An Analysis of Rental Growth Rates
During Different Points in the
Real Estate Market Cycle
by
Glenn R. Mueller, Ph.D.
Real Estate Research Group Head at
Legg Mason Wood Walker, Inc. and
Faculty member of the Berman Real Estate Institute at Johns Hopkins University
internet [email protected]
and
Anatole Pevnev
Vice President, Real Estate Research
Legg Mason Wood Walker, Inc.
internet [email protected]
111 S. Calvert Street, P.O. Box 1476
Baltimore, MD 21203-1476
410-539-0000
presented at
The American Real Estate Society Meetings
Sarasota, Florida
April 16-19, 1997
Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle
2
Analysis of Rental Growth Rates During Different Points
in the Real Estate Market Cycle
Abstract
Real estate markets go through both physical (demand and supply) cycles and financial cycles (capital flows
and price movements). (Mueller 1995) If asked when a market cycle last peaked, real estate professionals will
give different answers that use demand, supply, vacancy, rental growth or price trends. This lack of standard
definition is confusing and leads to both research and investment problems. A growing body of research
literature on real estate market cycles have examined the potential uses and understanding of real estate

portions of the real estate cycle.
Witten (1987) stated that every city had its own property cycles which will be unique in length of time and
degree of change and this comes from the internal dynamics of each market. He also stated that new supply
while being cyclical is somewhat more volatile than demand, as supply is often determined by the availability of
financing rather than by market need. He also observed that markets seldom move as smoothly as the
classically drawn curves, but instead move in "fits and starts" causing investors to hesitate and wait for clear
signs as to market changes.
Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle
3
Brown (1984) described cycle modeling as a simplification of the complexities of reality which hopefully
capture the crucial features of the economic sector or system being studied. He believed that time series should
be used to determine the length and breadth of cycles as it seeks to measure movement over time. Also the
longer the period of time the better the understanding of the movement. A key to cycle credibility is the
identification and removal of trend and seasonal components inherent in time series data. He concluded that if
feasibility analysts, investment advisors, and principals or lenders are to give credibility to cyclical behavior,
much more research needs to be done. There are currently no uniform measurement procedures making it
difficult to agree on the length and breadth of cycle rhythms. Because the downside of cycles creates extreme
economic obsolescence, real estate professionals need to maintain the perspective of cyclical timing.
Wheaton (1987) estimated the national office market cycle to have a length of between 10 and 12 years by
using a sample of 10 cities. He found that these 10 cities had turning points in their own series that are within
one or two years of the combined average series. He studied the causes of market movement that make the
office market cyclical. One of his findings was that the tenure structure of office leases was usually long term
(e.g. 10-15 years). His explanatory model found that expected employment growth has a strong significance in
determining cycle behavior thus creating an adaptive demand model and concluded that supply responds more
readily to the state of the economy (as developers adjust their expectations) than demand and can actually help
curtail the magnitude of the cycle. He concluded that both supply and demand respond to changes in the
economy although supply is definitely more responsive than demand.
Wheaton & Torto (1988) studied rent and vacancy rate cycles and found that there was a market rental
adjustment mechanism that caused real office rents to drop approximately 2% annually for every percentage
point of excess vacancy in the market. They also found that the average office vacancy rate was trending

bottom is passed demand growth begins to slowly absorb the existing oversupply and supply growth is non-
existent or very low. As the excess space is absorbed, vacancy rates fall allowing rental rates in the market to
stabilize and even begin to increase (typically at below inflation levels). As this recovery phase continues,
positive feelings about the market allow landlords to increase rents at a slow pace. Eventually the market
reaches equilibrium where supply and demand are in balance and the only excess space is that which will fulfill
future expected demand.
Graph 1

Market Cycle Quadrants
Declining Vacancy
New Construction
No New Construction
Increasing
Vacancy
Declining Vacancy
Increasing
Vacancy
More Completions
New Construction
Phase 1 - Recovery
Phase 2 - Expansion
Phase 3 - Hypersupply
Phase 4 - Recession
Equilibrium
In Phase two of the cycle (expansion) demand growth continues at increasing levels causing the need for
additional space. As vacancy rates fall below the equilibrium level, signaling that supply is tight in the
marketplace, rents begin to rise rapidly (above inflation levels) until they reach a "cost feasible" level that
allows new construction to commence. In this period of tight supply, rapid rental growth can be experienced
which some observers call rent spikes (as landlords demand higher prices and tenants agree to pay them due to
lack of alternatives in existing supply). Some developers may also begin speculative construction in

beginning to increase, rents will begin at negative levels and increase as the cycle moves toward the
equilibrium point, but still stay below the level of inflation. In the growth phase of the cycle rents will increase
at higher than inflation rates, reaching the highest rate at the market peak (highest occupancy or lowest
vacancy). In the hyper supply phase rents will continue to grow but at declining rates until the market reaches
equilibrium on the way down. In the recession phase rents will continue to decline and growth will be below
inflation levels or even negative as the bottom of the cycle is reached.
The distribution of rental growth rates should also vary during different points in the cycle, being very wide at
the bottom of the cycle and narrowing as the market improves, all the way to the peak of the cycle. This
distribution tightening should be the result of the market becoming more efficient as landlords take control for
the tenants and look to their competition for pricing. As the market goes through a down-cycle the rent
distribution should steadily increase as landlords fight for tenants and tenants are able to demand lower rents.
At different points in the down-cycle some landlords will try to hold out for higher rents while others will drop
their prices to obtain tenants at any cost, causing the distribution of asking rents to widen until the market
reaches the bottom and the cycle. When the market finally bottoms all landlords finally resolve themselves to
the situation and distributions may narrow. Then the cycle starts all over again. Thus the apriori expected
change in rent variance is one of narrowing as the market improves in an up-cycle to the market peak, then
widens in the oversupply and recession phases of the cycle and then potentially consolidates at the bottom of the
cycle.
Data
Market information was used from Torto Wheaton Research including demand, supply, absorption, vacancy
and gross asking rent growth data for 54 office markets and 54 industrial markets. The time period for each
market varies and begins as early as 1967 and concludes with the 4th Quarter of 1995. Each gross asking rental
growth rate is the average rental growth rate for all buildings available in a given market. Thus if one building
has three spaces available at $15, $16, and $ 17 respectively, the average asking rental rate of that building will
be $16 - not size weighted or value weighted.
Methodology
The following steps were completed for each market:
1. An equilibrium vacancy rate was calculated according to the Mueller-Laposa methodology
(1994). Actual vacancy rates for the market were compared to the equilibrium vacancy rate
in order to identify specific time periods corresponding to cyclical phases.

15
14
13
12
Cost Feasible Rents Level
Hypothesis to be tested include:
1. Rental growth rates vary by physical cycle position. Increasing during an up-cycle and
declining during a down-cycle
2. Rental growth distribution varies by cycle position, with distributions narrowing during an
up-cycle and widening during a down-cycle. Then consolidating at the market bottom.
Results
Summary tables, graphs, and general descriptives are presented in Exhibits 1-8.
Office vacancy rates started at a high of 22.8% at the bottom of the cycle (position 1) and the standard deviation
of vacancy rates was 4.8%. (see exhibit 1) Office vacancy rates reached their lowest point of 4.4% at position
11 the peak of the cycle. The standard deviation of vacancy rates steadily declined throughout the up-cycle to a
low of 2.5% although the standard deviation at the peak was 2.9%. Vacancy rates rose during the down-cycle
back to 19.3% in position 16 and standard deviations grew back to 4.3%. Average office absorption also grew
during the up-cycle from a low of 2.2% to a high of 8.7% and then fell during the down-cycle back to 4.4%.
The standard deviation of absorption did increase in the up-cycle and decline in the down-cycle (see exhibit 2).
Office completion rates were high at the bottom of the cycle 7.7% then dropped to 3% on average in position 2
and stayed low through the recovery phase and into the first position of the expansion phase (position 7). From
the cost feasible point, completion rates rose to a peak of 8.9% in position 13 (already over the top and into the
hyper supply phase) and stayed strong through the rest of the down-cycle. (see exhibit 3). Office rental growth
was negative in cycle positions one and two then was low but positive through the rest of the recovery phase of
the cycle. Beginning at the equilibrium level rental growth jumped to 4% (above inflation levels) and increased
to a high of 13.8% in position 10 (just before the cycle peak). Rental growth then steadily declined during the
Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle
7
hypersupply and recession phases of the down-cycle . Growth dropped below inflation in the recession phase
and became negative again in position 16. (see exhibit 4).

These results lead to the conclusion that local supply and demand characteristics do play a major role in rental
rate growth in markets. These results can be used for making investment decisions, as more accurate rental
growth rates can now be entered into the discounted cash flow programs used by real estate investors. The next
step in research is to look at the correlation of prices to rental rate growth to see how much influence rental
growth has on prices, followed by research on the capital market factors (interest rates and capital flows)
impacts on prices.
Analysis of Rental Growth Rates During Different Points in the Real Estate Market Cycle
8
References
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Fershtman, Chaim and Fishman, Arthur, “Price Cycles and Booms: Dynamic Search Equilibrium”, The
American Economic Review (1992) Vol 82, No. 5, 1221-1233.
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MacMinn, R. D. “Search and Market Equilibrium,” Journal of Political Economy (1980) 88, 308-315.
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