The fall season of commercial real estate events, seminars and symposiums is drawing to a close and once again the resounding topic of interest is where we are in the real estate cycle. Although this is a topic of great import, determining our cyclical position taxes common analogies and must include the influence of investor sentiment.
Headwinds and Tailwinds
Real estate investors are apt to discuss the market in the term of headwinds and tailwinds, a binary system. However, there are more than two aeronautical implications for wind. As a pilot, headwinds are immensely beneficial when taking off and landing. Headwinds provide lift for takeoff and help close the gap between airspeed and land speed on approach, making both events all the more safe and controllable. On the other hand, once in flight pilots vastly prefer tailwinds to increase speed and efficiency.
Contrarily, why would a real estate investor ever want headwinds? Never, I would argue. Yet understanding which way the winds are blowing is of paramount importance in deciding how to invest. Negative employment trends, low consumer confidence, tight lending standards and impactful policy issues can all function as headwinds.
Let’s examine the current market. If demand is our source of propulsion (propelling the market forward, if you will), low interest rates and a mountain of capital to place act as an accelerant – also known as tailwinds.
Tailwinds are very helpful under static conditions, yet on approach to an inflection point in a market cycle they act as a false indicator of demand, resulting in overinvestment which generally leads to a downturn.
Returning to the analogy of flight, when landing pilots purposely seek headwinds in order to provide resistance to forward motion, ultimately as a means of testing reality. If a pilot lands with the wind at their back, it would be hard to tell if the plane’s propulsion was driving them forward (fuel/demand) or if the extent of forward motion was caused by the enhancement of wind speed (low interest rates/demand to place capital).
For the real estate investor, false indicators of demand can lead to an asymmetry between position in the demand cycle and position in the “perception” cycle (sentiment).
Investor sentiment is the great driver of investment decisions, often driving the market beyond its own fundamentals—at least temporarily. Seth Klarman states the same, yet far more eloquently, “The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.” Deviation between sentiment and reality is often the dislocation between actual demand and perceived demand. Commercial real estate is a multi-trillion dollar industry, so why are their deviations? Haven’t we figured it out by now?
First, unlike nascent technological innovations in alternative industries that have pioneered and produced predictive analytics, real estate investment isn’t based on that much science. Secondarily, the temporal distance between investment decision and result (for example, purchasing land to delivering a new building) is quite far, and market forces are apt to change in the interim. Finally, sentiment often drives the decision to invest or not invest.
Much like the discussion of headwinds versus tailwinds upon landing, when it comes to commercial real estate investment, the preference depends on the viewpoint of the person asking the question. If you have a lot of capital to place we are in the 7th inning of a double-header. If you have decided to sit tight on your money, you likely believe we are rapidly approaching the bottom of the ninth.
As prevalent as chewing tobacco is to baseball, so are baseball inning analogies to the duration of commercial real estate cycles. A great solution to the age-old conundrum of timing cycles is to invest in demand.
Real estate cycles produce highs and lows, yet measuring and following demand is a much greater hedge against a downturn than any cyclical analysis. I argue that demand is headwind/tailwind agnostic. Although demand is often perceived as a tailwind, it is more appropriately likened to the fuel within the plane. Sometimes demand is dampened by headwinds, other times the perception of it is accelerated by tailwinds.
Understanding demand metrics is the hallmark of successful commercial real estate investment. Every thoughtful investment thesis is grounded in demand analysis and part of that thesis is sorting headwind from tailwind and sentiment from reality. As we get close to closing out 2015 and preparing for 2016, it is an excellent time to invest in thoughtful analysis to position your investments and capital for the year to come.