Where are we in the real estate cycle?

Investors are still worried about finding an answer if markets have bottomed out and if it is already the right moment to invest in real estate in the United States. How do you find out if prices will not start slipping again amidst glooming unemployment news, and where to invest? Is it only about location, or are there certain real estate products which will recover faster and sooner than others?

All justified questions that, even for a savvy and seasoned real estate expert, are a challenge. In such a difficult investment climate, it is important to focus on key drivers of an industry. Real estate has always worked in cycles. The rational for this is very simple. Supply can never be too quickly satisfied as demand surges. Real estate development is determined by long lead times until finally the product reaches its final customer. By then market could have already changed. So in real estate, due to its “none-just-in-time-manufacturing characteristic,” we will never find the ideal demand and supply equilibrium.  Therefore investors will always need to look where we are currently in the cycle.

Of course price is a significant factor in determining a good or bad investment. But how do we know if we are buying at the right price. Therefore it is important to understand the principle equation in real estate: Land Value = Value of property – Cost of Development – Developer Profit. The concept of Land value is based on the idea of calculation a residual value. In 2004 we have seen outrageous prices for property and land and during the last three years those have fallen to levels last seen a decade ago. However, construction cost or generally replacement cost did not equally dip.

This leads in some cases to the phenomena of a negative land value as seen in areas such as Florida, Nevada and California. In a capitalistic system a negative land value will not sustain with one exception: Negative Demographic growth. In such cases as seen in Detroit for many years property values will remain shattered.

So we can currently determine a good price for a property if the purchase price is less than replacement costs, a positive growth of population and ideally a low unemployment rate. Interestingly, South East Florida offers those ingredients. Prices are at record low levels for ages, population growth is healthy and unemployment rates have constantly decreased throughout the last months. This trend has been confirmed by the constant capital influx to the Greater Miami area from foreign investors, which leaves us with the question “which real estate product to invest in.”

Therefore, it is important to understand the correlation of unemployment and demand of space. Office and retail space have the strongest correlation with unemployment rates, since a drop in employment immediately results in lesser need of space for offices and less consumption which in return reduces the need of retail space. For residential space this works differently. People need shelter and start to rent opposite than buying. This drives up rents as currently seen in many regions, especially in Fort Lauderdale. Higher rents once again open up opportunities for developers, since sudden market prices jump over replacement costs. In addition, the lack of new rental products during the last 3-4 years pushes rents upwards. As a summary, investments in rental apartments, existing or new developments is, right now, a great opportunity.