Beyond the Cycle: Why Has the Growth Spurt Persisted—and What Could Bring It Down?
Have a series of whiffed swings left the current business cycle mired in the ninth inning, in danger of stranding the winning run in scoring position? Would it be more apt to relate the economy to a fourth-quarter red-zone nail-biter with rising wages threatening to blitz on third down? Or is it best said that the expansion has entered its third trimester, careening towards an inevitable deliverance that, with luck, will be neither premature nor stillborn?
When it comes to business cycles, the imaginations of real estate soothsayers can be positively pregnant with possibilities—and the analogies to match.
As the calendar prepares to turn to the 10th full year following the trough of the 2008 financial crisis, a strong economy and solid real estate fundamentals have investors checking their math, re-examining their assumptions about what drives robust markets and whether they inevitably falter on a schedule that, historically, has rarely been more generous than a decade or so.
“It’s the game of musical chairs,” said Mark Grinis, the head of real estate, hospitality and construction for EY. “You’ve been circling those chairs for a long time now. And it’s starting to feel like, ‘Do I need to start thinking about where to set myself up?’ ”
A strategic adjustment before the figurative music stops could be crucial for institutions hoping to get on solid footing before a fall. Lenders might choose to step back from the most speculative of construction loans, for instance, and landlords might want to take a careful look at their portfolios’ real underlying value if they harbor plans to offload properties in the years to come. But being prepared for the end of a business cycle without leaving returns on the table would involve a precise forecast of the expansion’s peak.
Unlike at the ballpark, there’s no scoreboard to tell you how far along in the game you are. Since the end of World War II, only one economic expansion—from March 1991 through March 2001—has lasted longer than the current growth period before collapsing into recession. Twelve months from now, that record could be broken, and some students of the industry attribute the current spirits to a range of specific changes in the economy, from smarter regulation to technological advancement. But some more experienced hands feel that ups and downs have come at such regular intervals in the recent past that they can depend on the pattern continuing.
“The history of [anyone’s career] in our business is that of the three or four real estate cycles that they potentially have been through,” Gerry Prager, a senior vice president at Savills Studley, remarked. “It’s been just that: a cycle, six to eight years, up and down. That fits perfectly into the baseball analogy, because when it ends, it really ends.”
That view, on the other hand, would seem to run up against the doctrine of efficient markets, which holds that free exchange prices assets as accurately as possible given imperfect information about the future. Efficient market believers, led by economist Eugene Fama, who first applied the idea to stock-market trades, say that recessions can’t possibly be seen in advance because today’s values already reflect the best possible guess of what the future holds.
“There’s no real schedule for cycles,” said David Amsterdam, Colliers International’s president of investment, leasing and the company’s eastern region. “If there were a data set to prove that there were time boundaries [for an expansionary period], investors would bet on them, creating a self-fulfilling prophecy.” If the end of the current cycle was already written on the walls, in other words, institutions would begin selling off and shorting real estate today, and the downturn would have already begun.
“We’ve flattened out the edge of information,” Amsterdam added, pointing to the ways technology has made financial data more transparent.
Rebecca Rockey, the head of forecasting at Cushman & Wakefield, shared that assessment.
“It’s very, very hard to identify accurately and time the notion of a bubble,” she said. “They exist and they pop, but there are always going to be things on the radar that will be risks.” Even the sharpest forecaster has no foolproof method for distinguishing underlying value growth from frothy asset bubbles, she said.
Nonetheless, a few economic variables have built reputations as trusty barometers of crummy weather on the way. Some investors like to watch the yield curve for government debt, a chart showing how guaranteed returns on purchases of long-term bonds compare with the yields available on overnight debt. Bond yields move inversely to price, so when there’s high-demand long-term security in the form of 10-, 20- or 30-year Treasury debt, yields on those bonds decline, indicating that traders see a downturn on the horizon. Another way of understanding the signal is that long-term bonds would only trade at trim yields when investors have a gloomy outlook for other investments over the same period of time.
In September, the difference in yields between 10-year Treasury bonds and the rate the Federal Reserve was paying on overnight debt fell to below nine-10ths of a percent, the lowest spread since early 2008.
Other prognosticators prefer to gauge the economy’s fundamentals for signs that growth could soon trip over its own gait. But uncertainty stems from the variety of economic data that can be seen as sock and buskin. Strong labor markets, for instance—today tighter than they’ve been since the late 1960s—might indicate that the economy is putting all available resources to use. But low unemployment could also serve as a sign that wage growth is soon sure to drive inflation, derailing the economy by hampering consumption and investment.
Richard Barkham, CBRE’s chief economist, sees value in watching employment numbers and wages for the first signs of trouble.
“[Labor] productivity grows, on average, at about 1.25 percent,” Barkham said. “Once wages [start increasing faster], you’re adding to unit labor costs. One reason we’ve got a long cycle is that the last recession was pretty severe and knocked a lot of people out of the labor force. That has held back wages so far.”
By that token, a sharp increase in wages could mean the good times are nearing an end, Barkham noted.
But though labor market indicators have often predicted inflation in the past, some influential economists are questioning whether that tight relationship is fraying. In a speech last month, for example, Federal Reserve Chairman Jerome Powell said that rising wages are not yet a sign of an overheating labor market, because they have reflected productivity growth.
“The jury’s still out,” Rockey said, noting that the past relationship between higher prices for labor and for consumer goods might have been erased by the power of e-commerce. The internet makes it easier for people to comparison shop, she said, meaning that companies could be less free than before to pass higher wages on to consumers.
Still, she said, the forces of rising wages and higher inflation have a long history together.
“I’m not a person who believes the Phillips Curve is broken,” she said, referring to the economic model which hypothesizes that inflation and unemployment are significantly correlated.
Just as rising wages can spell difficulties for the broader economy, within real estate seemingly positive news can also bring a vicious undertow.
“There is new construction in every single market,” Grinis said, noting that he had recently been struck by the number of office towers rising from the ground in Boston on a recent business trip. “But as a real estate person who has seen a bunch of cycles, you say, ‘Wow, if we just have a little bit of a hiccup in demand, those will get tough to fill.’ ”
In its essence, disagreement within the industry over whether faltering demand—as would occur with inflation—or inhibited supply growth poses a greater threat to asset values rehashes an age-old academic debate about what makes cycles of growth in the broader economy tick. After all, differing views of business cycles rend academic economists into two camps as well: Keynesians, who believe that labor market friction and bad policy can get the economy stuck in a rut, against real business cycle theorists, who think that shocks to the system from outside of the economy, like big changes in energy prices, are usually to blame.
But both economic camps believe that improving technology is a key driver of growth over time and is therefore a crucial factor in determining the duration of business cycles and their dynamism for as long as they last.
“In the 1970s and the 1980s, the amount of data we had was horrible,” Grinis said. “We knew there was going to be a new building when a tractor showed up—but we didn’t know about the 15 other applications at the [city’s] Department of Buildings. This is [where] the ‘this-time-is-different’ people [get their argument]. They step in and say, ‘we have so much better data.’ ”
“The transparency helps us right now,” he said. “We can visualize; we can see problems coming. It’s only the problems we can’t visualize that can cause crises. For now, most people have underwritten their assets accurately, and are well positioned.”
What’s more, a conservative trend in how real estate financings have been underwritten could mean that a fall in asset values would let the industry down more gently than it did in 2008. With yields thinning on real estate debt today, investors have climbed higher in the capital stack to lock in more generous returns, contributing more equity to deals and reducing the portion of investments that are funded through debt.
“Before, you used to leverage as much as you could to boost your equity,” Grinis said, recalling prior expansions that coincided with higher yields on real estate debt. “One by-product of quantitative easing”—the Federal Reserve’s massive bond-buying program, which helped keep market interest rates at thin spreads during the recovery from the last recession—“is that there’s so much capital out there that everyone’s putting out 30, 40 or 50 percent equity.”
That buffer could help real estate markets avoid seizing up in the face of a sudden credit crunch.
“Let’s assume that property markets go down by 30 percent,” Grinis said. “It would be bad, make no mistake about it, but it’s not like every single capital structure would explode.”
Barkham also sees an upside in the continuing effects of last year’s tax cut—which will begin to hit personal and corporate bottom lines as taxpayers submit their 2018 returns.
“There are large amounts of people in the U.S. who get 20 percent to 30 percent of their remuneration from investment income,” Barkham said. Those high earners’ good vibes from tax relief have fueled the American economy’s last two quarters of gross domestic product growth, which rose above 4 percent from March to June, he said.
The CBRE economist has also been impressed with consumer sentiment, noting that “retail sales are pretty bloody strong.”
Grinis wonders if overblown research- and development-spending among tech companies could lead to a new version of the effect the dot-com crash had on real estate values. Startups and tech giants alike have snapped up office buildings around the world to house workers funded by billion-dollar research budgets, he said—money that could retreat overnight if tech spending doesn’t bear out technologists’ rosy visions for as-yet-unheard-of gizmos.
“If you go down the list of who’s investing the largest amount in research and development, it’s all the biggest names, like XYZ car company and XYZ social media company,” Grinis said. “The liquidity bomb that’s coming out of tech and startups—does it in any way trip when the economy slows?”
Barkham, too, worries that investors have grown self-satisfied with the notion that, unlike in 2008, they will now be able to spot overinflated property values before they burst.
“Don’t forget that we’re only 10 years away from the financial crisis—which was organized around real estate,” he said. “Nothing has changed that much.”