The Cycle

On September 8, 1974, millions of eyes around the world were transfixed on the banks of an obscure river canyon in Idaho to watch a determined man and a motorcycle. That man was Robert Craig “Evel” Knievel and he was sitting in a steam-powered X-2 “Skycycle” on the banks of the Snake River Canyon. He was going to attempt to jump it.

The Skycycle took off with a jolt and Mr. Knievel was knocked unconscious by the thrust. It was clear from the outset that there was a problem as the parachute deployed prematurely. The cycle cleared the canyon, but while getting ready to touchdown, the wind pushed the cycle back into the canyon with Mr. Knievel largely unharmed. Mr. Knievel’s cycle had failed him, but not nearly as spectacularly as when he had attempted to jump the fountains at Caesar’s Palace a few years earlier. Then, he suffered multiple fractures and ended up in a coma for 29 days.

When I think about (motor) cycles, I think of Evel Knievel. While for most of his career, Mr. Knievel rode a 750cc Harley XR-750, he was riding a 650cc Triumph Bonneville T120 when he attempted to jump the fountains at Caesar’s Palace on New Year’s Eve 1968. As with his choice of Skycycle for the Snake River folly, he tried to pick the right cycle for each occasion. However, if history is a good judge, Mr. Kneivel was particularly bad at picking cycles. He holds the Guinness Book of World Record with 433 broken bones from his various misadventures. Picking the right cycle is hard.

Picking cycles or the end to “the” cycle, seems to be all that we are talking about in commercial real estate economic circles these days. My former colleague at Legg Mason Glenn Mueller, now a professor at the University of Denver, was one of the pioneers of tracking the economic cycle in commercial real estate. In reality, there isn’t a single cycle in commercial real estate, there are actually three cycles: construction, rents and value, but they come together in “the” cycle because when one is up, another is typically down or certainly at a different stage than the others. While all are interconnected, they do not move in tandem and they certainly differ by asset class and market. While rents and values tend to move fairly closely in sync, construction follows a very different pattern, lagging rent increases and continuing beyond them (into the down cycle for rents) due to the long-lead time and the fact that you can’t stop construction on a dime.

And the cycle can be bent by changes in the broader economy and by structural changes to commercial real estate itself. Despite its size (PWC estimates there is $29 trillion of assets globally), commercial real estate usually reacts to the global economy. Commercial real estate didn’t cause the price of oil to drop in the last two years, any more than it was responsible for the tech-bubble of the early 2000s or the “sequester” in U.S. Government spending post GFC (which had a terrible impact on markets with large concentrations of government agencies). It is not always simple to separate cause and effect, as we saw in the late 1980s when commercial real estate was a leading cause of the demise of the S&L industry, or in the mid-2000s when the explosive growth of CMBS had global ramifications resulting in the market tanking as buyers all over the world were impacted. In a recent paper, we addressed several current structural changes directly impacting the real estate industry, including the huge inflow of foreign capital, regulatory and tax changes and permanent shifts in tenant demand, all of which have the potential to extend–or pre-maturely end–the cycle.

Given all of the variables how does an investor make educated guess about the end of the cycle? A terrific paper to be published on Wednesday by my colleague Dr. Richard Barkham talks about the macro drivers of the cycle led by unemployment. I have a somewhat different take, go micro.

In a global rout like we saw in 2008-2009 most markets and CRE asset types move in sync. But not all do and some are shielded a lot better than others. You also can’t go by “rules of thumb”, such as “New York will be negatively impacted by the fall in the financial markets” because of the concentrations of major banks and other financial institutions in this market. The reality is that while New York will be impacted, it will be less so than markets like London or Hong Kong, whose economies are not as diversified. This is confirmed by a recent study study by my colleagues in London. You also cannot say “Houston we have a problem” in all asset classes simply because the oil sector is weak. Yes, the office sector in Houston is weak and we are seeing record sublet space now hitting the market, but the retail sector is performing well and the other commercial real estate asset types are proving more resilient than the headlines might suggest.

In short, there isn’t a “cycle,” there are multiple “cycles” based on market, asset type and industry concentration in the local market. You need to pick the right “cycle” to prevent your Skycycle from falling into the canyon.

Evel Knievel’s Harley-Davidson XR-750 now sits for eternity in the Smithsonian’s National Museum of American History. Mr. Knievel held the record for the longest jump in an XR-750 of 19 cars, which stood for 27 years until Bubba Blackwell broke it with 20 in 2008. Next time you are asked where we sit in the cycle, tell them we are sitting in a Harley XR-750 and that you just added the 21st El Camino to the line of cars. Choose your cycle wisely.

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