The commercial real estate (CRE) sector has enjoyed a healthy recovery over the past few years, so much so that some investors are now contemplating the dangers of overdevelopment. That’s why many savvy investors are pursuing CRE markets that boast more supply constraints. Supply constraints are usually geographic, legal or political, and can help boost profit margins by making it difficult for development in the sector. Market research in various locations is required to pinpoint where these constraints exist and in what particular market sector, but experts note that finding them can greatly increase returns. For more on this continue reading the following article from National Real Estate Investor.
Commercial real estate has posted three-and-a-half years of robust total returns, attracting significant inflows of investment capital. At this point we may want to begin to fear our own good fortune, as there is nothing worse than free-flowing capital to encourage over-development which tends to kill the party. One of the best protections against over-supply is to be in markets that are difficult to supply.
Constraints on new supply in a given market reduce an owner’s competition for tenants, which typically leads to higher occupancy, higher rent levels and faster rent growth. Supply constraints can stem from several sources and vary across both markets and time. Here several aspects of supply constraints are discussed, including their origin and economics, and introduce a way of measuring this feature across property sectors and metropolitan areas.
Supply constraints are broadly defined as limitations on the ability to deliver new development. These constraints generally fall into three categories, though some overlap is common.
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- Legal: Primarily zoning and land use regulations which restrict the location, quantity and/or pace of new development.
- Geographic: Physical limitations such as waterways, steep slopes and soil conditions which limit the location and/or quantity of new development. This category may also include the impact of existing development at a scale and density that limits available sites ripe for redevelopment.
- Political: Local opposition to development which is not codified through local regulations but which nonetheless constrains development potential.
In addition to the above types of supply constraints, economic factors may also limit development feasibility. For example, the limited availability and high cost of construction lending, as well as low market rents and prices, are currently restraining development in places that are not typically associated with supply constraints. These types of barriers are generally temporary and adjust with the larger real estate market, however, and cannot, therefore, be counted on over the mid- to long-term to impact the overall supply dynamics.
The ability of a market to increase supply in the face of rising demand varies across metro areas. If supply cannot be added to meet additional demand, then prices (rents, and eventually capital values) will rise accordingly. The amount of new supply that can be added directly impacts the corresponding change in rents. Therefore, markets with constrained supply should have greater rent growth during demand surges and a higher rent level given equal demand relative to markets with excess supply.
The dynamics of real estate supply greatly influence the potential for real estate investment returns. Markets where supply is constrained generally tend to have higher rent levels, greater rent growth and higher capital values. The figure below shows price elasticity and capital appreciation for the office sector, as measured by the NCREIF Index. The resulting trend line shows an inverse relationship between price elasticity and capital growth in all three sectors. The correlation is negative–in other words, those markets with a higher level of supply constraints have generated stronger capital appreciation over the study period.
Source: NCREIF, CBRE-EA
David Lynn, Ph.D., serves as Executive Vice President and Chief Investment Strategist at Cole Real Estate Investments, Inc. The views and opinions expressed in this commentary are those of Dr. Lynn as of the date of publication and are subject to change, and do not necessarily reflect the views of Cole Real Estate Investments and/or its affiliates.
