Testimony of
Glenn R. Mueller, Ph.D.
Before the
Subcommittee on Financial Institutions and Consumer
Credit
Of the
Committee on Financial Services
United States House of Representatives
September 14, 2006
Real Estate Space Market Cycles
By Glenn R. Mueller, Ph.D.
Professor - University of Denver
Franklin L. Burns School of Real Estate & Construction Management
&
Real Estate Investment Strategist - Dividend Capital Group, Inc.
Key Points
• The proposed banking agency guidance on commercial real estate lending concentrations appears to be predicated
on fundamental misconceptions of how the commercial real estate market functions today.
• Today’s commercial real estate market is very different from the one that existed in the late 1980s and early 1990s.
For example, the commercial real estate markets and their cycles are much more transparent today than they were a
decade ago. This increased market transparency should make future real estate cycles longer and less volatile.
• The proposed guidance also appears to be based on the faulty premise that all types of commercial real estate move
in the same cycle and that the residential real estate market and commercial real estate market are closely
correlated.
• Real estate space market cycles are different for each metropolitan area and for each major property type (Office,
Warehouse, Retail, Apartment and Hotel). Thus, the Chicago office market and the Chicago retail market can be in
very different places; and the Chicago retail market can be at a different point in its cycle than the Miami or New
York retail market. Space market cycles depend upon local economics of supply and demand.
• The real estate asset class has two major groups – Residential (home ownership) real estate and commercial (income
producing) real estate such as Office, Warehouse (industrial), Retail, Apartment and Hotel.
• Residential Ownership (housing) is not connected or correlated with commercial income producing real estate.
• Residential real estate markets and commercial real estate markets are fundamentally different. Residential real
estate is a production process that counts on consumers to purchase newly built and existing inventory. Commercial
real estate is an investment process that rents properties to businesses and consumers. New commercial properties
are owned by investors and only built when there is sufficient new demand.
• Banks that lend for new residential construction take a risk of unsold inventory. Banks that lend for new
construction of commercial real estate require that a take-out permanent mortgage be in place (reducing the pay-off
risk) and banks that lend on permanent commercial mortgages require the property be pre-leased to provide cash
flow to pay mortgage payments (reducing default risk).
• The space market cycle of the 1970s was 10 years long, the next cycle was 21 years long (1979 to 2000) and the
future space cycle is expected to be longer and less volatile due to fundamental changes that have taken place in the
commercial real estate market place.
• The current commercial space market cycle declined from 2000 to 2003 and hit an occupancy bottom in 2003. Price
declines and loan defaults did not happen in this down cycle like they did in 1990. The space market cycle is still in
the recovery phase for most property sectors today with a peak expected after 2010.
• The growth phase of this cycle should start in 2008 for most property types although retail is already in a growth
phase.
• The space market cycle is local in nature, driven by local employers (demand) and builders (supply).
• Demand and Supply drive occupancy rates which drive rental growth.
• Occupancies and Rents drive earnings which pay mortgage payments.
2
• The severe downturn that occurred in the commercial real estate market during the late 1980s and early 1990s was
triggered by factors that are not present in today's environment, such as (i) changes to the Internal Revenue Code in
the 1980s that encouraged people to make investments in tax shelter commercial real estate that were not based on
the underlying profitability of the project, and (ii) the expansion of lending powers of thrifts that allowed them to
make commercial real estate loans for the first time, and thus introduced numerous inexperienced lenders into the
market. These factors led to overbuilding.
• The potentiality for a commercial real estate bubble has significantly decreased because of the introduction of Public
Market Capital from Real Estate Investment Trusts (REITs) and Commercial Mortgage Backed Securities (CMBS).
This introduction of public capital has changed the dynamics of the space market cycle.
• Real Estate Space Markets can move differently from Real Estate Capital Markets.
Purpose of This Written Testimony
Earlier this year, the federal banking agencies issued proposed guidance entitled “Concentrations in Commercial Real Estate
Lending, Sound Risk Management Practices” (the “Guidance”). The proposed Guidance sets forth certain thresholds for
assessing whether an institution has commercial real estate loan concentrations that would trigger heightened risk
management practices and potentially higher capital requirements. After analyzing the proposed Guidance, it appears that it
is predicated on fundamental misconceptions of how the commercial real estate market functions today. These
misconceptions seem to be based on the assumption that this market has not witnessed fundamental changes over the last
two decades. Simply stated, today’s commercial real estate market is very different from the one that existed in the late
1980’s and early 1990’s. For example, the commercial real estate markets and their cycles are much more transparent
today than they were a decade ago. This increased transparency allows investors, developers and lenders to react much
more quickly to market risks and substantially reduces the potential for overbuilding. This increased market transparency
should make future real estate cycles longer and less volatile.
Another misconception underlying the proposed Guidance is the apparent belief by the banking agencies that all types of
commercial real estate (Office, Warehouse, Retail, Apartment and Hotel) move in the same cycle and, thus, bear the same
risk. This is simply not true. Commercial real estate cycles are different for each metropolitan area and for each major
property type. This is shown in the attached Market Cycle report (Appendix A). The Guidance’s one-size-fits-all approach
does not take into account diversification by geography and product type.
The definition of commercial real estate in the proposed Guidance also appears to be based on the misconception that the
residential real estate market and commercial real estate market are correlated to such an extent that certain types of
residential loans should be included within the definition of commercial real estate for purposes of the proposed Guidance.
This is a faulty premise because the commercial real estate market and the residential real estate market are fundamentally
different.
Commercial real estate is a necessary and important part of economic growth. In order to avoid any potential unintended
consequences, the bank regulatory approach to commercial real estate lending must be predicated on an accurate
understanding of today’s commercial real estate market environment. The purpose of this written testimony is to set forth
the changes that have occurred in the commercial real estate market over the last two decades in order to address the
misconceptions upon which the proposed Guidance appears to be based.
3
Real Estate Space Market Cycles
Introduction
Many economists consider commercial real estate cycles to be a mirror reflection of the economy. As one of the three major
factors of production (land, labor and capital) demand for commercial real estate is a necessary and important part of
economic growth. As the population of the world grows, these additional people need a place to work, sleep, eat, shop and
be entertained which constantly increases the amount of space needed. Many consider commercial real estate a cyclical
industry because its demand side is affected by economic cycles and supply historically lags demand.
Historically, the delivery of real estate space to meet the world's needs has been “lumpy”. Too little space is available
during times of rapid growth and once development production has geared up too much supply continues to be produced
even after demand has slowed. This lag between demand growth and supply response has been a major cause of volatility in
real estate cycles, after the effect of economic cycles. The ability to control space production is one key to less volatile real
estate cycles in the future. This testimony explains the fundamental reasons for historic movements in the office space
market demand and supply, and then attempts to project the demand and supply variables for the next cycle. While
estimating the space market building cycle is relatively straightforward with much data available for both the demand and
supply variables, projecting the capital cycle is much more difficult, as other investment markets (stocks, bonds and
international investments) must be considered because they compete for investor’s dollars.
Commercial vs. Residential
Please note that this testimony is focused on commercial (for rent) real estate markets and NOT residential (for sale) home
ownership markets. Residential (for sale) home ownership markets are a production process, where new inventory is
produced for consumers with the assumption that they can afford to purchase and will purchase homes. Residential
construction lending has higher risks as unsold homes do not produce cash flow to make mortgage payments. (This does
NOT include apartments.) Commercial (for rent) real estate monitors the occupancy levels and rents of existing properties
as well as new construction added to the existing supply and examines it against the existing business tenants who rent
properties and new tenants who may come into the market. Historically the residential and commercial markets have had
very different cycles and thus very different value changes and/or problems.
Space Market Cycle Fundamentals
The “space market” cycle is the demand and supply for space, which is very local in nature. Demand for space is a
function of the number of people who need space to live and businesses that need space to conduct their business. The
amount of space used is a function of both the need for space and the price of that space. The supply of space is a function
of existing space, space under construction, and future demand for space. Rent is a function of the current space available
(occupancy level) and the future expected space available.
The cost to purchase or construct space must provide an economic return for the investor. Most researchers have found that
rents are a function of the amount of demand and supply at any given point in time. The interplay between demand and
supply is easily described in terms of occupancy (or vacancy), which has a high correlation with rent levels. The supply and
demand for space is also property specific. Demand and supply for office space does not affect the demand or supply for
retail, warehouse, hotel or apartment space. Thus an investor or lender who diversifies their portfolio by both property type
and market can lower their risks substantially. This analysis uses the historic office markets as an illustration, but similar
cycles appear in the other four major property types including warehouse, retail, apartment and hotel. The current positions
of the 5 major property types and the 50+ major metropolitan areas can be seen in the Market Cycle Report attached as
Appendix A.
The 1970s Cycle
Demand: The 1960s had average annual overall office employment growth of 3.2% for the decade which produced strong
demand for office real estate into the late 1960s. The first half of the 1970s produced only 1.8% average annual office
employment growth, partially due to a recession in 1974 and office demand increased by only 1.7% in the early 1970s. The
second half of the 1970s produced strong economic growth (GDP) from the baby boom generation coming of age and
entering the work force with overall employment growth averaging 3.2% per year again. Office demand growth averaged
3.8% per year (faster than overall employment) during the second half of the 1970s as the information age began and the
middle management ranks, who analyzed more data for companies, expanded. (Exhibit 1) Several office markets had sharp
office demand growth from industry specific employment factors such as the oil boom in Denver, Dallas and Houston.
Supply: The early 1970s were characterized by a construction boom that was fueled by increased capital flows to real estate.
Major new capital sources were available as mortgage REITs were created by commercial banks that allowed them to
bypass their regulatory restrictions on how much and how many real estate projects they could lend to. The first half of the
4
1970s saw total office space construction increase by an average 5.6% per year. The recession of 1974 slowed GDP and
employment growth, and the office markets down-cycled and crashed in 1974 and 1975. Many construction loans defaulted
and never converted to permanent loan status. New “empty buildings” were foreclosed upon and held by mortgage REITs
whose stock values plummeted from a peak NAREIT Index of 112.39 in January 1973 to a low 39.09 in December 1974,
when the mortgage REITs could not make their dividend payments. The REIT industry, which had begun in 1960, grew to
around $10 billion in market capitalization and subsequently shrunk to $2 billion in 1975. The flow of capital to real estate
construction shut down and new space growth slowed to 1.5% in 1976 then recovered to a more moderate 3.2% average in
the second half of the 1970s.
The early 1970s period of overbuilding was initiated due to surprisingly strong demand growth in the late 1960s that
allowed the capital markets to “sell a story” about mortgage REITs to public investors. Oversupply pushed office
occupancies to a bottom in 1975 (Exhibit 5). After the crash, the public market branded mortgage REITs as “bad and high
risk” and this mortgage REIT branding still exists today in the minds of many investors.
Exhibit 1 shows the high rate of growth in supply and relatively low rate of growth in demand in the first half of the 1970s
causing a down cycle, while the second half was characterized by stronger demand growth than supply growth allowing
recovery and then expansion to take place.
Exhibit 1
1970s Office Demand & Supply
0%
2%
4%
6%
8%
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
Demand Supply
Oversupply Years Baby Boomers Go To Work
Source: FW Dodge, CB Commercial, BLS, Mueller
The 1980s Cycle
Demand: The U.S. began to move into the information age in the late 1970s and economic prosperity coupled with very
strong white-collar employment growth from the baby boom generation helped create a 4.7% annual average GDP growth
rate for the decade. A recession in 1981 was caused by high government debt pushing interest rates up to the high teens (10
year treasuries reached 15% in 1981) which caused construction spending and consumer spending to slow. After 1981
strong government spending, continued strong employment growth and the dawn of the personal computer age helped GDP
to maintain strong growth rates throughout the rest of the 1980s. Employment growth averaged 2.8% per year for the
decade while office demand grew an average yearly rate of 3.6% for the decade.
Supply: Real estate was a private marketplace in the 1980s, with little information available about construction starts versus
future demand. In addition, thrifts were allowed to lend on commercial real estate where they had no previous experience.
There were few researchers or national level data sources at the beginning of the decade and only a handful at the end of the
decade. Data was provided by commercial brokers whose motivation was to close deals. Computers made 10 year
investment projections a new way of life, but the standard occupancy assumption was 95% for each year going forward even
when many market occupancy rates were declining. Supply was growing at an average 7.7% per year during the decade
which was double demand growth, thus the occupancy rate was declining yearly. (Exhibit 5). The tax act of 1981 created
more capital flow to real estate for tax shelters and thus more construction of tax driven (non-economic) real estate deals.
5
1982 was the peak construction year with an almost 10% growth in new supply. The few warnings by researchers about
oversupply were not heeded. The tax act of 1986 did slow building, but not enough to bring supply growth back in line with
demand growth (Exhibit 2).
This overbuilding was also driven by the search for higher returns by the capital markets. The first half of the 1980s
produced a stock market return of almost zero and investors needed alternatives. Using their rear view mirrors, investors
bought real estate as an inflation hedge and diversifier for their portfolios. With a track record that started in the early
1970s, pension fund investors saw historic real estate returns as a good alternative for diversifying their portfolios. The
introduction of the NCREIF index in 1978 gave pension funds a benchmark to analyze real estate returns and more
confidence to invest larger amounts. In addition, foreign investors saw U.S. real estate as a safe haven for their money and
in the late 1980s the Japanese saw U.S. real estate as a much higher yield investment than their 3% real estate returns at
home. This kept real estate prices rising and new construction coming, even though the occupancy rates continuously
declined from 1979 through 1990. The construction boom did not stop until 1990 when the next buyer was not willing to
pay a higher price for an empty office building and real estate prices finally crashed. Individuals, followed by pension
funds, followed by foreign investors all had good “comparative” historic reasons to purchase real estate instead of stocks
and bonds. Even the 1986 tax act (which took away the individual investor tax incentives) did not shut down commercial
real estate investing and construction, as tax exempt pension funds and foreign investors kept on supplying capital to the
office market. (Smith et al, 2000)
Shortages of office space in 1979 and 1980 and the ease of suburban office construction allowed for massive amounts of
new speculative office construction in the 1980s. In addition, prosperous companies were building trophy downtown office
buildings to show off their success and developers had no problem finding capital to put up speculative buildings to sell to
investors. (Gilberto, 1992) Exhibit 2 shows the strong supply growth throughout the 1980s.
Exhibit 2
1980s Office Demand & Supply
0%
2%
4%
6%
8%
10%
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
Demand Supply
Oversupply Years
Source: FW Dodge, CB Commercial, BLS, Mueller
The 1990s cycle
Demand: Office demand growth was relatively stable in the 1990s at an average growth of 1.9% per year with the only year
below 1.5% being 1991, due to a mild recession. Office demand growth rose at over 2% from 1997 to 1999. The steady
expansion of the economy with GDP growth averaging 3.1% per year in the 1990s is more moderate than previous decades,
but much less volatile.
Supply: While both 1970 and 1980 saw real estate start the decade near a peak, 1990 saw the real estate cycle start at a
bottom. Overbuilding in the late 1980s caused the worst vacancy in office space (over 20%) since the great depression and
a mild recession in 1991 further reduced demand. It took until the mid-1990s for office markets to recover, on average,
across the U.S. and the growth phase of the cycle did not begin until the second half of the 1990s. Little new construction
6
took place in the first half of the decade with supply growth averaging 0.6% per year, as the excess space built in the 1980s
was being absorbed. Supply growth averaged only 1.3% for the second half of the 1990s, allowing occupancy to improve.
Both 1998 and 1999 were years when demand and supply grew at similar rates, creating a balanced growth in the market.
Rents improved throughout the second half of the 1990s as a result.
Bank and thrift failures in the late 1980s and early 1990s caused the government to create the Resolution Trust Corporation
(RTC) to dispose of their bad loans and the commercial mortgage backed securities (CMBS) market was born. Developers
who did have economic projects to build in other property types besides office could not find debt financing, so they turned
to the public capital markets. The equity REIT market re-emerged in 1992 as a capital source for real estate. As the real
estate markets improved, pension fund investors cautiously returned to the market and many tested the venture capital
investment potential of real estate. With new technologies, public market investment and renewed but cautious interest from
pension funds, data on real estate market activities became available during the 1990s and independent real estate research
departments at investment firms became a standard for improved underwriting. Prudential Insurance, then Equitable
Insurance, then most pension fund advisors established research departments by the mid-1990s with the head researcher
having a PhD. Then the REIT boom of 1992 to 1997 caused every major investment bank on Wall Street to develop a REIT
research team. The potential for overbuilding was reduced substantially as the research data from such companies as Torto
Wheaton Research, FW Dodge, REIT Reports and Co-Star became available and real estate market watchdogs were ready to
“blow the whistle” at the first sign of trouble. The higher information efficiency of the public markets and more freely
available information has caused the feedback loop between supply and demand to become shorter. Real Estate capital
providers now see problems within months instead of over a year and the public market capital is always trying to predict
when to stop supplying funds to new and existing properties. 1998 and 1999 saw office demand and supply virtually match
each other. (Exhibit 3) The Real Estate markets ended the 20
th
century in the healthiest cycle position since 1979.
Prior physical cycles indicate that when the U.S. economy grows rapidly, office development follows with a lag, and then
supply tends to overshoot actual demand when completed buildings come on line. It was overly optimistic demand
projections that created large amounts of oversupply in the last two historic cycles.
Exhibit 3
1990s Office Demand & Supply
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
Demand Supply
Oversupply Absorbed
Demand Supply
Matched
Source: FW Dodge, CB Commercial, BLS, Mueller
The 2000s cycle
Demand: The first decade in the new millennium began with office occupancies hitting their peak in the fourth quarter of
2000. Unfortunately office demand in 1999 and 2000 were higher than the long term U.S. trend, due to the growth of the
technology industry. The speculative bubble in the stock market gave capital to tech companies who grew quickly, causing
them to hire more employees and project their future space demands at unrealistic levels. The U.S. ended a long economic
7
expansion in 2001 after the tech bubble burst. Annual office employment declined for the first time by over -1% in 2001,
while office demand (absorption) declined by over -2% as firms with excess space put that space on the sub-lease market in
an attempt to rent unused space to other users and reduce their costs. This demand driven downturn was different from the
supply driven down cycles of the 1970s and 1980s creating a new challenge for researchers. National office employment
has always been positive in past cycles, while negative net absorption has been caused by too much supply. Office supply
did react quickly, declining to very low levels and allowing the market to bottom quickly and begin a recovery in 2003.
Office employment has grown from 2002 to 2006 and is expected to grow over the next decade. Some of the major reasons
for this continued growth include increasing demand from a globalized economy, continued technology revolution, and long
term population growth. Population growth at just under 1% per year on a 300 million U.S. base translates into 2.5 million
new people per year in the U.S., each year, for the next ten years. These additional people (half immigrants and half new
births net of deaths) still need additional real estate to work in, shop at, sleep in, eat at, and play in. This means the U.S. will
need to build one complete new city like Denver, or Phoenix each year for the next 10 years to meet space demand. While
there may be small periods of recession, the long-term prospects are positive. In this cycle office employment increased by
only 1.2% in 2004 and 1.4% in 2005 with a 5 year forecast of 1.5% going forward. Overall office demand (absorption) is
expected to follow similar but slower growth rates of 1.3% over the second half of the 2000’s decade. (Exhibit 4) With a
flourishing economy, office demand growth is expected to average around 2% in the first half of the century.
Supply: Construction starts for office declined each year for the first half of the decade, declining each year to make up for
the negative demand in 2001. The supply forecast average for the second half of the 2000 decade is estimated to be only
1.3% allowing occupancies to improve. (Exhibit 4) There are three principal reasons for this forecast:
1 - Public Capital Markets
With public market monitoring, it will be much more difficult to justify new space without an analysis of existing
competitive construction and user demand for existing space. We have already seen the public capital market reaction to
potential excess supply in cities like Atlanta where many new office construction projects were stopped in 1998 when Wall
Street analysts downgraded REITs and Commercial Mortgage Backed Securities (CMBS) issues that were investing in the
Atlanta office and industrial markets. New office supply in Atlanta dropped from 6.4 million square feet in 1998 to 5.9
million square feet in 1999. One Atlanta-focused REIT, Weeks Corporation, experienced a 20% stock price decline when
news of Atlanta oversupply was revealed in the financial press. This monitoring by the capital markets let the Atlanta
market move back into balance within a year’s time, instead of going through an overbuilding boom bust cycle.
The information feedback loop that is now in place is much more likely to avoid large boom bust cycles in the future, as
supply will be constrained by the wider availability of market information. The REIT market saw prices fall in 1998 and
1999 when direct markets were good and the outlook was even better, because the public capital markets were more
attracted to high-tech stocks. On the other hand, the CMBS market brought more capital than traditional real estate debt
lenders and many feared it would support non-economic projects. But in mid-year 2000, the REIT market recovered as the
tech market fell and improved in both 2001 and 2002, showing that an earnings growth focus may be correct over the long
term after all. The CMBS market has performed well from 2000 through 2006 with a focus on pre-leasing and tenant credit
instead of property value.
2 - Construction Constraints
Constraints on building have increased over the past decades. The number of studies and approvals necessary for new
construction has tripled in cost and time, over the past two decades. Environmental impact studies, traffic impact studies,
storm water runoff management and other societal impacts must now be analyzed and mitigated before development
approvals are given. While F.W. Dodge economists and data providers wrote about this lengthening, they were not able to
prove it as the company only began keeping historic data in 1994, all previous data gathered was discarded on a regular
basis. The cost of construction labor and materials has increased at high rates and construction labor was the hardest labor
force in the country to find in 2000 and the first half of 2001. Therefore producing new supply takes longer and is more
expensive. Development is now much more difficult than it was in previous cycles due to the up-front costs mentioned
above. Many of the major developers have become long-term investors as well, by turning their companies into REITs.
Capital partners for developers are now much more sophisticated than they have been in the past, requiring feasibility
studies and pre-leasing prior to funding approval.
3 - Greater Transparency
The real estate markets and their cycles are much more transparent than they were a decade ago. In 1990 there were a few
small firms collecting market data on 20 to 30 MSAs and selling it to a few large institutional investors. Over the decade
more than 30 market research firms have been started and recently they have been consolidated into a few national firms
that cover as many as 60 major markets in the U.S. in the five major property types. The largest firms are F.W. Dodge
(who recently merged their data products with Torto Wheaton Research), Torto Wheaton Research (a Division of CB
8
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Demand Supply
Supply Reacted to Demand Slow Down
FORECAST
Demand 1.5%
Supply 1.3%
Richard Ellis), CoStar (a national commercial multi-list system that has gone public and purchased four other firms), Grubb
& Ellis, Property & Portfolio Research and REIS Reports. These firms provide general market information free to the
general public and detailed data and trends to paying clients. With this information the multitude of research groups at
private and public investment firms and banks are able to monitor the supply risks of each market and property type as well
as forecast future potential investment opportunities. The availability of this research has made the real estate capital supply
chain more efficient and less prone to making oversupply mistakes. Thus market transparency should make the next real
estate cycle longer and less volatile.
Exhibit 4
2000s US Office Demand & Supply
Source: FW Dodge, CB Commercial, BLS, PPR, Mueller
Space Market Conclusion
The real estate cycle of the new century has already proven to be different with its demand driven downturn, but surprisingly
quick reaction of supply to slow as well. This supply demand balancing should produce a longer and more moderate cycle
for commercial real estate in the future. Having more stable occupancy rates should also produce more moderate but stable
rental growth in the future. The 1980s real estate cycle was driven by oversupply that was partially due to the private nature
of real estate markets, the tax shelter driven investments and the lack of good data. The future real estate cycles should be
more moderate due to restricted supply conditions and more rational capital markets that are led by better information,
monitoring and feedback systems that come with public capital sources. Eventually this more efficient market may reduce
the ability to capture superior returns from better proprietary information and arbitrage investing, but the stability will create
less risk for investors and lenders. An increased length in the economic cycle should be reflected in the increased length of
the real estate space market cycles. If the U.S. and world economic expansions continue for the next decade, the U.S. real
estate cycle recovery that began after the 2003 cycle bottom should move into a growth phase in 2008 for all property types.
The cycles for each of the 5 major property types (office, warehouse, retail, apartment and hotel) will move differently – as
they have in the past. Each city will also move at different rates depending upon local demand and supply characteristics.
The quarterly Market Cycle Monitor
research report is attached as Appendix A and a literature review as Appendix B.
9
Source: CB Commercial, Census Bureau
Capital Market Cycles
Historic Cycle Summary
Capital Flows are the major factor affecting prices in real estate as well as all other investments. When capital flows in,
prices go up.
The capital market cycles show that the public market was first tapped in a large way by real estate in the
1970s with mortgage REITs but this was a disaster because mortgage REITs were externally advised by their sponsor banks
that did not care about the defaults in those portfolios as the bank’s money was not at risk.
In the 1980s, the private real estate capital markets, driven by tax shelter investors, then non-taxable pension funds, then
foreign investors created a long 10 year capital flow to real estate in the 1980s that created the largest overbuilding cycle
ever experienced in the U.S. When the private capital markets turned away from real estate in the 1990s, the public markets
were again accessed with new and improved REIT and CMBS vehicles that are still evolving. The 1990s were different
though, because more information became available and the public markets began anticipating problems and not just
reacting to them. This created a real estate market that maintained a balanced demand/supply growth in 1998, 1999 and
2000. There are many positives to the public capital markets including: access to public capital markets, better data, and
accountability. There are also negatives to public markets such as stock price volatility, and competition for capital with
other public market sectors (stocks and bonds). If economic and employment growth could be estimated accurately, there is
a strong chance that real estate markets could estimate demand better and fine tune new supply even further than what has
already been attained in the first half of the 2000’s. The capital markets certainly seem to be making this demand – supply
balancing act more accurate.
Capital cycles have historically lagged the space cycle. Capital flows continued to increase years after occupancies and
rents declined in the 1980s. But in the 1990s the public markets helped to remove some of that lagged relationship and the
physical and financial market cycles moved in sync when the downturn came in 2001. Exhibit 5 shows the historic
movement of the office physical market and the financial flows of new capital supplied to office space construction. The lag
in the early 1980s was about 6 years, but in 1991 the rebound only lagged by one year and in 2001 occupancy declines have
created an immediate decline in new construction permits, thus the two cycles were moving together in similar patterns.
Exhibit 5
National Office Physical Market Cycle
1972 1976 1980 1984 1988 1992 1996 2000 2004
Market Cycle Permit
Source: BEA, CB Commercial, Mueller
Capital flows are difficult to follow and even more difficult to predict as the whim of investors has not been captured in any
known statistic. Current efforts by the Homer Hoyt Institute to study capital flows are funding research, such as the Real
Estate Capital Flows Data Sources Project that can be found at www.Hoyt.org. The most notable and important source of
capital flows data now comes from Real Capital Analytics, a firm started in 2000. The debt side of real estate is
characterized here by commercial mortgage originations. Exhibit 6 shows the mortgage originations from 1970 through
2000. The late 1970s and early 1980s produced an average $5 billion in mortgage originations per quarter. In the second
half of the 1980s the origination level rose to a peak $25 billion in one quarter (that is 5 times the normal average) and
vs. Financial Cycle = New Permit Values
80
84
88
92
96
Occupancy
15,000
20,000
25,000
30,000
35,000
40,000
45,000
50,000
55,000
60,000
65,000
Value ($Mil)
Physical
Financial
6
y
e
a
r
l
a
g
No Lag
10
($
stayed above the $5 billion level through 1990. This oversupply of capital (the gray box) was one of the major factors in the
false price appreciation support for real estate. In the first half of the 1990s originations were negative (foreclosures) and in
the second half of the 1990s rates returned to the average $5 billion per quarter level. Also note that the quarterly amounts
in the 1990s are more volatile than the early 1980s as the public markets now play a major role in originations. The
question is – where will it go in the future?
Exhibit 6
Flow of Funds Commercial Mortgages
All Sectors (1976 - 2000)
25,000
20,000
15,000
10,000
5,000
0
-5,000
-10,000
Mils)
False Price
Appreciation
Support
?
1970Q1
1972Q1
1974Q1
1976Q1
1978Q1
1980Q1
1982Q1
1984Q1
1986Q1
1988Q1
1990Q1
1992Q1
1994Q1
1996Q1
1998Q1
2000Q1
Source: Federal Reserve
Future Capital Cycles
Now that the public markets have emerged, real estate finally has access to the five major sources of the capital markets
(public debt, private debt, public equity, private equity plus international capital). The new Public Capital sources
developed in the 1990s (REITs and CMBS) have different effects, most of which appear to be positive on real estate and
include better data, faster access to data, multiple monitoring and reporting sources, and better access to capital. This new
era of public markets access and research oversight provides a feedback loop that should provide more balanced long-term
capital flows as well as stability to the real estate markets. (REIT’s low prices in 1998 and 1999 helped real estate markets
avoid too much new development that would have been difficult to lease in 2001 and 2002.)
Conclusion
U.S. real estate capital markets have gone from being local in nature in the 1970s to national in nature in the 1980s to public
and global in nature in the 1990s. The changing nature of all capital markets due to globalization makes the real estate
capital markets more difficult to understand and predict. The poor performance of the stock and bond markets since 2000
has pushed much more capital toward real estate in the U.S. because real estate is now seen as a safer and more stable
investment (A physical asset that can not evaporate into cyber space). It is also possible that this extra capital flow has
moved U.S. capitalization rates (cash-on-cash return) from their historic 7% to 10% range down to the European range of
5% to 7% during the 2000s decade.
11
APPENDIX A
12
Cycle Monitor -Real Estate Market Cycles
Second Quarter 2006 Analysis
August 2006
Physical Market Cycle Analysis of All Five Major Property Types in More Than 50 MSAs.
Construction costs continue to rise placing a damper on new starts. Through June, composite construction costs were up more than 8% for all commercial
property types with plastic leading the way at 19%, copper at 14% and concrete at more than 11% year over year. This is very high compared to the
consumer price index (CPI) of 4.3% over 12 months. Single family housing starts in June were down 11% over the previous year.
Office market occupancy average improved another 0.3% in 2Q06 and we expect 3% - 4% rental growth.
Industrial occupancy improved 0.2% in 2Q06, and we expect 2.5% to 3% rental growth for the year.
Apartment occupancy improved 0.2% in 2Q06, and we expect 4% rental growth for the year.
Retail occupancy improved 0.2% in 2Q06 and we expect 2% - 3% rent growth for the year.
Hotel occupancies improved 0.3% in 21Q06 and we expect RevPAR to grow by more than 10% for the year.
The National Property Type Cycle Graph shows relative positions of most subproperty types — major markets are reviewed
inside.
National Property Type Cycle Locations
Phase II - Expansion Phase III-
Hypersupply
Retail 2nd –Tier Regional Malls
2nd Qtr 2006
LT Average Occupancy
11
146
7
8
9
10
12
13
1
16
5
4
3
2
1
Hotel - Ltd. Service
15
Hotel - Full-Service
Power Center Retail
Senior Housing
Factory Outlet Retail
Industrial – Warehouse+1
Industrial-R&D Flex
Health Facility
Apartment
Office – Downtown
Office – Suburban+1
Retail NH & Com
Retail –1st-Tier Regional Malls+2
Phase I - Recovery
Source: Mueller, 2006
Phase IV - Recession
Glenn R. Mueller, Ph.D. (303) 953-3872 gmueller@dividendcapital.com
Dividend Capital Group, 518 17
th
Street, 17
th
Floor, Denver, CO 80202
www.dividendcapital.com 866-324-7348
All relevant disclosures and certifications appear on page 9 of this report.
13
-
The cycle monitor analyzes occupancy movements in five property types in over 50 Metropolitan Statistical Areas
(MSAs). Market cycle analysis should enhance investment-decision capabilities for investors and operators. The
five property type cycle charts summarize almost 300 individual models that analyze occupancy levels and rental
growth rates to provide the foundation for long-term investment success. 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.
Market Cycle Quadrants
LT Occupancy Average
Declining Vacancy
New Construction
Declining Vacancy
No New Construction
Increasing Vacancy
New Construction
Increasing Vacancy
More Completions
Phase II - Expansion
Phase III-Hypersupply
Phase IV - Recession
Phase I - Recovery
Source: Mueller, Real Estate Finance, 1995
Rental growth rates can be characterized in different parts of the market cycle, as shown below.
Physical
Market Cycle
Characteristics
Negative
Rental
Growth
Below
Inflation
Rental
Growth
Rents Rise
Rapidly
Toward New
Construction
Levels
High Rent
Growth in
Tight Market
Demand/Supply
Equilibrium Point
Rent Growth
Positive But
Declining
Below
Inflation &
Negative
Rent
Growth
Cost-Feasible New
Construction Rents
LT Occupancy Average
Source: Mueller, Real Estate Finance, 1995
OFFICE
The U.S. office market occupancy average improved another 0.3% in 2Q06 but is still 2% below
the long-term average. Thus, it is still a tenant’s market when negotiating new leases. The
national average finally moved from position 2 to position 3 as we predicted last quarter. Net
absorption for the quarter was more than 18 million square feet, and while new office
construction is increasing, it is still half the rate of 2000. Occupancy improvement from 2Q05 to
2Q06 was a full 1% and different sources state that national average rents have increased about
3% to 4% over the past 12 months. We expect almost 1% increase in occupancy for the next
year which can drive a 3% to 4% rent growth for the year.
Office Market Cycle Analysis
2nd Quarter, 2006
Orange County
LT Average Occupancy
Source: Mueller, 2006
11
146
7
8
9
10
12
13
1
15
16
5
4
3
2
1
Atlanta
Chicago
Dallas FW
Houston
Jacksonville
Kansas City
Milwaukee
Minneapolis
Albuquerque
Baltimore
Cincinnati
Cleveland
Columbus
Detroit
New Orleans
Norfolk
Philadelphia
Pittsburgh
St. Louis
Austin
Memphis
Portland
Raleigh-Durham
W. Palm Beach
N. New Jersey
Oklahoma City
Richmond
San Antonio
Seattle
Stamford
Wilmington
Charlotte
Denver
East Bay
Ft. Lauderdale
Honolulu
Orlando
Phoenix
Riverside+1
Sacramento
Boston
Hartford+1
Indianapolis
Las Vegas
Long Island
Los Angeles
Nashville
Salt Lake
San Francisco
San Jose+1
Tampa
NATION+1
Miami+1
New York+1
San Diego+1
Wash DC+1
Note: The 11-largest office markets make up 50% of the total square footage of office space we monitor. Thus, the 11-largest office markets are
in bold italic type to help distinguish how the weighted national average is affected.
Markets that have moved since the previous quarter are now shown with a + or - symbol next to the market name and the number
of positions the market has moved is also shown, i.e., +1, +2 or -1, -2. Markets do not always go through smooth forward-cycle
movements and can regress, or move backward in their cycle position when occupancy levels reverse their usual direction. This can
happen when the marginal rate of change in demand increases (or declines) faster than originally estimated or if supply growth is
stronger (or weaker) than originally estimated.
15
Industrial
Industrial occupancy improved by 20 basis points in 2Q06, providing a 1.1% occupancy increase year over year
from 2Q05. Eighteen cities improved their cycle position by at least one point, which moved the national average
industrial cycle position to point #4 on the cycle graph. While new construction was strong at levels close to 2001,
net absorption was almost 18 MSF for the quarter. Absorption continues to be strongest in southern California
markets. Rents year over year were up 2.5% nationally. For the next year we expect another 0.5% occupancy
increase which should drive rent growth in the 2.5% to 3% range.
Industrial Market Cycle Analysis
2nd Quarter, 2006
Atlanta+1
Baltimore+1
Cincinnati
Columbus
Indianapolis
Jacksonville+1
Source: Mueller, 2006
11
146
7
8
9
10
12
13
1
15
16
5
4
3
2
1
LT Average Occupancy
Denver
Detroit+1
Hartford
Honolulu
Long Island+1
Memphis
Stamford
Kansas City+1
Milwaukee+1
Minneapolis
Nashville
New Orleans
New York
Norfolk
Oklahoma City
Orlando
Portland
Raleigh-Durham
San Francisco+2
Boston
Chicago
Cleveland
Philadelphia
Pittsburgh
St. Louis
Tampa
Austin+1
Charlotte+1
Dallas FW+1
East Bay
Miami
N. New Jersey+2
Richmond
Sacramento+1
San Jose+1
San Antonio+1
Salt Lake+1
Wash DC
NATION+1
Ft. Lauderdale
Phoenix
San Diego+1
Seattle
Las Vegas
Los Angeles
Orange County
W. Palm Beach+1
Riverside
Houston
Note: The 12-largest industrial markets make up 50% of the total square footage of industrial
space we monitor. Thus, the 12-largest industrial markets are in bold italic type to help
distinguish how the weighted national average is affected.
Markets that have moved since the previous quarter are shown with a + or - symbol next to the market name and the number of
positions the market has moved is also shown, e.g., +1, +2 or -1, -2. Markets do not always go through smooth forward-cycle
movements and can regress, or move backward in their cycle position when occupancy levels reverse their usual direction. This can
happen when the marginal rate of change in demand increases (or declines) faster than originally estimated or if supply growth is
16
stronger (or weaker) than originally estimated.
Apartment
Apartment occupancy improved 10 basis points in 2Q06, this producing a 0.5% occupancy
increase year over year. Multifamily construction starts were down 4% in the second quarter,
2% year over year and are hovering close to the long-term national average – which is
sustainable. This shows moderation by the construction industry and reflects the decline in
demand for condo conversions (the Condo craze is now over). Population growth and high
housing costs still produce the best apartment markets. We anticipate occupancies to increase
another 40 basis points in the next year. Rent growth was almost 3% year over year through the
second quarter and we estimate 4% rent growth for the next year.
Apartment Market Cycle Analysis
2nd Quarter, 2006
Norfolk
Source: Mueller, 2006
11
146
7
8
9
10
12
1
15
16
5
4
3
2
1
Columbus
Denver
East Bay
Honolulu
N. New Jersey+2
Phoenix
Salt Lake
San Antonio+2
Seattle+2
NATION
LT Average Occupancy
Baltimore
Sacramento
San Francisco+2
Cincinnati+1
Cleveland
Hartford+1
Houston
Indianapolis
Long Island+1
Milwaukee
New York
Pittsburgh
Portland+1
Richmond
Stamford
13
Chicago
Detroit
Memphis
Minneapolis
Nashville+2
New Orleans
Oklahoma City+1
Philadelphia
Raleigh-Durham
St. Louis+2
San Jose
Atlanta+1
Austin
Boston+1
Charlotte
Dallas FW
Kansas City+1
Wash DC
Jacksonvill1e
Los Angeles
Riverside
W Palm Beach
Miami
Orange County
San Diego
Tampa
Ft. Lauderdale
Orlando
Las Vegas
Note: The 10-largest multifamily markets make up 50% of the total square footage of
multifamily space we monitor. Thus, the 10-largest multifamily markets are in bold italic type to
help distinguish how the weighted national average is affected.
Markets that have moved since the previous quarter are shown with a + or - symbol next to the market name and the number of
positions the market has moved is also shown, e.g., +1, +2 or -1, -2. Markets do not always go through smooth forward-cycle
movements and can regress, or move backward in their cycle position when occupancy levels reverse their usual direction. This can
happen when the marginal rate of change in demand increases (or declines) faster than originally estimated or if supply growth is
stronger (or weaker) than originally estimated.
17
R
ETAIL
Retail occupancy improved 0.2% in 2Q06 but is up only 0.5% year over year. Consumer
spending is now reflecting higher gas prices as the recent detailed consumer spending report
showed people are spending more on books and less on electronic media; more on beer-groceries
and less on restaurants; more on toys/games but less on sporting equipment and jewelry; more on
personal care and less on home care. Regional mall occupancy appears to have peaked as it is
hard to increase occupancy past 95%. Thus, mall rental growth will be the best of the retail
property types. The national retail average remains in the growth phase, at position 7 on the
cycle where it appears to be stabilizing, even with a slowing economy. We expect the national
occupancy position to hold at this level for the year, and rental growth to moderate to the 2%–3%
range over the next year.
Retail Market Cycle Analysis
2nd Quarter, 2006
Source: Mueller, 2006
11
14
6
7
8
9
12
13
1
15
16
5
4
3
2
1
10
LT Average Occupancy
Boston
Houston
Milwaukee
Norfolk
St. Louis
Sacramento
Salt Lake
Seattle
NATION
Denver
Los Angeles
Minneapolis
Orlando
Philadelphia
Pittsburgh
Richmond
San Antonio
San Jose
Austin
Jacksonville
Memphis
Atlanta
Charlotte
Cleveland-1
Dallas FW
Hartford
Indianapolis
Kansas City
Oklahoma City
Baltimore-1
Miami
Orange County
Portland
Cincinnati+1
Columbus
Detroit
Las Vegas
Nashville
N. New Jersey
Raleigh-Durham
Riverside
Stamford
W. Palm Beach
Chicago
East Bay
Honolulu
San Francisco
Tampa
Wash DC
New Orleans
Ft. Lauderdale
Long Island
New York
San Diego
Phoenix
Note: The 15-largest retail markets make up 50% of the total square footage of retail space we monitor. Thus, the
15-largest retail markets are in bold italic type to help distinguish how the weighted national average is affected.
Markets that have moved since the previous quarter are shown with a + or - symbol next to the market name and the number of
positions the market has moved is also shown, e.g., +1, +2 or -1, -2. Markets do not always go through smooth forward-cycle
movements and can regress, or move backward in their cycle position when occupancy levels reverse their usual direction. This can
happen when the marginal rate of change in demand increases (or declines) faster than originally estimated or if supply growth is
stronger (or weaker) than originally estimated.
18
HOTEL
Hotel occupancies improved 0.3% in 2Q06 and 1.2% year over year. Demand continues to be strong across the
board with air travel up and most planes full. It is good news for the hotel industry that airlines have been able to
become profitable in the face of higher fuel prices, but at the expense of few flight options for travelers.
Construction starts have been very strong in many markets with Lodging Econometrics (www.lodging-
econometrics.com) reporting a 50% year-over-year increase, which is a new high for this cycle, but about 15%
below the peak set in 1998. Construction is highest in Washington, New York, Dallas, Los Angeles and Atlanta.
Occupancy levels are now expected to improve another 1% over the next year, which would provide a RevPAR
growth more than 10% in the next year as well.
Hotel Market Cycle Analysis
2nd Quarter, 2006
Source: Mueller, 2006
14
6
7
8
9
12
13
1
15
16
5
4
3
2
1
11
10
LT Average Occupancy
Boston
Cincinnati
Detroit
Indianapolis
Pittsburgh
Hartford
N. New Jersey+1
Portland
Richmond+1
Salt Lake-1
San Jose-1
Charlotte-1
Dallas
Long Island
Las Vegas+1
Milwaukee+1
Minneapolis+1
Nashville+1
Miami
Raleigh-Durham+1
San Antonio-1
San Francisco
Stamford+2
Tampa
Cleveland
Columbus
Kansas City
St. Louis
Atlanta
Baltimore+2
Ft. Lauderdale+1
Jacksonville
Norfolk
Orlando
Philadelphia
Riverside+1
Sacramento
NATION
Chicago+1
East Bay
Denver
Houston
Memphis
New Orleans
Oklahoma City
Seattle-1
Austin
Los Angeles
Orange County
Phoenix
San Diego
Wash DC
W. Palm Beach
Honolulu
New York+1
Note: The 14-largest hotel markets make up 50% of the total square footage of hotel space that we monitor. Thus,
the 14-largest hotel markets are in boldface italics to help distinguish how the weighted national average is affected.
Markets that have moved since the previous quarter are shown with a + or - symbol next to the market name and the number of
positions the market has moved is also shown, e.g., +1, +2 or -1, -2. Markets do not always go through smooth forward-cycle
movements and can regress, or move backward in their cycle position when occupancy levels reverse their usual direction. This can
happen when the marginal rate of change in demand increases (or declines) faster than originally estimated or if supply growth is
stronger (or weaker) than originally estimated.
19
s
-
-
MARKET CYCLE ANALYSIS — Explanation
Supply and demand interaction is important to understand. Starting in Recovery Phase I at the bottom of a cycle (see
chart below), the marketplace is in a state of oversupply from previous new construction or negative demand growth. At this
bottom point, occupancy is at its trough. Typically, the market bottom occurs when the excess construction from the previous
cycle stops. As the cycle bottom is passed, demand growth begins to slowly absorb the existing oversupply and supply growth is
nonexistent or very low. As excess space is absorbed, vacancy rates fall, allowing rental rates in the market to stabilize and even
begin to increase. As this recovery phase continues, positive expectations about the market allow landlords to increase rents at a
slow pace (typically at or below inflation). Eventually, each local market reaches its long-term occupancy average whereby
rental growth is equal to inflation.
In Expansion Phase II, demand growth continues at increasing levels, creating a need for additional space. As vacancy
rates fall below the long-term occupancy average, signaling that supply is tightening in the marketplace, rents begin to rise
rapidly until they reach a cost-feasible level that allows new construction to commence. In this period of tight supply, rapid
rental growth can be experienced, which some observers call “rent spikes.” (Some developers may also begin speculative
construction in anticipation of cost-feasible rents if they are able to obtain financing.) Once cost-feasible rents are achieved in
the marketplace, demand growth is still ahead of supply growth — a lag in providing new space due to the time to construct.
Long expansionary periods are possible and many historical real estate cycles show that the overall up-cycle is a slow, long-term
uphill climb. As long as demand growth rates are higher than supply growth rates, vacancy rates will continue to fall. The cycle
peak point is where demand and supply are growing at the same rate or equilibrium. Before equilibrium, demand grows faster
than supply; after equilibrium, supply grows faster than demand.
Hypersupply Phase III of the real estate cycle commences after the peak/equilibrium point #11 — where demand growth
equals supply growth. Most real estate participants do not recognize this peak/equilibrium’s passing, as occupancy rates are at
their highest and well above long-term averages, a strong and tight market. During Phase III, supply growth is higher than
demand growth (hypersupply), causing vacancy rates to rise back toward the long-term occupancy average. While there is no
painful oversupply during this period, new supply completions compete for tenants in the marketplace. As more space is
delivered to the market, rental growth slows. Eventually, market participants realize that the market has turned down and
commitments to new construction should slow or stop. If new supply grows faster than demand once the long-term occupancy
average is passed, the market falls into Phase IV.
Recession Phase IV begins as the market moves past the long-term occupancy average with high supply growth and low
or negative demand growth. The extent of the market down-cycle will be determined by the difference (excess) between the
market supply growth and demand growth. Massive oversupply, coupled with negative demand growth (that started when the
market passed through long-term occupancy average in 1984), sent most U.S. office markets into the largest down-cycle ever
experienced. During Phase IV, landlords realize that they will quickly lose market share if their rental rates are not competitive;
they then lower rents to capture tenants, even if only to cover their buildings’ fixed expenses. Market liquidity is also low or
nonexistent in this phase, as the bid–ask spread in property prices is too wide. The cycle eventually reaches bottom as new
construction and completions cease, or as demand growth turns up and begins to grow at rates higher than that of new supply
added to the marketplace.
Demand/Supply
Equilibrium
Physical
Market Cycle
Characteristics
-New demand not
-New demand
confirmed
Excess space absorbed
(Parallel Expectations)
-Space difficult
to find
-Rents riserapidly
toward new
construction level
Demand growth continues
-New construction begins
(Parallel Expectations)
-Supply growth higher
than demand growth
pushing vacancies up
Low or negative
demand growth
-Construction
starts slow but
completions
push vacancies
higher
Cost Feasible New Construction
LT Occupancy Average
Occupancy
Time
Source: Mueller, Real Estate Finance, 1995
confirmed in
marketplace
(Mixed Expectations)
This Research currently monitors five property types in more than 50 major markets. We gather data from numerous sources to
evaluate and forecast market movements. The market cycle model we developed looks at the interaction of supply and demand to
estimate future vacancy and rental rates. Our individual market models are combined to create a national average model for all
U.S. markets. This model examines the current cycle locations for each property type and can be used for asset allocation and
acquisition decisions.
20
Important Disclosures and Certifications
I, Glenn R. Mueller, Ph.D. certify that the opinions and forecasts expressed in this research report
accurately reflect my personal views about the subjects discussed herein; and I, Glenn R. Mueller, certify
that no part of my compensation from any source was, is, or will be directly or indirectly related to the
content of this research report.
The information contained this report: (i) has been prepared or received from sources believed to be reliable but
is not guaranteed; (ii) is not a complete summary or statement of all available data; (iii) is not an offer or
recommendation to buy or sell any particular securities; and (iv) is not an offer to buy or sell any securities in the
markets or sectors discussed in the report.
The opinions and forecasts expressed in this report are subject to change without notice and do not take into
account the particular investment objectives, financial situation or needs of individual investors. Any opinions or
forecasts in this report are not guarantees of how markets, sectors or individual securities or issuers will perform
in the future, and the actual future performance of such markets, sectors or individual securities or issuers may
differ. Further, any forecasts in this report have not been based on information received directly from issuers of
securities in the sectors or markets discussed in the report.
Dr. Mueller serves as a Real Estate Investment Strategist with Dividend Capital Group. In this role, he provides
investment advice to Dividend Capital Group and its affiliates regarding the real estate market and the various
sectors within that market. Mr. Mueller’s compensation from Dividend Capital Group and its affiliates is not
based on the performance of any investment advisory client of Dividend Capital Group or its affiliates.
Dividend Capital Group is a real estate investment management company that focuses on creating institutional-
quality real estate financial products for individual and institutional investors. Dividend Capital Group and its
affiliates also provide investment management services and advice to various investment companies, real estate
investment trusts, and other advisory clients about the real estate markets and sectors, including specific
securities within these markets and sectors.
Investment advisory clients of Dividend Capital Group or its affiliates may from time to time invest a significant
portion of their assets in the securities of companies primarily engaged in the real estate industry, such as real
estate investment trusts, or in real estate itself, and may have investment strategies that focus on specific real
estate markets, sectors and regions. Real estate investments purchased or sold based on the information in this
research report could indirectly benefit these clients by increasing the value of their portfolio holdings
, which in
turn would increase the amount of advisory fees that these clients pay to Dividend Capital Group or its affiliates.
Dividend Capital Group and its affiliates (including their respective officers, directors and employees) may at
times: (i) release written or oral commentary, technical analysis or trading strategies that differ from or contradict
the opinions and forecasts expressed in this report; (ii) invest for their own accounts in a manner contrary to or
different from the opinions and forecasts expressed in this report; and (iii) have long or short positions in
securities or in options or other derivative instruments based thereon. Furthermore, Dividend Capital Group and
its affiliates may make recommendations to, or effect transactions on behalf of, their advisory clients in a manner
contrary to or different from the opinions and forecasts in this report. Real estate investments purchased or sold
based on the information in this report could indirectly benefit Dividend Capital Group, its affiliates, or their
respective officers, employees and directors by increasing the value of their proprietary or personal portfolio
holdings.
Dr. Mueller may from time to time have personal investments in real estate, in securities of issuers in the markets
or sectors discussed in this report, or in investment companies or other investment vehicles that invest in real
estate and the real estate securities markets (including investment companies and other investment vehicles for
which Dividend Capital Group or an affiliate serves as investment adviser). Real estate investments purchased or
sold based on the information in this report could directly benefit Dr. Mueller by increasing the value of his
personal investments.
© 2006 Dividend Capital Group, 518 17
th
Street, Denver, CO 80202
21
APPENDIX B
Literature Review
Real estate cycles were first discussed by Homer Hoyt in 1933 in his analysis of the Chicago marketplace. Since that
time market cycles have received scattered attention over the years. Pritchett (1984) theorized that there is a national
real estate market cycle, but the cycles for each property type were not coincident. He stated that supply growth and
decline always lagged demand growth and decline, thus turning points in the top and bottom of any cycle could be
determined when the supply growth and demand growth were moving in opposite directions. However, recognition of
turning points was less useful to investors than anticipation of such points. He applied these ideas by stating that the
most advantageous buying opportunities generally exist during late declining, bottom, and early rising portions of the
real estate market cycle.
Witten (1987) stated that every city had its own property cycles which were unique in length (time) and degree of
change (magnitude) and were dependent on the internal dynamics of each market. He also stated that new supply while
being cyclical is somewhat more volatile than demand, since supply is often determined by the availability of financing
rather than by market need. He also observed that markets seldom move as smoothly as the classically drawn curves,
but instead move in "fits and starts" causing investors to hesitate and wait for clear signs as to market changes.
Brown (1984) described cycle modeling as a simplification of the complexities of reality which hopefully capture the
crucial features of the economic sector or system being studied. He believed that time series should be used to
determine the length and magnitude of cycles as it seeks to measure movement over time. Also the longer the length of
time studied, the better the understanding of the cycle movement. A key to cycle research is the identification and
removal of trend and seasonal components inherent in time series data. He concluded that if feasibility analysts,
investment advisors, and principals or lenders are to give credibility to market cycle analysis, much more research
needs to be done. There are currently no uniform measurement procedures available, making it difficult to agree on the
length and magnitude of cycle movements. He concluded that the downside of market cycles creates extreme
economic obsolescence, thus real estate professionals need to maintain the perspective of cyclical timing in their
decision making.
Wheaton (1987) using a sample of 10 cities, estimated the national office market cycle to have a length of between 10
and 12 years. He found that each city had a turning point (peak or trough) in its own market cycle that was within one
or two years of the combined average of the 10 cities. He studied the causes of market movement that made the office
market cyclical. One of his findings was that the tenure structure of office leases was usually long-term (e.g. 10-15
years). His explanatory model found that expected employment growth was significant in determining cycle behavior
thus creating an adaptive demand model (supply will react to increased demand with a lag) and concluded that supply
responds more readily to the state of the economy (as developers adjust their expectations to general economic
indicators such as GDP growth and interest rates) than to actual local demand. This adjustment can actually help
curtail the magnitude of a cycle as GDP growth is more moderate than local demand growth. He concluded that both
supply and demand respond to changes in the economy although supply is more responsive than demand.
Wheaton & Torto (1988) studied rent and vacancy rate cycles and found that there was a market rental adjustment
mechanism that caused real office rents to drop approximately 2% annually for every percentage point of excess
vacancy above the long-term average in the market. They also found that the average office vacancy rate was trending
upward over the 1968 to 1986 time period studied. Probably due to the excessively high supply rates of the 1980s.
Pyhrr, Webb, and Born (1990a, 1990b) in two different articles compare typical trend models for real estate analysis
with a theoretical cycle model based upon demand, supply and inflation inputs. They conclude that the timing of
acquisition and disposition in the cycle can be very important to the overall return received from real estate
investments. Pyhrr, Born, Robinson and Lucas (1996) compare traditional valuation methods against a model using
cyclical assumptions including demand, supply, absorption, occupancy rates and rental rate differences between newly
constructed and existing properties. They conclude that valuations with cyclical assumptions can dramatically alter
valuation conclusions, but that a cyclical model may be a better indicator of investment value (long-term), than market
value (one point in time).
Mueller and Laposa (1994 and 1995) discussed the difference between overall market and submarket cycles. Their
research found that submarkets can move differently from the overall market cycle in the short run, but submarkets will
typically trend with overall market movements in the long run, because the locational advantages of a submarket
become appropriately priced in the marketplace over time.
22
Mueller (1995) stratified real estate market cycles into two distinct cycle types: first, a physical cycle that described
only the demand, supply, and occupancy of physical space in a local market that affects rental growth and second, a
financial cycle that examined the capital flows into real estate for both existing properties and new construction which
affects property prices. This separation between physical and financial cycles helps to clarify earlier work that mixed
many definitions and helps explain the lag that appears to exist between market occupancy and rental movements
versus real estate prices.
Grenadier (1995) developed a theoretical option pricing model of how vacancy rates and rental rates interact. He
hypothesized that there is considerable inertia from existing building owners to adjust rents and occupancy levels in
reaction to changing economic environments (the owner’s option to rent). He also attempted to explain the recurrence
of overbuilding during periods of low occupancy, by proposing that the costs of re-leasing can make vacancy “sticky”,
because landlords may choose to wait for higher rental rates before leasing space and that long construction times
coupled with the inability to reverse a construction start decision can cause too much new supply. He also modeled
demand volatility and theorized that markets with greater demand volatility had a higher propensity to overbuild.
The economic literature addresses price dispersion under various search models. Butters (1977) postulated that a
consumer’s imperfect information is insufficient to support price dispersion. Others have shown that heterogeneity
among producers explains price dispersion [Carlson and McAfee (1983), MacMinn (1980)]. Nitzan and Tzur (1991)
show that price dispersion can exist even when fully rational economic agents on both sides are homogeneous.
Fershyman and Fishman (1992) present a dynamic search model which accounts for cyclical patterns of prices and
demand. Thus, the behavior, strategies, and expectations of landlords and search behavior of tenants at various
points in the real estate cycle may be explained by search theory models and price dispersion theory when we
examine the rent price distributions in real estate markets. Applications to real estate value pricing are more difficult
as homogeneous expectations are difficult to apply to heterogeneous assets.
Bibliography
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of Real Estate Research, 9(4), 1994
Brown, Gordon T., "Real Estate Cycles Alter the Valuation Perspective," Appraisal Journal
, 52(4): 539-549, 1984.
Butters, G. R. “Equilibrium Distribution of Sales and Advertising Prices,” Review of Economic Studies
44 (1977)
487-491.
Carlson, J.A. and McAfee, R.D., “Discrete Equilibrium Price Dispersion,” Journal of Political Economy
(1983) 91,
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Fershtman, Chaim and Fishman, Arthur, “Price Cycles and Booms: Dynamic Search Equilibrium”, The American
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Mueller, Glenn R., Laposa Steven P., Real Estate Market Evaluation Using Cycle Analysis, paper presented at the
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23
Mueller, Glenn R., Laposa Steven P., Evaluating Real Estate Markets Using Cycle Analysis
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