When it comes to developing and investing in commercial real estate, having the ability to predict the future would be a tremendous advantage. Unfortunately, the crystal ball we acquired from Amazon.com doesn’t cover Montana’s commercial real estate market.
The fundamental factor influencing the value of commercial real estate is the equilibrium of supply and demand within a local market. If supply is scarce and demand is robust, property values rise; conversely, if there’s an abundance of supply and weak demand, asset values decline.
Engaging in commercial real estate development and investment is a challenging endeavor, primarily due to the extended timelines involved. The development of large-scale projects like apartment complexes, industrial subdivisions, or mixed-use developments can take years to complete. Most investments in this sector are held for periods exceeding a year.
Ideally, we’d like to complete construction when the market is at a point of high demand and limited supply. However, it’s often the case that a surge in demand attracts a surplus of supply, which can lead to an increased vacancy rate. In such situations, two scenarios can unfold. Demand persists, but there is more supply to compete with, resulting in a longer lease-up or property sale period.
In the worst-case scenario, demand dwindles as supply surges, and the local economy experiences a downturn. When facing such challenges, there may be little recourse beyond accepting losses or patiently waiting for the local economy to rebound. Prevention, as they say, is the best cure.
While a crystal ball that reveals every future event is but a dream, delving into the details of a place’s economy offers a valuable alternative to ensure profitable investments.
Here, we outline two types of information that can help predict demand stability within a market:
Base Industries and Employment
Base industries and employment represent the core revenue generators that bring income from external sources into a community. For instance, when a new copper mine opens, the copper it produces is sold globally, creating revenue that supports local businesses and services while bolstering the local workforce.
Base industries can also encompass services, such as hospitals or tourism, which attract external funds to the community.
Communities poised for growth typically possess a diverse array of base industries, which mitigate risks associated with an overreliance on a single sector. These are markets where real estate investments offer less risk as they can recover from unforeseen economic shocks more quickly. Missoula is a good example of a community with a diverse base economy. The University of Montana, the healthcare system and a high concentration of state and federal employment provide stability. Other key sectors include tourism, manufacturing (wood products) and non-profits.
Some communities have very focused base economies. While they can see rapid growth and affluent residents, a downturn in the industry can sink the community quickly. A great example of this is communities that have economies focused on resource extraction. If demand for the raw material drops, the mine may cut back activity or close altogether. Often this triggers an emptying out of communities and plummeting real estate values. It is possible to successfully develop in these types of communities, but a very through understanding of the ebbs and flows of the base industry is required.
On the flip side, communities devoid of external revenue sources face growth challenges and eventual decline, resulting in diminished demand for new real estate. There are communities where base industries are stagnant or declining, and most remaining employment is in the service sector or government. Often these communities also have a large percentage of income from social security and disability payments.
Understanding the sources of a community’s income is paramount. Per capita income is derived from three primary sources: earnings from employment, income from investments, and transfer payments like social security and disability benefits. Income from investments and external sources, such as social security, can bolster local businesses and housing markets, ensuring community stability even during economic downturns.
A significant concentration of income from social security and benefits may suggest an aging population or economic challenges. Conversely, an emphasis on income from investments may point to an affluent but industry-deficient community.
Nationally, the proportion of per capita income derived from earnings from work is declining, while income from investments is on the rise. A growing share of per capita income from transfer payments can signify a dim future, potentially due to a dwindling workforce in base industries.
A surge in income from investments may indicate a community with a high quality of life, attracting growth industries that could follow suit.
Developing commercial real estate will never be an enterprise free of risk. Until they invent a crystal ball, analyzing different types of economic data about the community allows for informed, strategic decisions. Equipped with this knowledge, we can aim for investments that yield returns rather than regrets.
Stay tuned for the next article in this series, where we use this data to assess the base employment and per capita income breakdown in Bozeman and Missoula. Will their booms end with a bust?