An In-Depth Look at Commercial Real Estate Life Cycles

Swiss commercial real estate (CRE) is currently producing stronger average net initial yields than residential real estate, standing at 3.4% versus 3.1% as of the end of 2023. Much like the residential sector, Swiss CRE is benefiting from strong demand in the face of weak supply.

Throughout 2022 and 2023, the demand for office space remained very high, driven by the post-pandemic recovery and strong employment growth. Despite the economic slowdown, employment demand continues to rise, having surged up 2.2% in Q3 2023 on an annual basis, further fueling the need for office spaces. That said, supply levels still remain below pre-pandemic levels. Moreover, the volume of new-build permits is at its lowest level this century. With these forces, CRE yields still have room for the upside.

Yet, before jumping into the CRE market, prudent investors should familiarize themselves with the three key CRE cycles: the asset ownership lifecycle, the market cycle, and a building’s lifespan.

1. Buyer’s guide: The asset ownership lifecycle

The asset ownership lifecycle covers the 4 typical stages of ownership: from acquisition to exit.

a) Acquisition

The acquisition phase is pivotal as it lays the foundation for the success or failure of an investment. Commercial real estate properties vary significantly, from location and yield to maintenance and lifespan. It therefore pays off to be diligent when it comes to finding a property that matches your criteria. While this stage is called “acquisition” it could more accurately be called “research, and matching.”

The first step is determining if you want to buy an existing CRE property or participate in the development of a new property. Developing a property may offer greater flexibility and control in the long run. However, unless you have development experience, it’s usually a lot easier to invest in an existing property. Developers must be prepared for numerous unexpected pitfalls. On the other hand, the age of existing buildings is a factor that cannot be overlooked when investing in an existing property (more in the Building lifespan section).

Next up is financing (for one buying the whole property). It’s essential to establish what you can afford before embarking on the search for the right property. By talking with bankers and brokers, you can gain insight into your potential loan-to-value ratio and the split between interest and capital payments.

After financing comes market research. What cities, localities, and tenants match your criteria? Are you looking to rent to tech startups in bustling Zurich or government contractors in Bern? What are the short term and long term dynamics at play? This research should be conducted with your target net operating income (NOI) and return on investment (ROI) in mind.

Once you’ve found the right property, you need to start negotiations with the owners by sending them a Letter Of Intent, or LOI (for one buying the whole property). The LOI outlines the timeline and milestones that lead to the final sale. The former will include time to perform due diligence on several factors, including the physical condition of the property and its environment, and legal aspects such as ownership, permits, and zoning. If all checks out, final negotiations ensue, followed by underwriting analysis and agreement with your bank or broker, legal consultations, contract finalization, and ultimately, settlement and the transfer of ownership.

Remember: the sales process has many steps and takes time. What’s more, every sale is different, so having an experienced lawyer can make things much smoother.

b) Value-add

Once you own the property (or your share in a project), you can dedicate time and resources to exploring ways to increase its net operating income (NOI). This enhancement process involves efforts on both ends of the financial spectrum: reducing costs and boosting revenue. Nonetheless, typically, there is more leeway to increase revenue than to decrease costs.

Revenue can be increased by making improvements to the property that will increase occupancy or justify higher rents for existing tenants. This can range from cosmetic improvements such as updating the foyer and landscaping to large-scale renovations that transform the building's layout and look. Keep in mind that any changes are rather to be planned carefully with your finance partners, contractors, and existing tenants.

c) Stabilization

Once you’ve poured money into the property, it's time to reap the rewards and focus on ensuring that maximum returns are achieved. This can be done by sustaining high occupancy and making sure rents grow in line with or faster than inflation by, among other things, keeping good tenants happy and replacing bad tenants. However, one must be careful to keep up property maintenance and closely monitor cash flows for any signs of issues with the property.

d) Disposition

No building lasts forever. This entails that most investors will reach a point, usually around the 15 to 20-year mark, when they will want to sell their property, refinance it, or bring in other investors (if they own the property as a whole). Before making a decision, these options should be considered through a thorough analysis that factors in current and projected returns as well as financial and maintenance expenses. Has the property already achieved your desired returns? Will future returns trend upwards or decline?

Some investors intend to sell in the stabilization phase as soon as they’ve achieved their target returns. Other investors prefer to keep reaping returns until the property's outflows (the money spent on expenses like insurance, taxes, maintenance, etc.) surpass its inflows (the money one makes from rent). It’s best to determine your exit strategy ahead of time so you can be prepared to act when the right conditions come into place.

Moreover, if selling is the chosen route, assessing the market cycle becomes crucial to capitalize on potential growth opportunities and avoid missing out on the lion’s share of growth.

2. Investor’s guide: Market cycle

CRE investors must pay attention to both local and national real estate market conditions when buying or selling a property so as to ensure they get a fair and desirable price. The diagram below illustrates a general model for the CRE market with four phases. While investors can successfully buy or sell across all four phases of the cycle, this model can help them determine whether to exercise patience or take action.

Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.
– Warren Buffett

Real estate market cycle quadrants
Source: Crowdstreet

a) Recovery

The recovery phase is essentially the bottom of the previous cycle: occupancies are at or near their lowest, demand is weak, lease velocity is modest, and new construction has halted. Even so, as the saying goes, the darkest sky comes just before dawn; during this phase demand gradually rebounds, coupled with a dearth of new supply, leading to upticks in occupancy rates and rents – a clear sign of market recovery.

This phase represents a good opportunity to secure a high-quality location at a fair price. One can then take advantage as the market recovers by increasing occupancy and rolling over a series of short and long-term leases with rising rents.

Some would argue that Switzerland is currently in a recovery phase, with declining vacancies and slow construction growth (see chart below). However, with its strong employment demand and demand for CRE, Switzerland could soon be entering an expansion phase. A lot will depend on what happens with GDP growth over the next few years.

New-build permits and supply in office space (in CHF million)
Source: Julius Baer

b) Expansion

As demand starts to increase because of an improving economy or external factors, rising occupancies will meet low supply, and rents will rise. This uptick in rental rates stimulates new construction activity, and as long as demand remains strong, vacancy rates continue to fall.

Such a period presents an excellent opportunity for property acquisition and development (investment in value-add initiatives). Indeed, prices are still relatively low, yet the rising returns swiftly transition the newly acquired or developed property into the Stabilization phase. From there, one can capitalize on accruing returns or opt to sell and reinvest while the market remains in the expansion phase.

c) Hyper supply

At a certain juncture, escalating construction activity may reach a saturation point, leading to a resurgence in vacancies (although the likelihood of this occurrence is minimal in Switzerland, due to its stringent regulations outlined in the Swiss Planning Act from 2014, which significantly limits construction activity). Landlords may then lower the rent to attract new tenants, though existing lease agreements are unlikely to undergo revision. This turning point can arise sooner if there is a negative shock to demand, such as increasing interest rates.

During this phase, some investors might decide to exit while others will hold on to good “core properties” that have high occupancy and are tied down with high rents for several years. Ultimately, these decisions will be influenced by what caused the slowdown in demand in the first place. Is the economy deteriorating? Was it a short and sharp market correction? Or was it an external shock such as a bottleneck in materials that soon could be remedied?

d) Recession

If demand continues to fall and vacancies continue to increase, rents can plummet, and property prices can stagnate. The unprepared may find themselves in financial trouble: unable to cover their loans and other expenses. On the other hand, opportunistic buyers can seize the opportunity to acquire distressed assets at favorable prices. Eventually, as construction comes to a halt, supply will fall below demand and signs of the next recovery phase will emerge.

3. Building lifespan

On average, commercial buildings have a lifespan ranging from 50 to 60 years. Although good maintenance, refurbishments, renovations, and extensions can prolong a building’s life, they can only do so for so long. As a CRE investor, one needs to understand the expenses associated with the various stages of a building's lifespan.

For instance, new buildings normally undergo a shakedown period during which construction-related issues may arise, necessitating prompt resolution. While such issues may be covered by insurance, they can result in temporary loss of rental revenue.

Conversely, older buildings generally require more maintenance. Owners should thus strategically determine when to invest in initiatives aimed at extending a building's lifespan – a process often referred to as capital renewal. Sometimes, refurbishing proves to be a more cost-effective solution than investing in extensive renovations or expansions, although the optimal approach varies depending on each building's unique characteristics. Nevertheless, capital renewal tends to incur higher costs as a building age (see chart below).

Five-stage property life cycle model
Source: AssetInsights.Net

Conclusion

Many investors have made their fortunes through real estate ventures, particularly in the commercial sector. Unlike a lot of residential real estate, commercial properties often command high demand within very specific areas characterized by limited supply, such as New York and Zurich. Given this unique dynamic and the specific circumstances currently at play in the Swiss housing market (strong demand with weak supply), the newcomers can greatly benefit from comprehending the diverse cycles inherent in CRE investing.