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Commercial Property Insider

Who Else Wants to Understand the Real Estate Market?

10 Minute Read

Fortunes can be made and lost in the real estate market. How would understanding the commercial real estate market help you?

This article will give you a fundamental understanding of the commercial real estate market and how it is impacted by the broader economy, and why commercial property remains one of the most profitable investment vehicles used to achieve financial freedom.

1. Why commercial real estate

Before we talk about the commercial real estate market, it is important to first understand the allure of commercial real estate itself.

Commercial real estate remains one of the most effective vehicles to achieve financial wealth type due to the concept of leverage.

Leverage often involves using borrowed funds in the form of a mortgage to acquire a property. This allows investors to control a more valuable asset with a relatively small upfront investment.

The concept of leverage amplifies both potential returns and risks.

Positive leverage occurs when the return on investment (ROI) from a property exceeds the cost of borrowing. In such cases, leverage can amplify gains and increase an investor’s overall profitability.

On the flip side, negative leverage occurs when the ROI falls below the borrowing cost, potentially leading to losses exceeding the initial investment. Investors must carefully assess market conditions and property investment performance to manage leverage effectively.

Prior to taking on excessive financing, or in a high interest rate environment, we encourage property owners to review if they are achieving a positive or negative leverage. Negative leverage can stretch you too thin financially, and make you suspectable to reductions in rental income making it difficult for you to maintain required debt coverage ratios to service your loan.

Another key component of commercial real estate it’s enduring long term nature. Many investors still choose this as their investment of choice because of the “real” component of “real estate”.

This refers to that the property is tangible; it can be physically touched, and owners generally retain a higher degree of control over it. Regardless if the market is going up or down, you still have relative control over your properties value and make the most of their asset. If you want to increase the value of your commercial real estate, you can do renovations, find tenants to pay a higher rent or negotiate a higher sales price with a qualified purchaser.

Compare this amount of control that you may have owning shares in company in the form of a stock ownership. You could write a letter to encourage the company to perform at it’s best, but your level of control is reduced to keeping or owning stock.

These incredible benefits come with risks associated with property ownership such as property values can fluctuate in response to economic trends, government policies and interest rates, and there can be significant costs associated with property maintenance.

Even with the difficulties associated with investing in real estate, many investors prefer real estate as they believe (that when the building is kept in good condition, and is located in a desirable city), property values appreciate over time resulting in long-term investment potential.

Other reasons why people invest in commercial real estate are:

* Enduring cash flow / an income stream from rental payments

* Favorable tax benefits such as the ability to deduct mortgage interest expenses and property taxes

* The relatively passive nature of the property ownership

This makes commercial property ownership an investment vehicle of choice of many people who’ve achieved financial independence

2. What is the commercial real estate market, and how does it work?

The most simple way of understanding the commercial real estate market is by looking at the definition of a market.

A market refers to the environment where buyers and sellers meet to facilitate an exchange of goods and services. The commercial real estate market specifically deals with real property, such as land or buildings, that are typically used for business purposes.

Like any market that you are familiar with, it is governed by the principles of supply and demand. There are a variety of factors that impact the supply and demand of an economy, including monetary policy, interest rates, and the overall health of the economy as reflected in GDP and employment rates.

The Supply and Demand Fundamentals

How is the commercial real estate market? Understanding Commercial real estate market fundamentals with the Supply and Demand curve.

The red upward-pointing supply curve represents the quantity of available properties, while the blue downward-pointing demand curve signifies the desire of buyers for these properties.

The core premise of the supply and demand curve is that the higher the price something is, the more the supply will be and the less the demand will be. Where the lines intersect is equilibrium, where an agreement is reached between the price and quantity in the market.

When demand outpaces supply, property values tend to rise, creating a seller’s market. Buyers may engage in bidding wars, driving up prices. When there is an increase or upward shift in demand, the demand curve moves to the right up the supply curve, showing there will be an upward pressure on pricing. This occurs in a seller’s market.

In contrast, when supply exceeds demand, properties may linger on the market with little market activity, leading to price reductions. When there is an increase or upward shift in supply, the supply curve moves to the right down the demand curve, showing there will be an adverse effect on pricing. This occurs in a buyer’s market.

Impact of Supply and Demand on Property Values

As shown above in the two examples, the balance between supply and demand has a direct impact on property values.

The quantity of properties that are on the market can determine supply, and the quantity of inquiries, proposals, or overall buyer pool engagement can determine demand. A good commercial real estate agent will be able to talk confidently about the state of the market and whether we are in a buyer’s or seller’s market.

3. How does the broader economy impact commercial real estate?

The major drivers of the economy that affect the overall health of the commercial real estate market include the following:

Gross Domestic Product (GDP)

GDP represents the economic output of a nation or county. When GDP is robust and growing, businesses expand, leading to increased demand for commercial spaces such as industrial warehouses and retail stores.

Levels of employment

Cities act as economic hubs, drawing businesses, capital, and talent. Business owners choose locations based on factors such as infrastructure, access to markets, and a skilled workforce.

Unemployment levels act as a precursor indicator of the overall health of the local economy. Employers create jobs, which attract labourers who have money to spend and who need residences to live in, which overall strengthens the activity of the economy.

Net Migration

To fuel a local economy in terms of activity and production, a city needs a robust labour force. Attracting businesses creates job opportunities; cities experiencing positive net migration often witness increased demand for housing and commercial properties, driving up property values.

Consumer Confidence Index

When consumers feel positive about the economy, they are more likely to invest in real estate, either as owner-occupiers or investors. Check out the Insights & Research section of our website for the latest market report.

“The commercial real estate market is closely intertwined with the overall economy and interest rates.”

Interest Rates

Interest rates set by the central bank impact the cost of debt.

Low interest rates can spur the economy, reducing the total cost of capital, which can spur investment and improve cash flow and cash on cash returns.

Higher interest rates can make borrowing more expensive for individuals and businesses, reducing demand and cash flow, potentially discouraging investment, and causing a potential slowdown in market transaction volume.

However, it is important to note that an increase in interest rates isn’t necessarily a negative thing for commercial properties. When interest rates rise, capitalization rates often rise, but even though there is a correlation, the magnitude change doesn’t directly correlate with the cap rates.

Although there is a correlation between an increase in interest rates and an increase in cap rates, which can reduce property values, the effect of an increase in interest rates could be positive for an investment property if an increase in interest rates is due to a healthy and robust economy. Well-performing companies and tenants should be able to pay an increased amount of rent, helping to preserve your property value upon lease renewal even in a higher interest rate environment.

Excessive monetary policy involvement and prolonged periods of low interest rates may cause real estate bubbles in attempts to stimulate the economy. Although it will spur real estate transactions and increase sales volume and prices, a reduction in interest rates isn’t always positive for the economy.

It is important to understand the reason for the interest rate adjustments before being able to accurately assess if an increase or a decrease in interest rates is a good thing for the commercial real estate market.

4. The Real Estate Cycle

We often get asked “How is the commercial real estate market doing”.

In order to understand if the real estate market is going up or down, you need to understand where we are in the real estate cycle. As the article will further discuss, each individual market is in a different stage of its real estate cycle, and is influenced by both macro and microeconomic factors. For a more in-depth understanding, explore the related insights on our article, Do You Make These 5 Mistakes When Selling Without An Agent?

The macroeconomic environment, such as interest rates and GDP production, can impact the overall market sentiment. While microeconomic influences local job markets, infrastructure development, and population growth, can vary widely from one city to another.

A city offering favorable tax incentives may attract key employers and see a surge in demand for industrial warehouse space, which can further spur the local economy.

Alternatively, a city with a declining office vacancy base may face challenges in repurposing vacant office properties unless they are sold at a discount and repurposed as multifamily investments.

Understanding the nuances of a local real estate cycle and its unique economic influences is crucial for investors and developers. It allows them to identify emerging opportunities, anticipate potential risks, and make informed decisions.

The real estate market operates in a cyclical pattern consisting of four distinct phases, and understanding these stages is crucial for investors and owner-occupiers if you are trying to maximize your property value.

How is the Edmonton commercial real estate market? And understand what stage the market is in near you with our Secrets of the Commercial Real Estate Market Cycle graph.

Stage 1: Recovery

The real estate cycle typically begins with a recovery phase in the lower left quadrant of the cycle. This is marked by declining vacancy rates, increasing rents, and a slow but steady rise in property prices.

A recovery portion of the cycle follows a period of recession.

Stage 2: Expansion

During the expansion phase, the market experiences robust growth.

Demand for real estate is high, resulting in rising property values and increased construction activity. Rental income is strong, making it an attractive time for investors.

Stage 3: Hyper Supply

In the hypersupply phase, the market becomes saturated with new construction projects. Supply outpaces demand, leading to higher vacancy rates and potential rent declines.

This phase can be challenging for property owners, as they can see their property values decline.

Stage 4: Recession

The final stage is recession, characterized by falling property values, reduced construction, and high vacancy rates. This phase often triggers a correction in the market, leading to the next recovery phase as the cycle continues.

Key Indicators of the Real Estate Cycle

Identifying where we are in the real estate cycle involves an analysis of many of the factors discussed previously in the article, including vacancy rates, rental rates, construction activity, interest rates, and economic factors. Monitoring these indicators in your market is critical to understanding the real estate market’s direction.

Pro Tip: Early warning signals

Navigating the commercial real estate market fluctuations can be challenging. To protect your investments and assets, it’s important to recognize early warning signals of a market collapse, identify relevant economic indicators, and adopt strategies to mitigate risk.

It is highly unlikely that all the previously mentioned economic indicators in the market will be trending in the same direction, but as a whole, prior to a drop in prices or market crash, you may see two or more of these indicators moving in a negative direction, signalling areas of concern.

Early Warning Signals of a Market Collapse

Look for news on early warning signals of a market collapse to avoid getting caught in it:

Declining demand. A noticeable decrease in tenant interest and leasing activity may indicate trouble. When a significant number of businesses are moving out or closing down, it is a red flag.

Rising vacancy rates. Increasing vacancies can be an early warning signal. High vacancy rates can lead to reduced rental income, impacting your property’s cash flow.

Economic downturn. An overall economic recession often affects the real estate market. Watch for signs like rising unemployment, reduced GDP output, and declining consumer confidence through reduced spending habits on a national level, which may indicate a slowdown.

Interest rate hikes. Rapid interest rate increases can make financing expensive, affecting property affordability and demand. Large rate hikes can disrupt financing and investment momentum.

Overbuilding. A sudden surge in new developments can saturate the market, causing an oversupply of products and depressing rents.

5. Strategies to Reduce Downside Risk

Here are some things you can do to reduce your downside risk when investing in commercial real estate:

Have unshakable confidence in the local market in which you You need to understand the economic drivers and key employers in the region that you invest in. Being prudent in this key step will be a large component of your real estate success.

Pro Tip:

Remember, not all regions are in the same part of their real estate cycle. While national trends matter, regional and local factors often play a significant role. It is essential to have confidence in the local region where you invest. Areas with diversified economies and a history of resilience tend to weather economic storms the best.

Do detailed due diligence. Conduct thorough risk assessments before acquiring properties. Consider factors such as location, market conditions, and potential for future development.

Maintain a long-term focus. Commercial real estate is a long-term game; don’t panic when faced with short-term market fluctuations. Ensure any fluctuations are consistent with your long-term objective and perspective of the property.

Proactively create cash reserves. Maintain adequate cash reserves to weather unexpected challenges like vacancies or significant capital improvements or repairs.

Maintain the condition of your building to attract quality tenants. Ensure that you are doing any proactive maintenance or injecting money into your building to adapt to business trends. High building standards will help you earn the most rent possible. Remember to strive to keep your tenants satisfied to build long-term relationships and reduce the cost of tenant turnover.

Professional Guidance. Connect with a good commercial real estate agent who can provide market insights and guidance on an accurate property valuation. For a more in-depth understanding, explore the related insights on our article, When Commercial Real Estate Agents have to sell a property, what do they do?

Conclusion

It is important for investors and owner-occupiers to understand the fundamentals of the commercial real estate market, maintain a long-term perspective when investing in real estate, and have an overarching confidence in the specific market in which you invested. High interest rates and vacancies may impact your property valuation or cash flow.

Commercial real estate investment comes with risks, but being diligent and informed of market trends can help you weather downturns in the economy. Pay attention to early warning signals, monitor economic indicators, and implement strategies to mitigate risks.

About us

City Commercial is a commercial real estate brokerage that specializes in industrial real estate in Edmonton, Alberta. If you found this article helpful and would like to be connected with a good commercial real estate agent that can help you assess the strength of your local real estate market, we can leverage our experience and networks to connect you with a good commercial real estate agent near you.

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