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SPECIAL REPORT
Real Estate Cycle Methodology
In this premier issue of
Emerging Trends in Real Estate®Value Cycles,
PricewaterhouseCoopers launch-es the first industry-wide, accessible publication ofreal estate value cycle information and analyses. Thissemi-annual publication compliments our annual
Emerging Trends in Real Estate® 
and our quarterly
Korpacz Real Estate Investor Survey® 
. The followingsummarizes the significant steps of our methodology.
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Hold a tennis ball waist high and drop it. The tennisball will bounce back up, although not to its previousheight if left alone. The distance from the ground tothe top of the bounce is called amplitude, and thetime from the bottom (or top) to another bottom (ortop) is called duration. Over time, the tennis ballgradually comes to a stop. However, if an externalsource hits the tennis ball anytime while going up ordown, a new amplitude is created. This simple analo-gy generally describes real estate value cycles.Real estate value cycles exist in both the residentialand commercial property markets, and this in turnaffects owners, tenants, investors, and lenders. Rents,cap rates, and valuation are impacted by the cyclicalnature of real estate. There are “national” real estatevalue cycles, “city or market” cycles, and cycles forindividual property types within a city. Property realestate value cycles — office, warehouse, retail, multi-family, and hotel — are each impacted by differenteconomic, financial, and demographic factors.The modeling and forecasting of real estate valuecycles has received significant attention in the realestate industry over the last seven years. Public andprivate real estate investors are cognizant of over-building of the 1980s and the subsequent effects uponthe real estate industry in the early 1990s. Supply ofreal estate exceeded demand, causing vacancy ratesto rise, rents to fall and cap rates to increase, ultimate-ly leading to decreasing property values. Investorswant to know where the real estate market is heading,which submarket is hot, which submarket is losingmarket share, and where new supply will show upover the next five years. Basically, investors want toknow what the future risks to an investment are. Thegood news is that more timely information on realestate markets is available as we approach the 21stCentury than was available in the 1980s. The moreinformation and data we have, the better the accuracyof our forecasting models.
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PricewaterhouseCoopers receives primary data for 58metropolitan statistical areas (MSAs) and five propertytypes (office, warehouse, retail, multifamily, andhotel) on a quarterly basis from third-party vendors.This data is compared to the data from the previousquarter to observe and document significant changesin historical and forecast numbers. Every attempt ismade to gather historical data as far back as possible.In many cases, the data extends back 20 or moreyears; however, for some markets and property typeshistorical data is simply not available.We believe that the explosion in the quality, quantity,and timeliness of real estate information over the last10 years has produced a more efficient real estateasset class. The natural result of the increase in timeli-ness of real estate information is a reduction in the lagbetween vacancy and rental rates of specific propertytypes in a market, to pricing and value. Research
 
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shows that the relationship between vacancy rates andcap rates has collapsed over the last two years, suchthat market movements in vacancy rates are assimilat-ed quickly in pricing and valuation of real estateassets. Current trends in the real estate informationmarket will push the present state of the real estateindustry to new frontiers in the 21st Century.Our real estate value cycle methodology incorporatesboth the physical real estate cycle and the capitalmarket real estate cycle through a simple concept.The physical real estate cycle addresses real estate eco-nomics — the interaction between supply and demandof real estate that impacts vacancy rates and rental rates.The capital market real estate cycle addresses the redis-tribution of real estate assets from sellers to buyers — thecreation of real estate value through new construction.The combination of the physical and capital marketreal estate cycles occurs in the formula known tomany in the real estate industry…V = I/R, wherein Vequals value, I equals income, and R equals the caprate. The physical real estate cycle directly impactsthe income (I) of real estate assets. If vacancy ratesincrease and occupancy declines, rental ratesdecrease. The multiplication of occupancy and renttheoretically equals income. The capital market realestate cycle impacts cap rates (R), which respond tochanges in vacancy rates and changes in income.The bid-ask between sellers and buyers is impactedby real estate cycles and new construction by devel-opers and owners.Real estate values can increase or decrease by thechanges in income or cap rates. If income decreasesover time, holding the cap rate stable will decreasevalue. Conversely, holding income stable withdeclines in cap rates increases value. The best situa-tion for increases in real estate value is increases inincome with decreases in cap rates, and the worstcase is decreases in income with increases in caprates. We believe that income (I) and cap rates (R)respond differently depending on the real estatecycle phase as illustrated in Exhibit 11.
Exhibit 11
121110987654321
RecessionRecoveryBottom
R:I:R:I:R:I:
ExpansionContractionPeakDetrendedBalancePoints
R:I:
REAL ESTATE MARKET VALUE CYCLE
LEGENDI=IncomeR=Cap rate
Balanced Value Line
 
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Our real estate market value cycle includes 12 points,two of which are labeled
“detrended balance points.” 
A detrended balance point is similar to a fulcrumpoint that indicates neutral value risks to real estateassets impacted by the physical and capital marketcycles. Based on our research relating to the relation-ship of vacancy and cap rates, we use historicalvacancy rates as a proxy for values. We use a uniquemethod to calculate the detrended balance points —a parabolic function that allows the use of an entiretime series of vacancy rates, yet allows for changesof balance over time. Thus, the cyclical nature of aspecific market’s property type in the early 1980s hasless impact on the present balance point, or valueinflection in 2000.Each phase of the real estate value cycle has a pre-determined set of decision rules for six variables:supply, demand, rents, vacancy, cap rates, andinvestor interest for each point in time for which wehave data (see Exhibit 12). The result is a series ofpoints which, when plotted on a time axis, yieldsthe value cycle chart. This analysis is completed foreach market and property type, resulting in the cre-ation of 290 individual cycle charts, plus the fivenational properties market overview charts that areillustrated in this publication. Additional cyclecharts are also prepared which track submarkets inoffice and warehouse categories and historical cyclepatterns in each market and property type.By way of example, let’s look at the national officemarket overview (see page 6). This overview presentsa snapshot of the office markets in all 58 MSAs. Forthis analysis, the sine wave represents the progressionof the theoretical real estate value cycle. This simpli-fied view is useful for presentation of the currentposition of each market; however, care should betaken not to turn the snapshot into something that itis not. The snapshot does not answer dynamic ques-tions about the historical movement of the marketsthrough the cycle. Only an analysis of individualmarket cycle charts can address differences in theduration and amplitude of value cycles. The same istrue for forecasts of the expected movements of eachmarket over the near term.
Exhibit 12
DECISION RULES FOR MARKET POSITIONS
I N D I CATO RS RECESSI O N RECO VERY EXPAN SI O N CO N TRACTI O N
SupplyDeclining,nilMinorBeginning to increaseIncreasing greaterthan demandDemand DecliningBeginning to increase Strong,greater than Positive,new supplybut slowingVacancyIncreasing to highsDecreasing to Declining to lowsIncrease tobalanced ratebalanced rateRentsFallingNo growthPositive growthPositive growth,but slowingCap RatesIncreasingStableStarting to declineDeclining asat high ratescapital flowsInvestorsNo transactionsBottom fishersInterestedInterestedValue ImpactsIncomes declining with Incomes improving withIncomes improving withIncomes stable orincreasing cap rateshigh cap ratesdecreasing cap ratesdeclining with stable orincreasing cap rates
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