It’s well known in property that real estate cycles come and go in perpetuity. Therefore, Investors need to be very astute to be able to continually stay ahead of trends in the market and closely monitor external factors which affect the overall health of the economy.
After all, change is the way of life! Supply and demand for multi-family apartments changes and you may go from periods of limited supply and high demand to excess supply with static demand; interest rates, too, both rise and fall depending on how the national economy is performing.
The only certainty amongst all of this is that change will occur—it’s often just a question of when; a question of how long the “good times” will last and how long the “challenging times” will be with us.
So, in short, all supply and demand factors, prices and rentals and cap rates in commercial and residential real estate follow a cyclical pattern, invariably closely linked to local and national economic trends.
This cyclical pattern of movement in prices and rentals, demand and supply, naturally enough is called a “real estate cycle” and usually includes four main phases.
What are the four main phases of a real estate cycle?
A real estate cycle is a four-phase wave type pattern through which property markets involving commercial and residential real estate move.
The generally acknowledged four phases of the real estate cycle are:
- over or hyper supply; and
One implication of a cycle is that, over time, there has never been a sustained expansion or hyper-supply period without an eventual recession, followed by recovery. A cycle is perpetual and, as sure as “boom” occurs, “bust” will follow although, of course, strictly speaking, the depth of the wave of the cycle may as easily as well be “soft and shallow” and not “hard and deep”!
What are the origins of the term and why is the cycle important?
The term “real estate cycle” first appeared in the 20th century about 100 years ago as real estate analysts began to study trends and see recurring patterns in the property market. Gradually, as more and more regulations were introduced to the property market, thanks to federal policy, the real estate cycle evolved into its current recognisable form.
Understanding the background and drivers of a real estate cycle can help investors predict upcoming trends and make well-informed decisions about their investments. It can be used by a variety of real estate professionals to predict the optimum time to buy, hold or sell, and those following information about the cycle include real estate agents or brokers, buyers, sellers, renters, and other professionals throughout the industry.
Ascertaining the current status of the cycle is important as it can provide up-dated, reliable information about the possible returns of an investment property, as well as help investors determine if a property is in the recovery, expansion, hyper-supply or recession phase of the cycle.
In turn, this will enable investors to make a more accurate assumption about the length of time the property should be held and the most appropriate exit strategy to take. Furthermore, the real estate cycle can help predict the likely future income and appreciation performance of an investment property, leading to better decisions about when or if to make capital improvements to retain or enhance property value.
Let’s look closer at the four main phases of a real estate cycle
The four main phases within the main cycle are as shown below, although it’s worth mentioning at the outset that as this is, indeed, a “cycle” with no beginning or end, it can be quite arbitrary to say which is phase 1 or 2…
However, we need to begin somewhere:
- recovery phase: follows the recession phase where construction has slowed or has stagnated and building occupancy and rental rates are low. After stabilisation, occupancy and rentals gradually rise, although initially rental growth is likely to be below the rate of inflation.The characteristics of the recovery phase can be hard to distinguish from the recession phase as the overall market may look much the same. However, researchers will be able to identify the change into the recovery phase by observing trends relating to occupancy and changes in demand. The recovery phase is a prime period for making investments into real estate since prices are low when compared to previous levels, and more so for properties in financial or physical distress which may/may not need renovations.For investors buying such properties, the potential eventual return on investment from operation or resale is high. They can wait out the remainder of the recovery period by adding value to these properties and be ready to sell or rent as the economy moves into its expansion phase;
- expansion phase: is when the real estate market has completely recovered from the recession phase, demand is high, supply is unable to keep up and rentals and prices are rising strongly. Vacancies will be low, property values have increased, and there are plenty of new construction projects.During this phase, many investors will buy new properties or renovate old buildings, either to rent or sell, since demand is high and new buyers or tenants, as the case may be, are usually readily available.With increased confidence from consumers, the overall economy is improving and job growth is strong; as a consequence, there is an increased demand for commercial space and housing accommodation. Whilst the market is on an upswing, many investors focus their efforts into developing or redeveloping properties which meet market demand in order to sell on, or secure attractive cash flows;
- hyper- or over- supply: follows the expansion period when many developers or investors have rushed to create new stock. As a result, as new construction projects near completion, often supply finally exceeds demand and vacancies will rise; rental and price growth will slow or stagnate.Some investors whose strategy is only to hold for the short-term may consider selling properties during this phase, and there will be others who are keen to unload assets as they are concerned about the impending recessionary phase on the horizon.Buyers during this phase will wait until the expansion phase to sell, adopting a so-called “buy and hold” approach. Another strategy sometimes adopted in this phase is to buy quality assets which otherwise may not be available in the market, assets with good tenants and long-term leases in place, in order to receive steady cash flow during the coming recession.Apart from there being too much inventory in the market, changes from the expansion phase may also be caused by a sudden shift in the domestic or international economy whereby demand weakens. For many this is an excellent time to adopt a so-called “opportunistic” approach; identifying properties which are likely to perform well in the expansion phase of the next real estate cycle, again adopting the aforesaid buy and hold strategy;
- recession phase: in this phase, the supply of new properties exceeds demand, and demand falls, resulting in high vacancy rates and reduced rental growth, possibly below inflation, or even negative growth. As prices fall, there may be some opportunistic investors looking for investment opportunities at large discounts to previous prices or even foreclosures of properties which have been repossessed by lenders. Investors will then follow the buy and hold strategy with a view to selling as the economy and markets begin to recover and prices and rentals increase.
What are some of the factors which cause real estate cycles?
There are a wide variety of factor which shape and affect the real estate cycle, some internal and some external, come economic and some as a result of so-called “black swan” or unexpected events However, some of the main factors are as follows:
- interest rates: greatly influence the sentiment and buying power of investors. High interest is often a deterrent for many investors as, if the cost of debt is too high, it is difficult to secure the required investment returns. On the other hand low interest rates encourage investment activity, as the long-term cost of financing is, clearly, cheaper.
- government policies: apart from changing interest rates which may be influenced by governments for policy reasons, authorities may intervene to boost markets which are particularly sluggish or in a prolonged recession. This may be by offering tax deductions, beneficial loans, subsidies, tax credits or a variety of homebuyer programmes to stimulate demand and incentivise consumers to purchase real estate. Or it may be more indirect when the government decides to designate an area for renovation or regeneration or plan major infrastructural improvements which benefit a local economy. Such types of incentives can greatly affect and influence US property market cycles;
- local and national economy: as you’d expect, the overall health of the economy is very important when it comes to predicting the housing market cycle. Typically, when an economy is doing well or on an upward trend, investors are more likely to acquire real estate, in expectation that prices and cash flows from rentals will increase;
- demographics: major shifts in the demographics or make-up of a population can drive a market significantly. For example, the increasing number of retirees selling homes and looking for rental accommodation, coupled with longer life expectancy can sustain demand in the multi-family rental market.
How long does a typical real estate cycle last?
The average real estate cycle in the US runs for around 18 years. However, real estate cycles vary in length and are unpredictable. Their overall duration relates to some or all of the factors mentioned above, and some cycles can last much longer than others.
The current cycle began not long after the GFC in 2008 and can be termed as a “bull market” where rentals and prices continue to increase. Some experts are once again predicting a slowdown and the recent interest rate yield inversion in the bond market, amongst other things, is said to be a signal for the gradual end of this current real estate cycle. However, as yet, there is no major evidence to support a slowdown.
Broad strategies to invest during real estate cycles
Having said the above, even though the current real estate cycle may be coming to an end, investment in real estate will continue, it’s just that the strategy for the different cycles may change. Here are several investment strategies based on the real estate cycle which may be considered:
- recovery: buy and hold strategy acquiring many assets, multi-family investments, using private equity lending;
- expansion: buy and hold or buy and flip strategy, multi-family and commercial acquisitions; perhaps sell towards end of the cycle;
- hyper-, over- supply: selectively buy and hold for the recovery period;
- recession: invest in distressed assets, foreclosures and bank-owned homes; seek private equity and hard money loans
CPI Capital knows that any experienced, knowledgeable real estate investor must understand real estate cycles as a primary concept, if their aim is for long-term success.
As developers and investors, we have extensive experience in all four phases of the cycle – recovery, expansion, hyper- or over- supply, and recession and their underlying causes and effects.
We are aware of the possible consequences of shifts in the real estate market so have to keep our research and analysis at the cutting edge to continue to help us find great investment opportunities. And, even if the economy does start to appear sluggish, we have a variety of strategies to remain upbeat and successful throughout the next real estate market cycle!
CSO, COO, Co-Founder CPI Capital