Thousands of years ago, our ancestors believed that weather was random or driven by the gods. Today, meteorologists can predict hurricanes and droughts, based on their understanding of multiyear cycles like El Niño.

 

Similarly, most people believe that commercial real estate booms and busts are completely random. But, this decade has seen a revolution in the understanding of commercial real estate cycles, and a huge leap forward in accuracy. It's now common knowledge that cycles exist and are predictable.

 

Back in 1930, the economist Homer Hoyt discovered recurring pricing cycles in real estate data. Many researchers built on this, including Fred Foldvary, who predicted the 2008 crash, back in 1997.

 

Then in the mid-90s, Dr. Glenn Mueller started research that would ultimately lead to identifying and isolating the twin cycles that drive real estate: the physical and financial cycles. This insight enabled detailed forecasting of the two components of every real estate investment (rental income and price appreciation), for the first time. This concept quickly became an industry standard and earned Mueller the prestigious Richard Radcliffe Award for groundbreaking research by the American Real Estate Society in 2010.

 

So it’s a treat and an honor to introduce my guest today: Dr. Glenn Mueller. Over 30 years, he’s published 95 articles in academic and industry publications, including 14 on real estate cycles and 33 on investment strategies and portfolio allocation. He’s currently a professor at the Denver University Burns School of Real Estate and Construction Management, and a visiting professor at Harvard University. Additionally, he publishes the eagerly followed Dividend Capital Research “Cycle Monitor”, which is a free quarterly report on the physical cycle position of major commercial property types in more than 50 metro areas.

                                        

The Real Estate Crowd Funding Review (RCFR):    In 2010 you were awarded the Richard Ratcliff award by the American Real Estate Society. This is a very selective award and only awarded for groundbreaking research that introduces a new paradigm and pushes the boundaries of real estate knowledge.  What was the new paradigm you introduced, and why was it useful for investors?

 

Mueller:   I separated the physical cycle from the financial cycle which was the ground breaking concept that is now commonly accepted in the marketplace.

 

The physical cycle is the interaction of demand and supply that drives occupancies that affect rents (the income producing portion of real estate returns). It’s very local in nature as well as property specific.  The financial cycle is made up of the capital flows to real estate that affects real estate transaction prices. The financial cycle is much more national in nature.

 

What I did was separate those from the total return, which is income and price appreciation. For example: If I got a lot of buyers, even if income isn’t going up, prices could go up and they could be connected together. But sometimes they disconnect which they did in the 1980’s. 

 

RCFR:  Before you did this, did forecasters simply combine the two together and produce less accurate forecasts?

 

Mueller: Correct. Or they made no forecasts at all.

 

RCFR:  Speaking of forecasts: Every quarter, you put out a one year look ahead forecast about the physical cycle, which addresses occupancy (and thus rental income). How accurate has it been? For example, were you actually able to predict the rental drops that occurred at the start of the Great Recession, a year in advance?

 

Mueller: Yes I did.

 

RCFR: That’s very impressive. How exactly does the model of the physical cycle work?

 

Mueller:  Real estate markets are cyclical due to the lagged relationship between demand and supply for physical space. The long-term occupancy average is different for each market and each property type. Long-term occupancy average is a key factor in determining rental growth rates — a key factor that affects real estate returns. There are four phases in the physical cycle: recovery, expansion, hyper supply, and recession.

The cycle monitor analyzes occupancy movements in five property types in more than 50 Metropolitan Statistical Areas (MSAs).
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supply is pretty easy to predict. Demand comes from forecast employment growth which is harder because the raw data is never very accurate. On the demand side, we look at employment growth on a city by city basis to see how things are going.  If you have a city with no employment growth, there's very little or no demand growth for real estate.  If there is a demand for real estate then occupancy should rise and rents rise. More people renting pushes rents up.

 

But on the other side there’s supply. If there is no new supply, then the market is going to get tighter and the rents are going to go up even faster. But if there is some supply growth (employment is growing at 2% and supply is growing at 1%) then great and the market is tightening up. But if there is too much supply (which happened in the 1980’s where we had employment going up by 3.8%, but supply was going up an average of 7.7% a year), the market is putting out more supply than is needed. Then occupancy drops and therefore landlords have to drop their rents to attract tenants.

 

(Editor’s note: for more details on the physical and financial cycles, as well as how to use them in your own investments, see our cycle tutorials, which include information from Dr. Mueller’s models).

 

More on the physical cycle

There's more to the physical cycle that's important to your investments. Learn more in part 2.