Attorney Advice on Market Cycles

As a real estate Attorney you may often be asked about certain markets. We all know that markets go up and markets go down. And we are often led to believe that the trick to making money in real estate is foreseeing the point at which a market is moving up or down. Basic economics describes the four cycles and their inherent differences and fluctuations as follows:

  • Down Cycle
  • Absorption Cycle
  • New Construction Cycle
  • Market Saturation Cycle

The truth is that there are no consistent set of cycles which will determine your success or failure in real estate investment. And- sorry there is no Santa Claus. There are only two viable and profitable ways toward successful real estate investment.

(1) Value Creation – here you as the purchaser take the asset and perform some function which creates more value. That can be done in numerous ways:

  1. expending capital to improve the property and make it consistent with market demand;
  2. a zoning change increasing the amount of units that can be sold or leased;
  3. changing the use so that it is now being utilized at its highest and best use:
  4. remodeling to meet improvements in technology or simply aesthetic desires: and
  5. cutting energy costs where the asset is usable for a related use and energy was a significant issue.

The implementation of any idea or formula that makes the asset more valuable.

(2) Poor Pricing – the Seller just priced it wrong. Perhaps they didn’t know that a new public transportation system was coming to the area. Maybe the seller was not aware of the significant changes in demographic changes over the course of the recent years.

Everything else is smoke and mirrors – at least in the first 10 years- then based upon 100 years of history- most property will increase for real. Just ask the Indians who sold us Manhattan.

Now you must be very aware of the actual market risks that not only exist at all times but are very real.

(3) Non-Controllable Risk: Although world events are controlled by someone who is not us, we must nevertheless be aware of these risks and attempt to mitigate them:

  1. Opportunity Risk
  2. Inflationary Risk
  3. Physical Destruction Risk
  4. Liquidity Risk

(4) Controllable Risk: A brief list of potential risks that are more in our control are as follows:

  1. Poor assumptions in pro-forma (absence of adequate reserves) – See Capital Section
  2. Construction cost overruns (schedule failures, bankruptcy of contractors, weather conditions) – See Construction Section
  3. Extended lease-up, sell-out or construction schedules (excessive tenant relocations)
  4. Lower than anticipated rents or sales prices
  5. Higher vacancy and low absorption rate (inadequate marketing budget, vulture clauses, absence of market studies, pre-leasing and pre-sales)
  6. Poor acceptance of the product by market (dated appearance, poorly functioning space, lack of expansion options) – see Marketing Section
  7. Inaccurate or escalating operating costs (failure of systems, safety problems)
  8. Staff problems (dissatisfaction, leadership failures)
  9. Legal complications (excessive litigation)

Actions you can take to mitigate Risk:

Initial screen: The purpose of an initial screen is to sort potential acquisition opportunities based on their potential for value creation and their match against your investment criteria.

  1. Is the property in a manageable market area?
  2. Is the property institutional grade and/or can it be upgraded to institutional grade.
  3. Is the recommended purchase price below replacement cost?
  4. Are there repositioning, re-leasing or re-development opportunities that would create value?
  5. Are there barriers to entry in market, limiting the potential for new competition to be built? These barriers may be a lack of developable land or legal limitations on growth (e.g. high impact fees, a lengthy and cumbersome approval process, requirements for pre-existing infrastructure, etc.).
  6. Is renovation or construction limited or restricted because of historic or new governmental restrictions?

Zoning: Compliance with local zoning must be addressed. Building and other code issues should also be identified, with particular focus on ADA, Seismic (if applicable) and Life Safety concerns. Additional areas of governmental concern:

  1. Conformity to local and state and use plans
  2. Adequacy of water supplies and drainage
  3. Avoiding erosion, pollution, traffic congestion
  4. Impact on schools and other government services (negative and positive)
  5. Preservation of scenic, historic, natural resources

Rent Comparables: Properties in the market that will directly or indirectly compete for tenants with the subject should be inspected. A summary of the current rents, asking rents, lease concessions, amenities, major tenants and relative strengths and weaknesses should be prepared for each property inspected.

Sale Comparables: Properties that have recently sold (or are currently under contract for sale) and are similar to the proposed acquisition should also be inspected. A summary of the sale prices, cap rates, rental rates, amenities, major tenants and relative strengths and weaknesses of each property should be documented.Note: Properties currently being marketed but that are not under contract should only be utilized in the event adequate comparable data for properties already sold or under contract is not available.

Visibility: Can potential customers easily find the property?

Access: Does the property enjoy convenient ingress and egress from nearby local and major thoroughfares?

Parking: Is there adequate parking for the tenants? Can parking be increased?

Population: Is the local market stable, recovering or declining (absorption rate)?

Design planning: Obtain pertinent information concerning the following:

List of contacts:

1. Building inspector
2. Zoning official
3. Fire inspector
4. Electrical inspector
5. Plumbing inspector
6. State highway engineer
7. Health or sanitary engineer
8. Electric company
9. Gas company
10. Water company
11. Telephone company
12. Cable company
13. DEP agency

This article is just a short example of the realities of real estate investment and the futility of cocktail discussions of Market Cycles and their impact on your life.

by Anthony Palazzo
General Counsel and Attorney at Law