Understanding the Basics
Similar to other major investment vehicles, real estate is cyclical. One of the most important aspects of any real estate investment is the market in which the asset is located. Understanding where that market is currently at versus where it is going to be in the future is crucial. The cycle will typically reset in times of recession and then move into recovery, expansion and complete the cycle with hyper supply. While there is never a set duration that the cycle will last, many place the timeline anywhere from 7 to 18 years.
The past two years have represented unprecedented conditions for real estate. Some markets are historically more stable so experienced less of a shift from their paths (Midwest). Other markets are more volatile and experienced significant changes in their trajectory, some for the better and some for the worse (Sunbelt, West Coast, etc).
There are a few indicators that can consistently help to deduce what phase a given market is currently in including vacancy, new construction, absorption, employment and rent growth. The status of these five indicators can paint a fairly accurate image of the current state of any market.
Recovery
This phase follows recessionary environments and can be one of the more complex phases to identify. Typically in this cycle you see a very favorable basis as prices are attractive and the market is just starting to climb. The recovery phase is the longest stage of the full market cycle. During this phase you can expect to see some of the following:
- Decreasing vacancy rates
- Low new construction
- Moderate absorption
- Low/moderate employment growth
- Negative/low rental rate growth
Expansion
This phase corresponds with strong job growth, increased demand from both homebuyers and renters, and an overall stable economy. This part of the cycle is often times seen as the best time to buy in. Expansion comes after a proven recovery cycle so risk of investment is seen to be lower. While buying in the expansion phase does not provide as significant of returns that would be experienced while purchasing during a recession, it is a risk-adjusted investment that provides solid returns for an asset you can be confident owning and operating. During this phase you can expect to see the following:
- Decreasing vacancy rates
- Moderate/high new construction
- High absorption
- Moderate/high employment growth
- Medium/high rental rate growth
Hyper Supply
This phase follows expansion where in an attempt to ensure that the supply on market meets the growing demand, developers and investors become very active. Towards the beginning of this phase of the cycle, real estate investors are receiving the highest premiums for their property. The time of transition from expansion to hyper supply would likely be the worst time to purchase. This phase of the cycle is the trickiest to navigate and often leads to investors sitting on the sideline until things cool down. While it is important to possess a sense of patient aggression when pursuing deals in hyper supply markets, sitting on the sideline is not always the answer. Buy and hold is the best approach to take when sourcing new deals during this phase. During hyper supply, we can expect to see the following:
- Increasing vacancy rates
- Moderate/high new construction
- Low/negative absorption
- Moderate/low employment growth
- Medium/low rental rate growth
Recession
This phase comes as real estate supply greatly exceeds the demand. This presents the largest (and riskiest) opportunity to scoop up distressed real estate for pennies on the dollar. Investing during this stage often times represents a high-risk investment phase as the recovery phase may not come for an extended period of time; however, if timed properly these investments can have the greatest return. During this phase, we can expect to see the following:
- Increasing vacancy rates
- Moderate/low new construction
- Low absorption
- Low/negative employment growth
- Low/negative rental rate growth
Key Takeaway
Long-term success in real estate investing, whether commercial or residential, requires a good understanding of the four-phase real estate cycle. Regardless of the planned duration of your hold, if you properly underwrite properties using conservative assumptions and perform thorough due diligence before purchasing, you will do well even during the wrong cycle.
As always, we hope this is insightful. If you’re interested in learning how to invest or discussing some of our current investment opportunities, don’t hesitate to reach out!
Cheers,
Mitch and Kevin
