Commercial Real Estate: Definition & Economic Cycles

Instructor: Laura McCullough

Laura has a MBA, is completing an EdD, has developed online business and human resource courses, and taught theater and speech communication courses.

This lesson explores economic cycles of commercial real estate and examines real estate market drivers, including economic growth, competition, and education.

What Is Commercial Real Estate?

Players of Parker Brothers' Monopoly® win by owning, developing, and leasing commercial property. Competition to purchase or trade deeds is fierce and the game doesn't end until one player owns everything. Like Monopoly®, this lesson is about commercial real estate, the economic conditions that categorize the four phases of its cycle, and the implications of local and global competition and education factors affecting the value and demand for commercial properties.

Commercial real estate is property used for business purposes. It includes multifamily residences, office structures, retail/restaurant facilities, industrial sites, and land. Commercial property is usually leased to tenants, and its long-term occupancy rates determine rental growth and value.

The Commercial Real Estate Cycle

Phases of the commercial real estate cycle are identified by changes in a market's economic growth rate, which indicates the strength of an economy over time. It is usually stated as a percentage of the value of its gross domestic product (GDP) compared from one period to another. GDP is the value of all goods and services produced during a period and is adjusted to reflect inflation. Inflation occurs when purchasing power decreases to levels below what could be purchased previously.

graphic image of the commercial real estate cycle

The four cycles in commercial real estate are:

  • Recovery: This phase includes economic growth hovering at or slightly above the inflation rate due to past GDP decline. Negative job openings limit leasing activity and new construction of commercial real estate.
  • Expansion: Economic growth increases to a normal GDP in this phase. Strong, local job growth leads to improved occupancy rates. New construction of commercial properties resumes until an equilibrium is achieved and supply meets demand.
  • Hyper supply: This phase features economic growth due to booming GDP. Local job growth may loosen in this phase or there could be an over-development of commercial property, either of which lessen a market's occupancy rate and tip the equilibrium toward a saturated market, where rental grow is moderated.
  • Recession: Negative economic growth due to low GDP is seen in this phase. Local job losses lead to an excessive supply of properties, which causes occupancy rates to fall to a low point. There is no new construction.

Global Economic Implications for Local Businesses

Commercial real estate markets have geographic boundaries. When local businesses improve, more capital is available to invest either internally in capital improvements or externally to generate additional income. Traditional investments are made by purchasing stocks and bonds, but stock exchanges are volatile and bond markets produce low returns. More desirable commercial real estate investments generate greater returns on investment and are less risky, because rent is earned and the value of property typically increases over time. Listing prices, however, are based on qualitative location data and are difficult to quantify because long periods are necessary to analyze a property's occupancy and rental growth rates.

The United States' stable governing structures and the value of its currency makes real estate investments ideal for global businesses. Foreign investors pay higher prices for properties in gateway cities, such as New York, Los Angeles, San Francisco, etc., due lack of familiarity with the local market. Their strategic plans for the properties sometimes include novel approaches, i.e., a hotel's penthouse floors converted into condominiums for foreign citizens conducting long-term business in the United States. Foreign investors, therefore, add to the demand for properties in local markets.

Effects of Competition and Education

Competition and education factors also add to the demand for commercial real estate. Well-established empirical studies have documented the correlation between educational performance and school funding levels with that of increased residential real estate values.

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