Since most real estate expenses are fixed, increased revenues translate almost dollar-for-dollar into increased profits. Increased profits attract new development of vacant land or redevelopment of existing properties.

Basic economics tells us that new supply will satisfy demand and eliminate the upward pressure on rents and land prices accordingly. But here’s the twist: it takes a long time to add new inventory to the real estate market once it’s needed.

Market studies must be undertaken. Land sales must be negotiated. Zoning and permitting must be obtained. Financing for the project must be found (no easy feat coming out of a recession). Only then does new construction begin. And the construction itself takes a long time (two to five years for the average development).

By the time meaningful amounts of inventory start to come online, the overall economic expansion has been under way—without the benefit of new supply—for five to seven years. During all of that time, occupancy rates and rents have been increasing.

In fact, the cycle reaches a point at which rents are not simply going up—they are going up faster and faster (rent growth is accelerating). Investors build this trend into their forecasts. And we reach that critical point in the real estate cycle where, as William Newman documented as far back as 1935, the price of land begins to reflect not the existing market conditions but rather the anticipated rent growth to come.

Investors, believing the price is justified by the future growth, overpay for the land relative to the current market, and start building for a future market. The boom is officially on.

PHASE III: HYPER SUPPLY

As long as the current occupancy rate exceeds the long-term average, there will be upward pressure on rents. As long as there is upward pressure on rents, new construction is financially feasible. This is the case for both the expansion and hyper-supply phases.

The First Indicator of Trouble

The delineation point between expansion and market hyper supply is marked by the first indicator of trouble in the real estate cycle: an increase in unsold inventory/vacancy.