Sensing the Urge: Let’s Talk About Evaluating Demand…
“As people seek to improve their living environment, there will be continuous demand for property. Investment in the real estate market should have reasonable prospects in the long run.” – Li Ka-shing
Lately, I’m sure many of you know about the activity in the real estate market, whether you are seeing it in the news or witnessing it first-hand. It isn’t any secret that most of the activity is a result of increased demand. There’s no question there are a litany of supply issues to speak of, which certainly impacts pricing dynamics, but today we’d like to focus on the demand side of the spectrum.
You can either consider this market to be driven primarily by artificial demand (via monetary policy) or not. Regardless of nuance, it is still a demand dynamic. The underlying drivers of demand say so.
Which brings us to our discussion today – how to evaluate market demand. Alternatively, how to look at market factors that impact demand.
Preliminary Thoughts
Below we talk about some of the higher-level factors responsible for some of the movement we see in the real estate market – the economy, demographics, interest rates, and government policy.
We would like you to keep in mind that the “puzzle” is more complicated than it seems. Also, a number of the high-level factors do have a clear and distinct relationship with the market, but when it comes to the real world, what takes place may be quite different.
With that said, we would like to reiterate the importance of understanding the primary drivers of the real estate market in order to effectively evaluate a real estate investment opportunity.
The Economy
This factor is often seen broken up by measurements (or indicators) that provide insight on individual components of economic health, a driver of market demand. Among some of the indicators are GDP, employment levels, manufacturing activity, and the prices of goods.
If these indicators reveal “bad” numbers, you can generally assume that the economy’s health is not in its “best shape.”
But this generalization forgets to account for other forces, such as the cycle of the market and how it impacts a specific type of real estate.
To illustrate this further, let’s compare shopping malls to a commercial office building. In most cases, a mall would experience more negative impacts from a sudden plummet in the economy than a commercial office building.
Why?
As it relates to malls, when average incomes drop dramatically, research shows consumers' first move typically involves a reduction in their discretionary spending habits. In other words, there is a drop in consumer demand for malls and the goods it offers. A mall is driven by discretionary spending, and if most consumers aren’t buying anything in stores, a chain reaction within the mall may occur. In the mall, when some businesses cannot pay their bills, they are forced to shut down, often breaking their more-flexible lease. Depending on the characteristics of the mall tenants and existing demand to become a mall tenant, a sharp increase in vacancies may take place with virtually zero replacement tenants in sight (i.e. a very low demand from businesses).
In the case of a commercial office building, property owners often lock up the most stable tenants (i.e. businesses) in long-term leases, so there is no ability to change an office rental even when the economy’s conditions are poor. Therefore, an office building is generally more durable than a mall in the case of an economic downturn. Of course, there are other dynamics to consider when it comes to office asset stability (and retail, for that matter), but that’s beyond the scope of this blog. Further, neither are an asset class our firm focuses on.
Demographics
Just like the economy, demographics also have indicators, in the form of statistics, that provide insight on the potential demand of a real estate market. Population-based examples include age, race, gender, income, migration patterns, and population growth.
Amateur investors forget the importance of these statistics when evaluating a property, resulting in mispricing mistakes and misinterpretations of which properties are in high demand. We must not forget that large demographic shifts can have significant long-term impacts on real estate.
One example is the baby boomer generation (i.e. grouped by age) and the significant influence that their retirement may continue to have on the real estate market. Starting their retirement back in 2010, baby boomers have shifted the demand landscape in many ways already:
The demand for second homes in popular vacation spots has increased as more and more baby boomers retire
The demand for larger homes has decreased because all baby boomer children have moved out for the most part and their incomes are now lower.
There’s a segment of baby boomers that have become renters by choice and renters by necessity, driving substantial movement in the multifamily real estate market as a result.
Interest Rates
Interest rates and any changes to interest rates can have a large influence on a person’s decision to purchase real estate or not. Put simply, as interest rates decrease, the cost to obtain financing (mortgage or a loan) also decreases. Lower financing costs creates an increase in demand, and eventually real estate prices go up as a result.
The opposite scenario is also important to review. As interest rates increase, the cost to obtain financing also increases, which decreases demand, and generally results in real estate prices going down.
Government Policy
Government policy may implement policies related to taxation (deduction, credits, and subsidies) that provide the real estate market with temporary increased demand – a scenario that can last as long as they are in place. Some think of this as the artificial creation of demand.
Awareness of current government policies, such as tax incentives, can help one determine the potential changes demand while identifying the possible false trends.
For instance, let’s examine a scenario where the government implemented a first-time homebuyer's tax credit for the purposes of boosting housing market sales in the middle of a time when economic growth was sluggish. According to the reported statistics, over two million Americans took advantage of the temporary tax credit, which was a significant increase in home ownership. Without knowledge of the tax incentive and the result it had on the housing market, one might have instead concluded that demand was produced from other factors.
There are many other examples of policies that impact various asset classes in real estate.
Reviewing the Main Points
There are a number of factors that impact real estate demand, prices, availability, and investment potential.
The cycle of the economy influences the prices and demand for real estate. An investor can reduce the potential negative impacts through strategic investments in parts of the real estate market that are less impacted by economic downturns.
Demographics provide characteristics, such as age, income, and migration patterns of the population. These characteristics are used to identify actual or potential buyers, retirees, and how likely they are to make a purchase of a home or even a second home.
Interest rates impact the price and demand of real estate. Low interest rates increase the demand from homebuyers, reflecting the decrease in cost of obtaining a mortgage. This results in an increase of home prices.
Government policy, such as the implementation of various tax incentives can either temporarily increase or decrease demand in the real estate market.
To make effective investment decisions for the long term success of your real estate portfolio, you must have an accurate high level understanding of the demand drivers from a macro and micro level. As policies or patterns change, we can course correct our strategy as necessary, and anticipate the next beneficial wave for opportunistic positioning. By remaining educated and nimble, we can avoid pitfalls and capture opportunities appropriately, and pass along those benefits to our investment partners.
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