General market risk is one of the most macro levels of risk that a real estate investor can assume. Market risk is made up of the economic and financial cycles within an economy. At Realized, we consider market risk to have nine specific components, which we’ll go over in this article.
Factoring market risk into any potential real estate opportunity and current holdings can help shed light on how top-level currents in the economy may impact properties.
Market Cycle and Outlook
The economic cycle creates the boom and bust cycles that economies periodically go through. There are four phases in the cycle. Each phase occurs at specific points in the cycle.
- Recovery — Occurs right after a recession. In this phase, the market is starting to improve. It’s a period of declining vacancy and no new construction.
- Expansion — Market is solid and continuing to improve. This phase ends with a top in the market. Vacancies are declining and there is new construction.
- Hypersupply — With the market having already peaked, this is a declining phase. There are increasing vacancies but new construction is ongoing.
- Recession — The market is beginning to bottom. Vacancies continue to rise and there are more completions from the previous construction boom.
Identifying which phase the market is in can be tricky. You can generally get an idea if you are in one or two phases adjacent to each other. For example, you’ll have a good idea if you are in the expansion or hypersupply phase or recovery vs. expansion phase. Economists will also publish their thoughts on which phase they believe the market is in.
Monitoring the trend in the employment rate can also help identify where the economy might be in the cycle. Are jobs increasing or decreasing? The employment rate is widely published and commented on.
Are the incomes of wage earners increasing? If employment is holding steady and incomes are not increasing, the economy may not be able to maintain its current rate of growth. Additionally, consider which areas of the country have income growth vs. those seeing little to no growth in incomes and maybe even a decrease.
Areas with income growth have the potential to increase real estate values. This makes identifying those areas all the more important.
Interest Rates and Credit Cycles
The cost of borrowing directly impacts real estate. Low mortgage rates mean people can afford a more expensive home. Commercial lenders are also able to take advantage of low rates.
The credit cycle is tied to the FED’s lowering and raising of rates. The FED funds rate doesn’t increase or decrease randomly. The FED often broadcasts its intentions at FOMC meetings. Rates are either rising, decreasing, or holding steady. They don’t jump around.
Tracking capital flows can be a global or local endeavor. However, starting at the global level shows the cross-border movement of capital and which countries are benefiting from increases vs. those that are seeing decreases.
Capital moves around for various reasons, including the following:
- Recent policy changes by central banks
- More stringent regulations
- Economic activity (recession vs. booming economy)
- Shifts in demographics
Rotation of leases can also show where capital may be flowing next. For example, monitoring five and ten-year leases can reveal properties that will soon be coming on the market. Five and ten-year leases that started in 2011 and 2016 will soon be ending (i.e., 2021). The types of businesses in these leases are known. How has the economy and trends changed since the start of those leases? That will help project the types of businesses that may be seeking new leases.
Venture capital also has an impact on capital flows. Where is venture capital deploying its funds, and which projects are they trying to raise capital for?
Population Growth and Migration
This is a general observance of trends in population growth. It can show where people are moving. Just because people are moving into an area doesn’t necessarily mean its population is growing. Instead, it’s important to consider the net growth of an area.
Demographic Trends and Household Formation
Demographic trends are a more detailed look at population growth and migration. They factor in incomes, job types, marital status, and race of a population. Monitoring these trends can reveal if an area has potential for real estate valuation increases.
Socio-cultural trends are driven by changes in technology, the environment, and (social) media. These trends used to be more identifiable geographically but with the Internet, it’s more difficult to tell where a trend stops and another starts.
It’s best to view socio-cultural trends as a whole across large populations. Meaning what society is focused on technologically, environmentally, and its use of social media. Right now, we might say that smart homes, electric cars, green energy, (rights) equality, and the use of platforms such as TikTok, Facebook, and Twitter are driving socio-cultural trends.
Government policies are made up of regulations, taxes, tariffs, interest rates, and various rules at both the federal and state levels.
All of the above contributing factors to general market risk help shape investors’ views of where the economy is going and what might be in demand.
Not shown above but also falls under general market risk is the correlation between different industries. Some industries have a high correlation, while others may go in opposite directions. As one industry is identified to be in a declining phase, other highly correlated industries are likely to be on the same trajectory, providing advanced notice of a coming potential decline in those industries.
We also have to factor in shocks to the system that can change correlations and relations. For example, before the pandemic, student housing was less cyclical than office or multi-family. We might have gone so far as to say that it was recession-resistant. The pandemic has proven that to be false.
The pandemic is considered a tail risk. General market risks that we may have taken for granted were revealed to be far more fragile than originally thought. These tail risks are difficult to assess, but as more of them occur, it can help strengthen the reliability of models.
Because there are so many moving parts to consider, strong analysis is the only way to keep up with general market risk. Monitoring trends and even considering tail risk should be basic components of any thorough analysis.