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Why CRE Prices Increase After Supply Exceeds Demand

If there's more supply than demand, why do rents continue to climb?

Supply and demand are the ever-locked dance partners that swing to the music of space and capital markets. In commercial real estate, this means the dance is ultimately between commercial space and commercial users of that space. We could go into an entire couple of books on the economic drivers behind the supply and demand equilibrium, but let's focus on the interaction between the two and what that means for pricing in both terms of leasing and sales.

Each quarter Dr. Glenn Mueller, from the University of Denver, publishes the "Real Estate Market Cycle Monitor" which outlines where different asset types are in the market cycle for 54 MSA's (Metropolitan Statistical Areas) around the country. Each report is applied to a graphic shown below that gives a visual into how markets move through the economic cycle.

The graphic is broken down into four quadrants split between two axis, the "x" axis showing long-term occupancy average for that particular market, and the "y" representing the supply/demand equilibrium. It's important to note here that even though there is a point (#11) that shows a supply/demand balance, in reality this can never be achieved mostly due to lag times in new construction, but a variety of other reasons as well. I would like to focus on the third quadrant titled "Hypersupply", which is described as "rent growth positive, but declining." Economic theory holds that if supply outweighs demand, prices should decline in response. Yet in commercial real estate, it can take sometimes months or even years for pricing to decline, even while supply outweighs demand. Why is that?

There are a couple of reasons for this: (1) pricing is based upon anticipated future rents, and (2) pricing changes move very slowly in commercial real estate.

If the pricing is going up, we tend to feel as though it will continue that trajectory, as well as the inverse being true. As leases and contracts are executed, it is usually based upon the premise that momentum will continue in a certain direction, despite market fundamentals showing otherwise. Landlords want to capture the momentum of the markets, and tenants want to lock in pricing before it goes up further. This trend is slow to reverse.

This leads us to the second point in why pricing changes don't occur quicker past the equilibrium and that's based upon three variables including poor information, long-term rental contracts that don't allow for quick adjustments, and long construction lags forcing slow supply indicators. Information in real estate is notoriously bad. Unlike equity markets where pricing is easily obtained, details and pricing in rental contracts are often kept confidential leading to more speculation than facts. Also, by the time rental pricing can be obtained, the information can be months or years old. Rental contracts for most asset types (excluding hospitality) are typically long-term, meaning that as markets shift, tenants and landlords are still locked in contracts based upon pricing from years past, slowing the chance for swift adjustments. Lastly, construction typically lasts for years which also slows the response for supply constrained adjustments to pricing.

Commercial real estate is an illiquid asset that doesn't move quickly to supply and demand shocks and is in a constant state of disequilibrium. If the stock market is a sports car, the CRE market is a big rig with 18 flat tires. Of course this is part of the beauty of real estate in that it doesn't have a knee jerk reaction to capital and space markets that can occur in equities. The real key for investors is to understand the supply and demand balance and anticipate changes in future rents and pricing to get ahead of it.

About the author:

Michael Hironimus, CCIM is the Certified Investment Advisor and Principal Broker for Duckridge Realty specializing in commercial real estate investment portfolios for high net worth clients and institutions, focusing on market, financial and risk analysis. He is also a faculty instructor for the CCIM Institute, teaching professionals globally in the CI-102 Market Analysis Core Course.

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