A common strategy in real estate investment suggests buying assets when prices are low and developing them later when the market is stronger. However, new analysis of historical market data challenges this long-held belief, indicating that the highest returns on development projects may actually occur much earlier in the economic cycle.
Research from investment firm Hines suggests that the premium for developing property over simply acquiring it is greatest during the initial recovery phase of the market. This finding could prompt a significant shift in how investors time their development and acquisition strategies.
Key Takeaways
- New data suggests that the highest returns for real estate development are often found early in the market cycle, not late.
- Investment risk tends to be lowest early in the cycle, despite weak market fundamentals like high vacancy rates.
- Risk levels historically peak later in the cycle when strong fundamentals can lead to overpriced assets.
- A flexible, data-driven approach to deciding whether to buy or build is recommended over traditional market timing rules.
A New Framework for Market Cycles
To understand when to buy, hold, or sell, investors often rely on models of the real estate cycle. A framework supported by historical data divides the cycle into distinct phases, each with its own characteristics regarding market fundamentals and capital markets.
This analysis uses data from sources like CoStar, JLL, and NCREIF, covering over 80,000 historical market observations since 1990. The cycle is typically broken down into phases such as "Early Buy," "Late Buy," "Hold," and "Sell."
Defining Cyclical Risk
In this analysis, risk is quantified as the probability that market prices will be lower in five years than they are today. A risk multiplier of one is considered neutral. Values below one indicate lower-than-average risk, while values above one signal an elevated risk environment.
The Early Buy Phase Explained
The "Early Buy" phase is often characterized by challenging market conditions. Vacancy rates are typically high, rents may be falling, and tenant demand is weak. However, because property prices have already gone through a correction, they are often at their lowest point.
According to the research, the risk of prices falling further over a five-year horizon is quite low during this phase—on average 32% lower than the neutral risk level. Despite this, institutional investors often stay away, leaving opportunities for private high net-worth individuals and family offices.
When Risk and Returns Diverge
As the market cycle progresses, risk levels begin to climb. The analysis shows that the average risk multiplier surpasses the neutral level by the "Late Buy" phase and reaches its peak in the "Prepare to Sell" phase.
During the "Prepare to Sell" phase, fundamentals like rent growth and occupancy are strong. However, this positive sentiment can cause capital markets to become overly enthusiastic, driving prices to levels that are unsustainably high. At this point, the risk of a future price decline is at its highest, with the risk multiplier averaging 1.37.
Peak Risk vs. Strong Fundamentals
The period when market fundamentals appear strongest can often be the riskiest time to invest. Over-enthusiasm in the capital markets can lead to asset prices that are disconnected from their underlying value, increasing the likelihood of a future correction.
This dynamic creates a situation where perceived safety (strong current performance) masks underlying risk (high prices). As both fundamentals and capital markets eventually cool, risk declines, setting the stage for the next cycle to begin.
Development vs. Acquisition Returns
The core of the research compares the returns of acquiring an existing asset versus developing a new one at different points in the cycle. Using unlevered total return data from NCREIF, the analysis provides a clear picture of performance.
"While you probably wouldn’t want to break ground in the earliest part of the cycle, this may be an opportunistic time to option land for the invariable improvement in market fundamentals that tend to occur as the cycle progresses."
Joshua Scoville, Senior Managing Director, Global Head of Research at Hines
The data shows that development projects generally yield higher returns than acquisitions across almost all phases of the cycle. More importantly, it reveals that returns for both strategies are highest early in the cycle and decline significantly as the market enters the sell phases.
Comparing Returns Across Phases
The average unlevered total returns for both acquisitions and development projects follow a similar pattern: they are strongest in the "Early Buy" and "Late Buy" phases and weaken considerably later on. This contradicts the conventional wisdom of waiting for a hot market to build.
- Early Cycle Returns: Both development and acquisition returns are at their peak. The premium for taking on development risk is also at its highest.
- Late Cycle Returns: As the market moves into the "Sell" phases, returns for new projects fall, sometimes below the level needed to justify the associated risks.
This suggests that while starting construction during the weakest point of the market may be impractical, securing land or development rights during this time can be a highly effective strategy. Competition for development sites is often lower, which can provide greater negotiating power with landowners.
Strategic Implications for Investors
This data-driven perspective challenges investors to rethink traditional timing strategies. Rather than adhering to the "buy early, build late" mantra, a more nuanced approach is required.
Early Cycle Strategy
In the "Early Buy" phase, the focus should be on securing future development opportunities. This could involve optioning land or forming partnerships. With less competition for sites, investors can position themselves for the market's eventual recovery without committing large amounts of capital to construction immediately.
Late Cycle Strategy
For development projects initiated in the later, riskier phases of the cycle, a different strategy may be necessary. Instead of a "merchant-build" approach where the asset is sold upon completion, a "build-to-core" strategy might be more prudent.
A build-to-core strategy involves developing a property with the intention of holding it for the long term. This helps investors ride out potential market downturns and avoid being forced to sell at a low point in the next cycle.
Merchant-Build vs. Build-to-Core
- Merchant-Build: A strategy where a developer builds a property with the primary goal of selling it quickly after completion to realize a profit. This is riskier in late-cycle markets.
- Build-to-Core: A strategy focused on developing a high-quality asset to be held as a long-term investment, generating stable income. This approach can mitigate timing risks.
Ultimately, the research concludes that a flexible, data-forward approach is superior to relying on preconceived notions of market behavior. The decision to buy or build should depend on a thorough analysis of market conditions, geography, and property type, rather than a one-size-fits-all rule.
