Simply put, the core focus of the real estate manager is to increase and preserve the value of the managed property. As commercial or investment real estate is valued based on the income stream associated with a particular asset, it is imperative to ensure that rents are at or near market and expenses are managed. A property’s performance will depend on the market as driven by the economy and economic trends, in particular, have a significant impact on a property’s operations. In order to understand the impact of economic trends on real estate, it’s important to first understand the fundamental principles of economics.
Economics is the study of the range of activities necessary for the satisfaction of human needs. These activities include the production, distribution, and consumption of manufactured goods and agricultural products as well as the various services provided to individuals and businesses. Fundamental to all of these activities is the use of land and the construction of buildings to house these activities—real estate is an important component of economics in general. In fact, ownership of land was once the principal measure of wealth in one’s lifetime.
Today, money is the measure of wealth. The material substance of wealth—an automobile, a home, furnishings, stocks, bonds, and other investments—is expressed as the money value of those items. The interrelationship between money and the goods and services it can purchase goes beyond money’s role as a medium of exchange. Money allows comparison and measurement of the values of goods and services that are otherwise not readily comparable or measurable—it serves as a standard of value. Money itself has value based on its purchasing power—it serves as a store of value during the time between specific transactions. The value of money fluctuates over time because of changing factors in the marketplace, such as interest rates, inflation, money supply, and world events.
In any study of economics, an important element is the market—the place in which the exchange of goods and services between willing sellers and buyers actually takes place. The town square market, a retail store, and a real estate office are all markets. In these markets, purchases and sales take place between people who are face to face. In other markets—such as the New York Stock Exchange, Chicago commodity markets, and online—the seller rarely sees the buyer. The marketplace continues to be complex and multifaceted. Many elements are part of or have an effect on the market for a particular item. Price, supply, and demand have direct effects on rental space and employment levels. These phenomena are themselves affected by changes in technology and in the value of money. These elements of the market are of particular interest to real estate managers.
Price. In a complex economy where money is the medium of exchange used to measure the value of goods and services, the price of an item is the amount of money required in exchange for a unit of the item. Market factors determine the price of any item, and the price must be acceptable to both the buyer and the seller. If the price the seller wants is higher than the amount a buyer is willing to pay, no transaction will take place.
Supply and Demand. Prices in the marketplace are subject to the quantity of available goods and services and the relative value of money. The availability of goods and services is called supply. Availability of goods and services for sale is related to price, and more goods or services are offered as prices rise. When the amount of merchandise available for sale exceeds the amount that people are willing to buy, the excess volume reduces the value of the individual units and therefore lowers the price.
Price is not the only factor that limits supply. The price of one item can affect the supply of another related item. The supply of corn drops if the price of soybeans rises because farmers choose to grow the more profitable crop. Supply of a finished product depends on the price and availability of its components. An increase in the number of sellers of a specific product increases the supply of that product. Reduction of import restrictions permits foreign-made goods to compete with comparable domestic products and increases the overall supply. Sellers’ expectations are another consideration. For example, oil production may temporarily fall (i.e., be delayed) if prices are expected to rise in the future.
Another market factor that affects price is demand—the amount of goods or services for which purchasers are available. Conversely, price affects demand. Generally, the amount purchased increases as prices drop. Factors other than the price of an item also affect demand. The price of related goods is one example. A simple illustration of this is how the demand for tea increases when the price of its substitute, coffee, rises. On the other hand, demand for sugar, a complement to coffee, drops when coffee prices rise. Because the price of coffee with sugar rises as the price of coffee rises, reduced coffee consumption will lower the demand for sugar. Another example is income. People spend more as their income rises, increasing demand. People also spend less when confidence in the economy is low. People’s preferences also are a factor in demand, and advertising may alter preferences. An increase in the number of buyers will increase the demand for goods or services.
Over time, prices tend to be stable when supply meets or is equal to demand. When supply is less than demand, prices tend to rise; when supply exceeds demand, prices tend to fall. Taken together, these statements are the laws of supply and demand.
Rental Space. These same supply-and-demand phenomena occur in the real estate market. Successful companies change their operations when demand for products or services drops. For real estate managers, this focuses on the need to:
For example, when demand for rental space is strong, rents should go up. A growing or shrinking work force signals a need to evaluate office space needs. Rising income encourages consumer spending, and that creates a demand for retail businesses and, potentially, store space. An increase in manufacturing, warehouse and distribution, and research and development triggers a strong demand for industrial space.
Rising rents stimulate investment in existing income-producing properties (apartments, office buildings, shopping centers, industrial parks) as well as construction of new ones. As rental rates increase, the value of the asset increases. New development eventually increases the supply of apartments, offices, industrial, and store spaces beyond the demand for them, and rents stabilize or decrease. However, the value of the real estate assets inevitably decreases as its rental income diminishes.
Employment Levels. The labor market, too, is subject to the laws of supply and demand. The workforce consists of both employed and unemployed individuals. Full employment is an unachievable ideal. As new jobs are created, other jobs are removed from the market. Unemployment can result from corporate downsizing and outsourcing of jobs, long-term decline of a specific industry, or a general downturn of the economy. Full employment (in economic terms) can only result when everyone who wants to work can find a job.
Significant unemployment affects the real estate industry in several ways, most notably as a reduction of the income stream of a property. People who are not working do not have income from which to pay rent for housing. Rather than struggle to meet expenses on their own, renters may double up to share expenses, or young adults may return to their parents’ homes. Inability to pay rent may force residents to vacate apartments or face eviction. This cycle has been seen during the Great Recession.
The Bureau of the Census measures employment by surveying 58,000 households every month to gather information on their labor-market activities during the preceding week. From the data, the Bureau of Labor Statistics estimates the number of people employed and unemployed during that month. It classifies everyone over age 16 as employed, unemployed, or not in the labor force based on a specific definition of employment. The unemployment rate is the number of unemployed divided by the number in the labor force (the number of employed plus the number of unemployed). For real estate managers, levels of employment and unemployment, particularly as they change within a localized area, reflect people’s—and businesses’—ability to pay rent. The employment levels also indicate whether the need for housing or commercial space will increase or decrease.
Reduction of the work force means businesses have fewer employees. For most businesses, fewer employees mean reduced work space requirements. Unemployed people are generally not consumers, so retail businesses may have to cut back on inventory and the amount of space used to display merchandise. They may opt to relocate to smaller stores. In factories, the initial reaction may be the reduction of the length or number of work shifts, but eventually manufacturers may eliminate redundant equipment and then seek smaller sites. As the slowdown of business reduces the demand for space, it also reduces the demand for new construction. The market cannot absorb additional rental space, and the market for a specific type of space becomes overbuilt and rents drop.
The office building market is particularly affected by changes in the level of employment. High employment means that companies typically need more space to house their operations and personnel. However, high unemployment means companies need less space—they will also be less inclined to move because of the expenses involved. If they stay and renew a lease, they may seek to reduce the amount of space rented. If they do move, it will be because they have found a smaller space that meets their needs. The ultimate effect of major unemployment on office space is higher vacancy levels and slow absorption of new space. Some resort to sub-leasing space from companies that would like to downsize but can’t afford to move, or are hoping for a speedy recovery of their business. These prospective tenants have now found space outside of the pool of vacancies, thereby diminishing potential occupancy.
Technological Change. One of the most far-reaching causes of change in the marketplace is the increasing speed of new technologies for both consumers and businesses. With greater efficiency in production, improved modes of transportation, innovations in communication, and development of totally new products, technology has reshaped the way people live and work. New technology can affect production, distribution, supply, and demand, and the jobs created by technological change have a direct impact on the labor market.
Technology also has an impact on rental space. For example, development and widespread use of computers contributed to a growing demand for new office buildings because retrofitting of older buildings for the high-tech equipment used in many businesses can be very costly. On the other hand, the use of computers and their adjuncts may increase productivity in the workplace and have a negative impact on demand.
More specifically, home computing which began in the ‘90s affected both the demand for office space and the way it is used. Computers, smartphones, and other new technologies made it possible for workers to perform job tasks at home or at locations other than their employers’ offices. These workers could telecommute or establish a home office, where they could conduct their business with the tools they need. In such situations, the employer might need less space overall. A company might not maintain office space for a particular employee, but instead set aside a cluster of spaces for those staff members who only needed to work in the office periodically—a practice called hoteling.
Computers also altered inventories. Increased supplies of crops and manufactured goods generally increase demand for warehouse space. However, the ability to maintain accurate counts of items in stock, coupled with manufacturers’ desire not to invest large amounts of capital in inventory and their ability and willingness to ship small quantities on short notice (just-in-time delivery), reduced the need for storage space among distributors and retailers. And, the longer a product is held, there is more chance of damage, misplacement, and reduced value. The direct effect of this phenomenon was increased demand for smaller store and warehouse spaces.
By-products of technology provide other examples of technology’s impact on rental space. Prior to the 1980s, video stores did not exist. However, by the early 1980s, video rentals could be profitable in just about any size store, and those operations consequently leased space in every type and size of shopping center and provided additional profits to supermarkets, drug stores, bookstores, and other businesses until the mid 2000s. By 2010, video stores became nearly extinct as new devices and online video streaming (e.g. Netflix, Amazon Video, Hulu, Sling TV) made movies and TV shows directly available to rent and/or purchase.
The 1990s brought the ability to transact sales securely online without specific need for a brick-and-mortar site. The full impact of this change on the demand for rental retail space has yet to be fully realized; however, warehouse and distribution facilities have already experienced a noticeable impact. For example, portable devices for downloading and storing individual songs online significantly impacted retailers who sold music. Today, nearly all music is sold online. In addition, with the introduction of e-reading devices like Kindles and iPads, book retailers have also been greatly impacted, with Borders Book Stores declaring bankruptcy in early 2011.
Just as the co-working phenomenon is booming with companies like WeWork, who allow business owners and employees alike the freedom of being able to travel the country, pop in to a location, and set up shop with a rented desk or work station, so too is the hospitality space doing battle not only with each other but also with app-driven sites such as Airbnb and VRBO. These companies are just a part of the billion-dollar “Shareconomy” that is disrupting the traditional economy by offering a peer-to-peer as opposed to business-to-customer platform.
The U.S. government has an impact on the economy in numerous ways. The government is also a purchaser of goods and services from private industry, and that stimulates production and fosters competition. On the other hand, specific legislation and regulatory programs add to consumer prices and skew the costs of doing business (e.g., requiring governmental agency approval of drugs, pesticides, and other products before marketing; setting minimum wage rates; taxing specific products such as tobacco, alcoholic beverages, and gasoline). Price controls (supported prices for agricultural products) and regulation of competition in U.S. markets (limitations on imports, subsidies for domestic products) are other examples.
In addition to its participation in the economy, the federal government also measures economic activity. It collects information on wholesale and consumer prices, interest rates, money supply, levels of production and consumption of goods, construction starts and permits issued, sales of new and existing homes, population and more. Trends and changes in these indicators are used to chart economic growth, inflation, and the place of the U.S. economy in the world at large.
Other indicators are also relevant to real estate and its management. Fluctuations in interest rates are a measure of the availability of funds for borrowing—for investment, construction, and operating capital. The U.S. Federal Reserve System may lower the discount rate at which it lends money to its member banks as a way to stimulate economic growth. The Producer Price Index (PPI) and the Consumer Price Index (CPI) are measures of inflation at the wholesale and retail levels, respectively. (In leases written before the 1990s, real estate managers often used the CPI for rent increases based on increased operating costs. The CPI is discussed in detail later in this chapter.) The number of building permits issued, the number and value of construction starts, and the absorption rates for newly constructed space chart the health of the U.S. real estate market. Real estate professionals in general and real estate managers in particular follow many of these economic indicators as a matter of course, which may help guide their decision-making processes.
For decades, the productivity of the U.S. economy was measured as gross national product (GNP). The GNP is the market value of all final goods (tangible objects such as canned food and automobiles) and services (intangible objects such as entertainment activities and transportation) produced by an economy in one year’s time. It measures output attributable to U.S. residents regardless of their geographic location. Because foreign trade provides some of the goods and services Americans purchase, its effects are also included in the measurement of GNP. It accounts for the volume of goods and services exported to and imported from other countries. When imports exceed exports, the net value of the GNP is negative (as it was during the late 1980s in particular).
Beginning in 1991, however, U.S. productivity has been reported as gross domestic product (GDP), which measures the same factors for economic activity located only within the United States. (Nearly all other countries measure productivity as GDP, so use of GDP facilitates comparisons of U.S. economic activity with that of other countries.)
The U.S. GDP is currently measured in billions of dollars. The amount is calculated by adding together the value of personal consumer purchases (durable and nondurable goods and services) and government purchases of goods and services at the federal, state, and local levels, plus the investment of private capital in new plants and equipment, commercial buildings, and residential structures (fixed investment), and new stocks of business inventory. The investment amount is adjusted for depreciation (using up) of the existing capital stock during the process of production. A rapidly rising GDP may signal rising interest rates or the beginning of a period of increasing inflation. A declining GDP may forecast falling interest rates or impending recession. (Some economists consider two consecutive quarters of declining GDP as an indicator of recession.)
Real estate is a significant portion of GDP (10 percent in 2010). It comprises construction, professional services, and real estate finance and accounts for designing, building, brokering, financing, and managing real properties (residential, office, retail, industrial) built or traded for investment. It excludes building materials and construction of public facilities. Real estate’s contribution to the GDP exceeds those of durable and nondurable goods manufacturing, wholesale and retail trade, and the cost of government as individual sectors.
Of all the functions of government; however, taxation on income, regulation of banking, and control of interest rates are among those of greatest interest to the real estate manager. (The specific role of the various levels of government in the real estate market is discussed later in this chapter.)
Taxation. The functions of government, including the services it provides, have inherent costs. In order to pay those costs, the government must have income. Government derives its income from various sources, the most significant of which is taxes. In the United States, the federal government taxes the income of individuals and businesses. State and local governments impose taxes primarily on property, although some tax income and sales of goods and products as well.
The federal income tax, as its name implies, is a tax on personal and business income. Changes in the law have from time to time specifically encouraged or discouraged investment in income-producing property. In the early 1980s, the law provided for higher tax rates on higher incomes, but it also created a variety of tax shelters. An individual or entity could invest in property that generated little or no income and still make a profit on paper. The level of continuing inflation essentially guaranteed a selling price higher than the property’s purchase price. In addition, investors could use losses from real estate investments to offset income from wages and other sources. That reduced the property owner’s taxable income and, in some cases, lowered the tax bracket. However, the Tax Reform Act of 1986 changed that, and investment in real estate became less attractive because the act greatly reduced tax incentives. Property owners could no longer use losses that resulted from real estate operation to offset other income. The tax reform blocked them from sheltering that income from taxation. Owners who previously bought property for tax breaks found themselves in the position of having to use income from other sources to support their real estate investments that were operating in the red. Those who did not have extensive resources had few options, and they elected sale, foreclosure (default), and sometimes bankruptcy. Inflation slowed and property values no longer appreciated quickly—especially in overbuilt markets. As a result, the number of distressed properties on the market increased.
Changes in the federal income tax laws affect the amount of capital people are willing to invest in real estate and other assets. The Economic Growth and Tax Relief Act of 2001 lowered individual tax rates, and the Jobs and Growth Tax Relief Act of 2003 made further adjustments, including the reduction of the long-term capital gains tax rate from 20 to 15 percent. (Those capital gains rate cuts were to be effective for the tax years ending on or after May 6, 2003, and signed into law on May 28, 2003, but nearly all of the cuts—individual rates, capital gains, dividends, estate tax have expired after 2010.) Favorable capital gains tax rates encourage the sale of appreciated property. On the other hand, changes in the rules regarding depreciation—the method by which taxpayers are allowed to recover the cost of their investment—can encourage or discourage investment. The current long cost-recovery periods for real estate investment (27.5 years for residential property and 39 years for commercial property) diminish the rate of return on the owner’s investment.
Financial Regulation. A significant role of government relates to money. It produces the nation’s money and regulates the amount in circulation. When governments mint and print additional currency, they create inflation. When they reduce the amount of currency in circulation, they cause deflation. Printed money and coinage were traditionally backed by some type of convertible commodity. Each country fixed a value of the commodity for its particular currency so that international exchange could take place. Previously, gold was the accepted standard. However, the present standard involves a mixture of floating- and fixed-exchange rates. The value of the U.S. dollar floats with respect to the major currencies of the world.
The U.S. government also regulates banking. Deregulation of the thrifts in the 1980s gave rise to several phenomena. Branch banking (and branch S&Ls) became widespread, and the government allowed S&Ls to offer negotiable order of withdrawal (NOW) checking accounts and to lend money for commercial investment. A large number of banks and S&Ls entered the real estate market directly, often lending money in a manner that allowed them to participate in the property ownership. Many of those institutions had no prior experience in real estate investment, and they frequently made loans for the development of marginal properties. In addition, they allowed assets held in reserve to reimburse depositors to fall below required levels—sometimes as a result of real estate assets having lost value. When the borrowers defaulted on the loans, the financial institutions foreclosed on the properties. By the end of the 1980s, the market was glutted with troubled properties. Failures of S&Ls became widespread, and the Federal Savings and Loan Insurance Corporation (FSLIC), which guaranteed the deposits in the institutions, was required to pay back the insured deposits. The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), which the U.S. Congress enacted in 1989, transferred the responsibilities of the FSLIC to the Federal Deposit Insurance Corporation (FDIC), which is the insuring body for deposits in banks and in the few remaining S&Ls. As a consequence of the savings and loan crisis of the 1980s, the Resolution Trust Corporation (RTC)—a United States government-owned asset management company—was charged with liquidating assets (primarily real estate-related assets, including mortgage loans) that had been assets of S&Ls declared insolvent by the Office of Thrift Supervision. Although the RTC was first established in 1989, it was overhauled in 1991.
Beginning in the late 1990s, the government began allowing banks to acquire or merge with banks in other states. It modified the Bank Holding Company Act to authorize banks to underwrite and sell insurance and securities, conduct both commercial and merchant banking, and invest in and develop real estate, among other activities. However, the act limits the kinds of nonfinancial activities in which those new entities can engage. (Banks are not allowed to act as agents in real estate transactions.) National banks are allowed to underwrite municipal bonds. As a result, things became dramatically tighter due to the Dodd-Frank Act that was signed on July 21, 2010. It was enacted to promote financial stability by improving accountability in the financial system, to protect taxpayers by ending bailouts, and to protect consumers from abusive financial service practices. The Dodd-Frank Act changed the existing regulatory structure by creating a multitude of new agencies to streamline the regulatory process, increase oversight of specific institutions, and amend the Federal Reserve Act by promoting transparency and other changes.
International trade requires the exchange of the U.S. dollar for other nations’ currencies. In free markets, currency values generally appreciate in countries where inflation rates are lower than those in the rest of the world. Foreign demand for those countries’ goods drives up the value of the currency. Likewise, in countries with lower-than-average economic activity (specifically, low imports), exchange rates (currency values) rise. Countries where interest rates are high attract investment capital from all over the world. The reverse is also true: Currencies depreciate in value in countries with high inflation rates, high levels of economic activity, or low interest rates. The U.S. dollar has a floating exchange rate against foreign currencies, most notably the British pound, the euro, and the Japanese yen.
In the United States, the Federal Reserve System regulates the money supply by changing the required reserve ratio (the amount of reserves a bank must have on hand in relation to the deposits on its books), by changing its policy on lending to banks (raising or lowering the discount rate), or through open market purchase and sale of government securities. To increase the money supply, the Federal Reserve purchases U.S. government bonds (treasury bills or T-bills) that pay a fixed number of dollars of interest annually for various terms (one-year T-bills, 10-year notes, 20-year bonds). Increasing the money supply results in higher bond prices and lower interest rates. Conversely, when the Federal Reserve sells bonds, the money supply decreases, and lower bond prices and higher interest rates result. For example, consider a bond that pays $90 a year. It will yield a return of nine percent when the bond price is $1,000. However, if the bond price falls to $900, the bondholders will receive a 10 percent return.
Real estate investors and managers use the interest rate on treasury bonds as a benchmark—a risk-free rate of return. They use it to determine how much additional interest a real estate investment must return to compensate for its illiquidity and other risk factors. For example, if the risk-free rate of return on treasury bonds is six percent, a real estate investor may require an eight percent or larger return. Internationally, the London Inter-Bank Offering Rate (LIBOR) provides a similar benchmark. The LIBOR rate quoted in The Wall Street Journal is an average of the rates at which five major banks would be willing to deposit U.S. currency for a set period. It compares most closely with the U.S. rate on one-year T-bills.
Interest Rates. As part of its regulation of banking, the U.S. government controls the money supply by adjusting interest rates, and that has widespread effects. When the Federal Reserve System lowers the discount rate charged to its member banks (to stimulate economic growth), the banks, in turn, may lower the commercial prime interest rate they charge their most credit-worthy customers for short-term loans. This can lead to a reduction in the interest rate paid on deposits as well. Conversely, the Federal Reserve System may raise the discount rate to reduce the money supply or to discourage banks from excessive leniency in their lending and investment policies.
Interest is a major inducement for people to save. When an individual’s income exceeds the amount required to take care of basic needs, the surplus income can be spent immediately for personal enjoyment (to acquire possessions, for recreation, etc.) or set aside for future use.
Savings deposited in banks and related financial institutions do more than earn interest for the saver. That money works to produce more money. Banks use savings deposits to finance various types of lending. Consumers borrow money to purchase homes, automobiles, major appliances, recreational equipment, vehicles, etc. Businesses borrow money for operating capital, which they use to purchase raw materials for processing into finished products or to provide inventory of products for sale. Both individuals and businesses borrow money to invest in income-producing real estate. They pay the borrowed money back to the lenders with added interest. In fact, the amount borrowed often depends on the rate of interest charged.
When money is plentiful, interest rates tend to be low, and banks readily lend money to willing borrowers. Throughout the 1990s and into the 2000s, interest rates were kept low to fight inflation, despite a recovering economy. The low interest rates encouraged a boom in single-family home purchases and in refinancing, and the country enjoyed a strong economy in the latter part of the 1990s.
The exuberant purchasing and refinancing began to wane in 2004 when the Federal Reserve Bank began to raise the federal funds rate and the federal discount rate, which in turn influenced the prime rate quoted by financial institutions. When money is tight, however, interest rates tend to rise, and individuals and businesses tend to borrow less. High interest rates encourage saving and discourage borrowing. Changes in interest rates are among the factors that contribute to inflation and deflation, and periods of inflation and deflation affect the sale and purchase of goods and services, usually in a cyclical manner. Controlling interest rates is one way the government attempts to control inflation and the amount of money available for borrowing. However, the recession of the late 2000s made credit tight and interest rates remained at a historically low level. As a result, consumers and businesses could not obtain credit as easily as they did before the collapse, but the steadily decreasing interest rates created easy credit conditions for a number of years prior to the Great Recession.
Periods of economic expansion or contraction may be short-lived (a few months), or they may go on for many years. Sometimes one region of the United States or the world is affected more than another region. Occasionally a single industry or a single market is the focus of economic change, but that is rare. Businesses and industries today are interrelated in such complex ways that whatever affects one significantly affects most, if not all, of them. Poor sales of consumer merchandise slow a retailer’s business, the retailer orders less from wholesalers and distributors, and they in turn take less of a manufacturer’s production. A raw material shortage curtails a manufacturer’s production, less merchandise is available for wholesalers and distributors to move to retailers, and consumers cannot purchase products they desire. Changes in technology, development of new materials, and discovery of new uses for existing materials are some factors that contribute to massive economic changes. They may make current materials and technologies obsolete, or they may create entirely new industries.
When business is good, selling goods or services is simple. Demand exceeds supply, prices are high, and making a profit is easy. When business is poor, supply exceeds demand, prices are low, and losses often replace profits. These various periods of inflation and deflation of an economy are known as the business cycle. The business cycle generally has four successive stages: recession, depression, recovery, and prosperity (Exhibit 3.1). By convention, professional economists look at the downside first, perhaps because its causes and effects are more readily apparent.
Recession. During periods of prosperity, all sectors of the economy expand. The increased demand for goods and services tends to raise prices. Prosperity also results in higher wages. When personal income increases, people have a tendency to spend that income—buying a more luxurious car, paying more in rent for a larger apartment, etc.—but only up to a point. Once their needs and wants are satisfied, many people will store their surplus income in the form of savings or investments.
When people actively save money, a corresponding reduction in consumer spending generally occurs. However, savings invested in banks or in stocks and bonds provide the capital for commercial investment. Spending by business firms temporarily offsets the absence of spending by consumers. The lessening of consumer spending affects businesses in two ways. Because merchants can no longer rely on the same level of sales, their income decreases, and they cannot afford to maintain the same inventory levels. Manufacturers still have to pay for raw materials, wages, and other costs of production.
Providers of services are also affected. Businesses may postpone or defer equipment maintenance and repairs. To control costs, they may have in-house staff provide services that they previously outsourced. Conversely, they may opt to reduce staff and outsource services that they can contract for less. To increase profit margins, manufacturers of consumer goods may deal directly with retailers, eliminating the wholesale distributor. Some may even choose to deal directly with consumers via factory outlet stores, direct mail (catalogs), or online. Competition increases as businesses try to maintain or increase their share of a dwindling consumer or industrial market. In order to maintain inventories and meet payroll expenses, businesses turn to bankers. Meanwhile, the bankers become cautious; their willingness to lend money to business for expansion may not extend to providing operating capital. Tightening credit also reduces the funds available for new construction. Prices cannot continue to rise in this environment. Not enough buyers are available—demand has reduced. This slowdown in business activity signals the beginning of a period of economic recession.
A number of economic factors measured by the U.S. government on a regular basis move upward and downward in the same pattern as the business cycle. Some of these indicators lead the cycle, some run concurrent with it, and others follow it. Of particular interest are the indexes of business activity—building permits, total output, employment, business formation, and new orders. A period of recession often follows sustained downturns in one or more of these indicators.
Indicators that relate directly to real estate include the total value of new construction put in place (all property types), nonresidential investment as a percentage of gross domestic product (GDP), total manufacturing and wholesale trade inventories, and retail sales. Other indicators of interest to real estate professionals reflect the general economy. These include consumer and producer prices, net exports, employment, and interest rates (especially the prime rate).
Indicators that tend to rise or fall in advance of a general rise or fall in business activity are called leading indicators. They are the most important because they give advance warning of future economic events. Normally they turn down before a recession and up before an expansion of the economy. The U.S. Department of Commerce publishes a composite index of leading indicators that is a weighted average of twelve of their leading indicators. Four components of this index are new building permits, net change in inventories, stock prices, and the money supply. The index of leading indicators is one of the most widely used indicators in the U.S. economy; however, its accuracy in forecasting recessions is not absolute because components of this composite index do not move together in exactly the same rhythm.
Soon, manufacturing costs catch up with selling prices. Banks raise their interest rates and may even refuse to make loans; businesses cannot borrow additional capital. The inability to obtain funds from banks leads to the failure of some businesses, and that can have a domino effect. One business may depend on payment from a second business to meet its obligations on a loan. When that payment does not come, the first business fails. Business failures mean banks and other lenders cannot collect their outstanding loans, and eventually the financial institutions themselves fail, which happened with the subprime mortgage lending crisis in 2008 and 2009. The term subprime refers to the credit quality of particular borrowers, who have weakened credit histories and a greater risk of loan default than prime borrowers. The banks’ faulty practices are a large part of what led to the Great Recession. Lending practices became so much tighter that even people with good credit experienced difficulty in obtaining loans, which further stifled the recovery and caused more businesses to fail.
Depression. A widespread reduction in business activity ultimately results. Employment drops, wages fall, and consumer demand declines. Surviving businesses try to sell all they can and buy as little as possible so they can meet contractual obligations, pay their debts, and avoid failure. As demand continues to decline, so do prices. The most serious outcome of all of these negative factors is a period of depression. Stocks of goods diminish as businesses sell and do not replenish their inventories. The rate of production is slow and prices are low. Interest is down and so are wages. Unemployment is widespread. Depression eliminates the weakest businesses and banks, and less competition exists in the marketplace.
Recovery. During a depression, however, business costs also decline because rents, wages, and prices for raw materials decline. Businesses will eventually have to replace machinery and equipment they did not maintain or replace during the depression. The need for new machinery creates a demand for capital equipment, and increased demand stimulates other businesses and leads to higher prices. These are early signs of recovery. After most recessions in the United States, once recovery gets started, employment and wages increase; however, the Great Recession did not follow typical recovery and was referred to as a “jobless recovery.” Eventually, recovery with jobs should occur. Additional income will increase the demand for consumer goods and services and tends to raise prices. Production costs will not rise as quickly as prices because rents, interest rates, and wages—which react more slowly to change—will remain low for some time.
Prosperity. When prices rise faster than the costs of production, business income increases in the form of higher profits. The reviving economy heads for prosperity once again. Prosperity is a period of good business. Businesses foresee opportunities for profits, so they borrow capital, increase their production, and try to enlarge their share of the market. Banks are willing to lend money for business expansion because such loans are easy to repay. Lending expands the banks’ business. The expansion of one business creates a demand for the products and services of other businesses, and that tends to raise prices. High prices in the marketplace attract other businesses to it, resulting in competition.
Population growth also fuels economic growth. In the United States, immigration has significantly affected the population. Foreign-born individuals represented 7.9 percent in 1990, 11.1 percent in 2000, and 13.5 percent in 2015. Changes in the size of the population affect the size of the work force. A growing work force means larger numbers of consumers as well. The Baby Boom generation dramatically increased the size of the work force beginning in the 1970s. However, they produced fewer offspring than their parents. As the Baby Boomers passed into middle age (in the 1990s and beyond), their children entered the work force—but in much smaller numbers. Only a few years ago, many Baby Boomers were likely to have retired as they reached age 65; however, with the financial turmoil from the Great Recession, which has sharply reduced the home values and financial investments of millions of boomers just as they approach retirement, this is no longer the case. For the first time, at least three generations of individuals will be in the work force together. The Bureau of Labor Statistics provide numbers of employed persons by detailed occupation and age, including median age—specifically in the real estate industry (Exhibit 3.2).
Prosperity tends to feed on its own momentum. Employment levels rise as businesses expand. Business expansion leads to new construction of office, industrial, and retail properties. High wages permit workers to purchase luxury items and invest in home ownership. During these times, housing starts to increase, especially single-family homes. Investment, savings, and purchases on credit are on the rise. Meanwhile, rents and interest rates begin to escalate as leases and contracts expire. The economy starts to slow down, checked by rising prices, wages, rents, and interest rates—all of which make money tighter—and the cycle repeats itself.
Throughout the business cycle, rents, interest, and wages do not change as quickly as other prices. Rents and interest rates usually remain fixed for a time; leases and other contracts run for months or years. Wages and salaries also remain fixed for extended periods, sometimes by contract. As general prices for goods increase, rents, interest, and wages are slow to catch up. The disparity in these costs of production in relation to the prices commanded for goods is part of the fuel behind prosperity. Rents, interest, and wages eventually catch up with prices, however, and that has the effect of reducing profits and creating losses—ultimately fueling a recession. The numbers of potential buyers diminishes, depressing real estate prices. Unavailability of capital precludes investment in improvements, and the real estate market becomes glutted with distressed properties. In the end, the credit crunch that results promotes recovery by limiting new building.
A period of depression does not always follow a recession, and recovery is not always a separate stage in the business cycle. Sometimes periods of prosperity follow periods of mild recession; economic expansion and contraction are apparent but not pronounced. Often a scientific breakthrough or development of a promising new technology can be a significant contributor to economic recovery. The real estate industry is part of the general economy, and it reacts to the same economic pressures, but its reactions are slower and stronger. (The nature of the real estate cycle is discussed later in this chapter.)
The amount of land available for use is strictly limited. Land also has unique characteristics based on its location and its inherent qualities. These factors give value to land and affect its desirability. Value is also created when land is made usable—i.e., prepared for development by grading, draining, and installation of curbs, sidewalks, sewers, and streetlights. Ultimately, the use or potential use of land determines its market value. Fertile farmland that yields more grain per acre is more valuable than less productive acreage. However, neither will be as valuable if the grain cannot be transported to the marketplace. A location that includes access to transportation is a key factor in the value of farmland. Land in urban areas is often considered more valuable than suburban land because of its intensive use. For instance, population density is very high for residential uses—a 100-unit apartment building may occupy the same amount of land as two or three single-family homes.
In some urban areas, residents accept high rents as a trade-off against long, expensive commutes to work. They expect ready access to public transportation and the cultural and entertainment features of the city as well as the amenities of the building to compensate them for that rent. Businesses willingly pay high rents for office space in urban areas because they have access to a large labor pool and to all the services available in a city. (Exceptions do exist. Some cities have lower rents per square foot than their surrounding suburbs.) Retailers will pay high rents to have store space in an area where wealthy people shop or to have access to large numbers of potential customers.
Markets for specific products and services exist wherever willing buyers and sellers of those products and services exist. The products themselves and the people who provide the services can move from one location to another. While land is fixed in location, owners of real estate may not be local. Large commercial properties, in particular, are typically traded at the national level and in international markets. However, the ultimate users are local.
The value of land in the local market depends on its use and any improvements to it. Because buildings and other improvements on land have a long physical life, the commitment to a specific use is not readily subject to change. Land use is affected by many factors, among them industry, population, highways—and supply and demand.
Yet another contributor to the down side of an economy is credit card debt. With easy availability of credit, consumers are as likely—or more likely—to make purchases with credit cards than with cash. When the credit card bills come in, some may have a tendency to pay only the minimum amount due, carrying forward a growing balance at a high rate of interest. Competition among credit card issuers encourages consumers to pay off an existing credit card balance using a new card at a lower interest rate. Those who continue to use credit cards without paying down the balance may become overwhelmed. And, with a flat salary or fluctuations in employment, bankruptcy can be an appealing option. Their creditors—merchants, property owners, and others—may be able to collect only a small portion of the debt owed—or nothing at all.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) made it more difficult for consumers to file for bankruptcy. The Act requires that incurred debts are discharged only after the debtor has repaid some portion of their debts instead of forgiving the entire debt. The legislative changes affected consumers and business bankruptcies. The Act requires the debtor’s income to be compared to the median income of the debtor’s state. If the income is above the median income, they are subject to being found “abusive” or in violation of filing for bankruptcy.
Industry. Changes in industry and the economy also affect land value. Inflation, wide fluctuations in the availability and cost of mortgage money, and the cost and availability of foreign crude oil are factors that affect the real estate market at the regional, national, and international levels. At the local level, empty factories and warehouses on the edge of a city may no longer be as useful as industrial properties. Creative developers and architects can usually find a way to convert them to other uses. Vacant warehouses that could not be sold or were no longer usable for their original purpose have been renovated and converted to housing. Factories, post offices, railroad stations, and historic buildings have been made over as shopping centers. Such changes, intended to increase the income from the property and therefore increase its value, also preserve landmarks and conserve raw materials.
Changes in a region affect land use. The growth that occurred in the Sunbelt (the Southwest) in the 1980s had nationwide impact. Many industries relocated there from the northeastern United States. The areas they left behind became known as the Rust Belt—also known as the Manufacturing Belt or Factory Belt in the Northeastern section of the United States running west of the Megalopolis (Washington D.C, Baltimore, Philadelphia, New York City, and Boston) through Pennsylvania, Indiana, Ohio, Michigan, and to the western shore of Lake Michigan. High technology and petroleum were the booming Sunbelt businesses. They brought jobs that created demand for new office space. However, dependence on them to the exclusion of other types of industries eventually had severe effects locally. Increased importation of petroleum reduced domestic exploration and production. Higher prices for domestic oil increased the production costs of products derived from it. When the oil and high-technology industries faltered, many cities—especially Dallas and Houston in Texas—suddenly had phenomenal amounts of vacant new office space and interrupted construction. Property values declined drastically.
Population. Changes in population size have a direct impact on land values. When the population in an area grows, land value increases. The increase in demand for the fixed amount of land leads to higher prices. Population growth is a direct result of the formation of new industries that provide jobs. New manufacturing industries attract support businesses (suppliers of raw materials or parts and distributors of finished goods), which also increase the number of available jobs. When the local population declines—particularly if significant numbers of people move away and others do not move in to replace them—demand for land decreases, land values decline, and prices fall. Population decline results when industries close down because they have become obsolete or lost their share of the market. Those satellite businesses that depended on the major industry may close down earlier because the components they supply are no longer needed or later because there are no finished products for them to distribute. These shifts in industrial activity that affect population size also affect the local economy by increasing and decreasing the amount of income available for discretionary spending.
Ample discretionary income and ready availability of credit encourage shopping, and that creates a demand for shopping centers. In order to meet the demand and create unique shopping environments, major malls include food courts, movie theaters, and other forms of entertainment, which also serves to lengthen the shoppers’ stay.
The U.S. population is aging rapidly, and more people are living longer than ever before. An aging population increases the demand for senior communities and retirement housing (which may be comparatively smaller and are likely to be more expensive and include recreational amenities). Such housing provides opportunities for specialty management. The aging population also increases the need for senior housing, nursing homes, and health care facilities.
Supply and Demand. In the real estate market, the laws of supply and demand are also at work. Usually the value of real estate in a given market is based on the present worth of projected future benefits to be derived from the investment. Stable values result when a balance exists between the supply of a given land use and the economic demand for that use. Supply may be limited and is not quickly increased. Supply declines because of deterioration, demolition, and destruction by hazards (e.g., fire). Change of use reduces the supply of one use while adding to the supply of another. Existing properties are part of the total supply even if they are not used. Demand changes, however, and many factors influence it. Population, income, credit, personal tastes and preferences, as well as governmental actions, taxes, and cost savings have an impact on demand. The imbalance between supply and demand means real estate investment can be riskier than other types of investments whose markets are more predictable.
When a particular use (e.g., office space, shopping centers) is in oversupply, the value of that type of property declines. An overbuilt market is a renter’s market. More space is available than renters who desire such space, so prospective tenants can negotiate lower rents and other favorable terms—some or all of which can have negative long-term effects on property value. An under-built market is more appealing to investors because it favors the property owner. When demand exceeds supply, the available space commands high rents because less competing space exists.
Governments at all levels affect real estate transactions in numerous ways. Local governments tax real property based on its value (ad valorem tax). The tax burden affects the value of a particular parcel of land and is therefore an important consideration in the investment in real estate. Local zoning ordinances impose limits on land uses, and compliance with them—or efforts to change zoning—can be costly. Appropriate zoning is particularly important in real estate development.
Federal regulations that affect financial transactions also have an impact on the real estate market. Acceptable interest rates and the availability of funds for mortgage loans determine how much buyers can borrow. As stated, high interest rates discourage borrowing. The amount of debt service (mortgage principal and interest payments) affects the return that an investor can derive from the purchase of a rental property. To meet debt service requirements, the property must generally produce more income. The amount of income needed to pay debt service reduces the amount of income the owner can keep.
Government ownership of land in national and state parks, highways and rights of way, public buildings, and military bases makes the government a major participant in the real estate market. The presence of various government-owned properties can increase or decrease real estate values, depending on what and where they are. A military base, for example, may be desirable because it brings jobs to an area. Conversely, if it attracts undesirable businesses to the area (e.g., bars or adult entertainment), a military base does not enhance surrounding property values.
Numerous governmental subsidy programs have an influence on property values and real estate investment decisions. Some housing programs subsidize rents for lower-income groups and may limit rental rates for private properties that participate in the program. Other programs encourage home ownership by offering more favorable terms for mortgage loans than are available in the private sector, in effect, competing with it. (Chapter 11 provides more information on government-subsidized housing.)
Federal programs are often the key to land development or redevelopment. One such program is urban renewal, which opens land in cities to new uses. Urban renewal has both short-term and long-term effects. The short-term effects are often negative because urban renewal displaces the original users to land elsewhere and results in a loss of property value in the sale. When urban renewal eliminates housing, the residents move elsewhere, often to the suburbs. It also encourages the movement of businesses and industries to the suburbs.
The displaced owners may have to accept less than market value for their properties because that is all they can get. (The sale price of a property may reflect low values of adjacent, blighted properties.) In the long term, however, urban renewal has many positive aspects, especially as it revitalizes the area. Development of a parcel of land for one use usually attracts development of adjacent land, often for a different use. Industrial development may attract research facilities and offices. Residential development tends to attract retailing and entertainment enterprises. Occasionally, the reverse is true.
Different levels of government occasionally impose rent controls, usually with the intent of setting upper limits on rental rates to maintain a pool of affordable housing. In general, rent controls interfere with the operation of the laws of supply and demand in the marketplace. In the absence of rent controls, more rents would tend toward the average rate rather than the extreme high (uncontrolled) and low (controlled) rates. Rent controls create an artificial lack of movement in rents at the lower end of the rate range. People tend to not vacate rent-controlled apartments.
The stagnation at low and middle rental rates forces those who are moving to go to areas where rents are higher. When controlled rents are substantially lower than market rents, the demand for those units is often disproportionately high, and the demand for units at market rates is consequently low. The reduction in rental income that results when controls are in place means less money is available for maintenance and repairs, so property owners defer maintenance. The lower income and the deferred maintenance contribute to lowering the property’s value. In order to sell a property after rent controls have been in place, the owner may have to take a loss. A loss may result anyway through deterioration, which can remove the property from the overall supply and curtail rental income altogether.
Some regulations affect real estate both directly and indirectly. Laws enacted to protect the environment offer a useful example. Concerns about the presence of asbestos in buildings led to demands for containment or removal of the material from certain classes of existing buildings and the use of other materials for fireproofing new buildings. The direct effect was tremendous costs to building owners for containment or removal of asbestos. These demands also had an effect on property value because the presence of asbestos made a building less desirable to prospective buyers. The potential for long-term liability if asbestos was discovered after the sale of the building added to the problem. Although the demand for removal or containment of this potential hazard changed as more research emerged, the effect on the real estate market did not go away. All levels of government can enact environmental regulations, and owners must comply with the most stringent requirements that apply in a given situation. Because of this, the environmental aspects of a property will continue to be a major concern for real estate owners and managers as well as potential investors.
Laws regarding fair housing are of particular interest to real estate managers. All levels of government make fair housing laws, and they specifically regulate how houses are sold and how apartments are rented (see Chapter 11). Federal income tax laws (discussed earlier in this chapter) specifically how it affects investment in real estate.
Just as other businesses have a cyclical nature, so does the real estate market. Statistics regarding real estate sales, new housing (single-family and multiple dwellings), mortgage lending, new construction, and absorption rates for rental space show periods of high and low levels of activity. Historically, the total of real estate transactions or sales recorded in real estate markets throughout the United States has operated on a long cycle that averages more than 18 years. However, some cycles have been longer and others have been much shorter. Discrepancies in duration often relate to important historical events (depressions, wars, or major technological changes). A short cycle that lasts up to five years also exists. It relates to the availability of mortgage funds, shifts in money markets, and governmental housing programs.
Like the business cycles previously mentioned, the real estate cycle has four components (Exhibit 3.3). They generally follow their business counterparts. As a result of overbuilding, demand begins to decline, absorption slows, and rents weaken further just as construction peaks. Overbuilding is a consequence of prosperity (or sometimes perceived prosperity), which cannot last forever. It precedes and then coincides with recession. The real estate market then undergoes an adjustment—demand continues to decline, occupancy diminishes further, and rent concessions become widespread. New building slows decidedly during periods of recession and depression. This is followed by stabilization, a period in which demand begins to increase despite declining construction starts, making inroads into the excess supply. This coincides with the depths of recession or depression and is the real estate equivalent of recovery. The last stage is development. As prosperity returns to the rest of the economy, occupancy is high, rents are rising, and absorption levels are high. Demand accelerates and the market needs new construction to meet the increased demand.
Activity in other sectors of the economy drives real estate demand, which consequently tends to lag behind the upward movements in the general economy. However, real estate demand tends to exceed the heights of the peaks and the depths of the troughs of the general economic cycle. Recovery and prosperity are reflected in high occupancy levels, high rental rates, strong real estate sales, large amounts of money available to lend at acceptable interest rates, and large volumes of new construction. Conversely, during periods of economic recession and depression, vacancies increase, delinquencies in mortgage and rent payments rise, and real estate sales decline in numbers of sales and prices. New construction slows and the numbers of mortgage loans and their dollar values decline.
Many of the factors that influence real estate cycles are inherent in the real estate market itself. Real estate is not always a mirror of the general economy. By its very nature, it is local, which has a greater impact on the local real estate market. However, conditions outside the immediate market area frequently generate real estate booms and busts. Globalization and institutionalization of investment capital had key roles in the U.S. real estate market in the late 1980s and early 1990s. The impact on the real estate cycle of the prolonged period of low levels of inflation and high unemployment in the mid to late 1990s and early 2000s are significant. If unemployment stays high and inflation stays low, both inflationary expectations and the price/wage spiral start to slow. In particular, the extended period of low interest rates may have ameliorated the effect of higher unemployment to some extent.
The consequences on today’s market have also been affected by the housing prices that peaked in early 2006, and then started to decline in 2006 and 2007—referred to as a “housing bubble,” which can occur in both the local or global real estate markets. It was reported in December of 2008 to be the largest price drop in its history. In October of 2007, the U.S. Secretary of the Treasury called the bursting housing bubble “the most significant risk to our economy” because it had a direct impact on the value of home and also on the nation’s mortgage markets, real estate, and home supply and retail outlets. The rapidly growing housing prices forced many residents to flee the expensive centers of many metropolitan areas to more suburban areas, which further explain how other factors can affect the real estate cycles.
Occupancy levels reflect the relationship between supply and demand at current rent levels. Changes in occupancy levels are of particular concern to real estate managers. However, the public sets the tone of the market. Occupancy levels that are extremely high indicate a probable space shortage and may justify higher rents. High vacancy, on the other hand, suggests a weak market in which renters are likely to resist rent increases.
The rental price level reflects the strength of the current real estate situation. It moves up and down in response to changes in supply and demand. When demand exceeds supply, higher rental rates can be charged, and rent increases as renewal of leases or as automatic adjustments under escalation clauses (in commercial leases) are more readily accepted. Real estate managers must know the prevailing trends in rental rates in their area.
Mortgage lending reflects the lenders’ confidence in the safety and desirability of real estate as an investment. Lenders must believe the property is sound, that it will retain its value or increase in value over time, and—most important from their perspective—that it will generate sufficient income to ensure repayment of the loan. Real estate managers should keep abreast of current interest rates in their area because rising interest rates adversely affect mortgage lending.
Building activity is a measure of the economic potential of vacant land. Large-scale construction can increase the supply of a specific use and depress the market for that type of space. When a surplus of space exists, construction slows, and that has wide-reaching effects beyond the real estate market itself. Unemployed construction workers may not be able to pay rent. They certainly will not have income to spend for consumer goods, and that will affect other segments of the economy.
The Consumer Price Index (CPI) is the most commonly used measure of inflation. The U.S. Department of Labor calculates the current year’s cost of a particular array of goods and services consumed by a typical family and reports it as a percentage of the cost of those same goods and services in a base year (also set by the Department of Labor). Among the goods and services “consumed” are food and beverages, housing, apparel, transportation, medical care, and entertainment.
The CPI is computed and published monthly or bimonthly for most of the metropolitan statistical areas (MSAs) in the United States. As a measure of inflation, the CPI provides the basis for raising wages and for adjusting Social Security benefits, pension benefits, and income tax schedules. Real estate managers may use it as a guideline for rental rate increases, but this practice has lost favor, especially in commercial real estate where it was once common.
Because existing long-term leases may still include references to the CPI, the following additional information is included here. Upward movement of the CPI favors the real estate manager whose leases include specific provisions for rent increases based on the CPI. The CPI provides a rationale (measure of inflation) and a rate (the percentage change) for the scheduled rent increases based on a reputable, nonbiased statistic provided by the government.
Because the CPI measures inflation over time, annual rent increases based on the change in the CPI are usually realistic. (A rent escalation clause based on the CPI enables the property owner to retain the current value of rent dollars.) However, downward movement of the CPI for any length of time can reduce or cancel the benefit expected. Many leases that contain CPI language usually have a floor and ceiling (minimum/maximum) so as to moderate times of extreme swings in the CPI.
Mortgage foreclosures reflect the inability of owners of real property to generate enough income from their properties to pay the debt on them. In general, foreclosures of income-producing real estate are an effect of economic recession or depression. Real estate loses earning power because of reductions in occupancy levels and rental rates. However, the absence of foreclosures does not necessarily signify prosperity. Real estate managers must understand the conditions that lead to foreclosures and be aware of foreclosure activity in the local market.
Since the real estate manager’s goal is to preserve and increase the value of a property through good management, it can best be done by trying to achieve the highest and best economic use for the property. An evaluation and understanding of economic trends is necessary to the accomplishment of this goal.
Economics covers the activities of production, distribution, and consumption of manufactured goods and agricultural products. Real estate is a part of the economic picture because land is fundamental to economic activity.
Value is attributed to the products of economic activity by agreement to exchange one kind of goods for another. The use of money facilitates exchange because it functions as a standard of value. It allows the measurement and comparison of the value of goods and services that otherwise cannot be readily measured or compared. Money is also a store of value through its purchasing power.
The marketplace is subject to the laws of supply and demand. When supply is less than demand, prices tend to rise; when supply exceeds demand, prices tend to decline. Changes in the supply of money in relation to the volume of goods available for purchase affect the overall economy. More money than goods signals inflation; the opposite signals deflation. Because the federal government can control the supply of money, its actions can lead to inflation and deflation.
In general, business activity is cyclical in nature. Prosperity is a period of economic growth, but economic growth cannot continue forever. Workers who have met their needs and wants tend to save their excess wages. When workers are saving and not spending their income, banks and other financial institutions have capital to lend to businesses for expansion. However, reduced consumer spending reduces business income, and financial institutions that lend freely for expansion become disinclined to lend money for operating capital. When the economy slows, prosperity is followed by a period of recession; supply exceeds demand, prices drop, and production decreases; profits fall off and businesses have less income to pay for operating expenses; wages decrease and unemployment increases; and borrowing slows and businesses fail.
At its lowest point, the economy may enter a period of depression. However, the surviving businesses take stock of their situations. Their inventories are low, and they have to replace equipment. Orders for new merchandise and machinery create demand, which leads to increasing prices, and the economy begins to recover. Recovery soon becomes prosperity, which is a period of high demand in comparison to supply. This is apparent in high profits, high levels of borrowing, and increased production. Unemployment is low, wages are high, and prices for consumer products are high.
Real estate is part of the overall economic picture primarily because of the relationship between land and economic activity. However, the real estate market is itself subject to the laws of supply and demand, and factors in the general economy of the nation and the world can have an impact on it. The real estate market is also affected by governmental actions, both those related specifically to real estate and those that affect the economy at large.
The real estate business is cyclical, and it follows a pattern similar to that of the business cycle. Changes in occupancy levels, rental rates, and mortgage financing are among the specific components of real estate cycles. Often, the cycles of real estate are reflections of the state of the general economy, although they tend to follow other trends and to be more extreme.