that whenever we get a little out over our skis, capital pulls back with concerns that we won’t absorb the product this time.  Which ironically is likely the reason that we usually absorb it.

Specific Asset Classes

Class A multifamily residential (apartments) have had a long bull market here (and nationally).  Rents have grown in a decade from just over $1 per sf per month to just under $2 per sf per month.  And during that time, cap rates have compressed from the 7-8% range (12-15x earnings multiple) to 5-5.5% range (18-20x multiple).  Rents/vacancy rates could have some softness over the next year due to a robust pipeline, but likely ok in the medium term.

Trends affecting this asset class is the continued desire to rent instead of own, and pay up to rent in a vibrant/urban area.  It seems like the multifamily party should end, or at least hit a bump, in the next year or 2 – but I’ve thought that for more than a couple of years so I don’t know everything.

Class A Office seems to be a little earlier in its cycle.  There was not much building until the last 2 years here.  Just absorbing existing space that was vacant.  We are seeing some pretty strong rent growth recently.  Office leases tend to be much longer than multifamily, so the rent growth sometimes takes a little longer to set it (which is why multi is a better inflation hedge).  Market-wide vacancy rates are in the mid teens, but nice product in good locations is much lower – mid to upper single digits, depending on how you measure.  Cap rates are in the mid 6 to lower 7 range.  There is more available capital needed during office ownership due to paying for upfits and leasing commissions when re-tenanting.

Trends affecting office are a continued densification across most tenant classes.  Open floor plans are changing a lot (think: techie offices with limited walled single offices and more shared/common space.  They are lowering the rentable space needed per employee while driving up parking demand.

Retail is starting to show signs of life after pretty weak showing since the recession.  There was some significant over-building here, including both malls & grocery anchored centers.  There is some growth of traditional strip grocery centers with all the single-family residential growth.  No malls on the horizon.  Continued & growing demand in some of the more urban/vibrant districts.  That growth is led by restaurants & service retail.  Rents vary widely depending on location, space layout/parking/visibility, tenant type, and credit worthiness.  Cap rates can vary a lot also – usually depending on how much of the income is from credit tenants.

The key to the retail market is having relationships with the tenants, and getting a lease with the appropriate anchor tenant.  This is the asset class with the highest barriers to entry for the “little-guy” real estate owner/developer, in my opinion.  And significant headwinds due to competition with internet sales.

This is getting a little long, so I’ll wrap it up soon…

Hotels have seen some strong growth recently, but seem ok in the right locations here due to job growth.   They have higher cap rates (lower multiples) because they tend to be very volatile.

Single family houses seem to be on a good trajectory.  Getting a bit hard to find land, so prices will continue to tick upward I’d think.  With all the job growth, we are seeing a lot of new product in the outlying areas.  Classic suburban sprawl.  Most people hate sprawl & McMansions in general, but have a hard time passing up that 2800+ sf house on a safe quarter acre, white fence optional.  So on & on it goes.   I think single family will do well here for a while.

I don’t really know anything about industrial.  I have heard it is a good space fundamentally here, but a relatively small market.

The Wrap

They key above all else is to make sure you are in a growing market with a solid foundation.  Winning in real estate is incomparably easier while the market tides are rising.

You don’t need to be able to write a textbook to invest in real estate.  In fact, it is really easy to buy a single family house and rent it.  I don’t suggest you lose yourself in analysis.  But some houses and neighborhoods make much better rentals than others – you should understand the difference.  Knowing when & where to buy is key in real estate; a lot of money is made/lost on the buy side.

Real estate is a supremely inefficient market.  Don’t bring your Random Walk Theory ’round here.  Do yourself a favor and get to know the market before placing your bet.  Your returns will be a lot better.

 

4 thoughts on “Real Estate Market Fundamentals

  1. “But some houses and neighborhoods make much better rentals than others – you should understand the difference. Knowing when & where to buy is key in real estate; a lot of money is made/lost on the buy side.+
    Do yourself a favor and get to know the market before placing your bet. Your returns will be a lot better.”

    AGREED! Never buy something because it is cheap and the numbers work out. Location is everything. When the market slows, guess which ones are tougher to sell? Just like stocks, when the markets hit a bit of decline – the weaker stocks go down super fast. You make your money when you buy and when you sell:) Great post!

    1. Thanks, glad you liked the post. Higher quality locations do seem to have a bit less volatility. Hopefully that will be true in the future.

  2. Great recap. I think values are headed down, as the jobs being created are at lower wages. Lower wages mean less rents and lower prices.

    The upcoming demographics suggest even lower income households.

    1. Interesting perspective. I assume you mean national values, and single family? What are you doing to hedge yourself?

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