Transcript Chapter 5

Chapter 5 Property Cycles
Property Development (6th Edition)
Publisher: Routledge www.routledge.com
Authors: Professor R.G. Reed and Dr S. Sims
5.1 INTRODUCTION
• There are no disagreements that property cycles exist, however they receive
relatively little attention in the property profession.
• A developer who understands the nature of the property cycle is able to plan
a project ensuring (as much as is possible) that it is completed and released
into the market at the best possible time, further reducing the risk and
maximising the return on the development.
• A smart developer will also carry out his own research to establish the
impacts of the cycle on their business and adjust their development strategy
accordingly.
• Understanding property cycles will assist a developer to minimise their
exposure to risk and maximise the likelihood of success.
5.2 THE EXISTENCE OF PROPERTY CYCLES
• At a starting point, property cycles can be defined as: ‘Processes which repeat
themselves in regular fashion’.
• Predicting the timing and magnitude of these rises and falls in the
marketplace has never been achieved to absolute perfection in any property
market throughout the world.
• The perfectly symmetrical example of a cycle in Figure 5.1 is unrealistic.
Amplitude of Cycle
Figure 5.1 Characteristics of a Typical Cycle Phase
+
Time
–
Length of each Cycle
5.2 THE EXISTENCE OF PROPERTY CYCLES
Property market characteristics which contribute to property cycle behaviour
include:
• Limited availability of reliable property data
• A time lag between the purchaser–seller transaction occurring and the
release of this information into the public domain
• The unique nature of each parcel of land and also each building
• Property and real estate is a large ‘lumpy’ asset
• The highest and best use of land is constantly changing
• Land is physically only in one location and can’t be moved
• Most investment in property is by individuals who infrequently trade.
5.3 TYPES OF PROPERTY CYCLES
•
Each property developer needs to conduct their own research into each individual
market to identify the length and amplitude of the cycles in their prevailing
market area (Figure 5.2). A generic property cycle does not exist.
(a) Short-Term Cycles
• Commonly accredited to Clement Juglar (1819–1905), these short-term cycles
refer to a period of between 7 to 11 years and were based on historical financial
information. Also known as the fixed investment cycle.
(b) Medium-Term Cycles
• Brought to prominence by Kuznet, the medium-term cycle is typically over a
period of 15 to 25 years.
(c) Long-Term Cycles
• With a complete cycle stretching over a period of approximately 45 to 60 years,
this theory was based on a number of ‘long waves’ where there was a series of
oscillations with an initial over-investment in capital.
(d) Extremely Long-Term Cycles
• This cycle is based on international relations and refers to four generations over a
period of 100–120 years (Modelski 1987). Significant events include the timing of
global wars and variations in the balance of global power.
Figure 5.2 Multiple Cycles in a Single Market
Time
5.4 BUSINESS CYCLES AND STRUCTURAL CHANGE
• As many property developments and investments are closely linked to the
economic and business frameworks, there is usually a relationship between
property cycles and business cycles.
• This relationship is highlighted in Figure 5.3 where there is a clear relationship
between (a) the property market, (b) the over-arching ‘real economy’ and (c)
financial markets or the ‘model economy’.
• The interaction of the short-run business cycle with property cycles creates
great variability in a developer’s plans and the ability to progress schemes at
different times.
• The developer also needs to be responsive to the more evolutionary changes
which occur in occupier preferences as a result of long-term changes in the
structure of the economy.
Figure 5.3 Property Market, Financial and Economic Framework
Real Economy
Real Estate Market
Economic upturn
Money Economy
Credit expansion
Increased real estate demand
Supply shortage
Rising rents/lower yields
Economic boom
Building boom
Economic down turn
Increased supply
Lower demand
Credit boom
Increasing interest rates
Rising rents/lower yields
Recession
Bottom of real estate market
Credit squeeze
5.4 BUSINESS CYCLES AND STRUCTURAL CHANGE
(a) The business cycle
• Research in the last decade or so has established the nature of the link
between the economic, or business, cycle and the property market. Useful
references on this complex topic include various papers on building cycles by
Richard Barras (for example see Barras 1994).
• Three important cycles have been identified, all of which exhibit different
periodicity: the business cycle (which drives the occupier market), the credit
cycle (which influences bank and institutional funding) and the property
development cycle itself.
(b) Structural change
• Underlying the short-term business cycle are longer-term shifts in occupier
requirements which result from structural changes in the economy.
• Developers (and investors) who monitor these long-term changes can begin to
create new types of product ahead of the rest of the market; equally they can
avoid being left with buildings which have a diminishing ‘shelf life’.
5.5 SURVIVING A MARKET DOWNTURN
• Since the market constantly fluctuates in cycles, the central question to be
asked is not if a market downturn will occur, but when will this downturn
actually occur?
• The inevitable downturn tests the survival skills of real estate developers with
little or no cash inflow whilst somehow managing to keep on top of their
existing repayment liabilities.
• The lack of cashflow usually forces a property developer to downsize or cease
operations with a loss of goodwill.
• The cyclical nature of real estate markets can have a positive or negative
effect on the operation of a real estate developer.
• As observed in Figure 5.4 the optimal scenario for a property developer is
when supply equals demand, i.e. avoiding an under-supply or over-supply
relationship.
• The model in Figure 5.5 highlights that an external structural change (e.g.
higher or lower lending interest rate as set by the government) can affect the
real estate market and also affect the level of market demand.
Figure 5.4 Equilibrium in a Real Estate Market
Figure 5.5 External Shift in Demand for Real Estate
5.5 SURVIVING A MARKET DOWNTURN
• After there is a downward shift in the demand curve (Figure 5.5), this then
creates the over-supply scenario in Figure 5.6 where this is a clear gap
between the original Q(0) and the new Q(1).
• At the same time there is a decrease in the agreed sale price of each lot,
down from the original P(0) to a lower P(1). In order to return towards
equilibrium there are only two realistic options, these being either to (a)
increase demand or (b) decrease supply.
• Since the real estate market is lumpy and not able to quickly reduce supply
(i.e. it may take years), the property developer must be able to survive a
sustained long-term period of depressed prices until the market recovers to a
supply equals (or is less than) demand scenario.
• Every successful property developer has a formal plan for surviving a major
market downturn and prospering on the other side of the cycle during the
upturn.
• A successful real estate developer would argue the most important three
words are actually ‘timing, timing, timing’.
Figure 5.6 Over-supply Scenario due to Lower Demand
Chapter 5 Property Cycles
Property Development (6th Edition)
Publisher: Routledge www.routledge.com
Authors: Professor R.G. Reed and Dr S. Sims