Undertanding Real Estate Cycles

Where do we start when we are analyzing real estate? Although this may be obvious to some a few months ago I had no idea the answer to this question. Real estate is a market that tends to lag behind normal market trends because it takes time for things to get built (i.e. if the market demands 1000 more units then multiple developers start construction which would release 1500 units in 2 years). When analyzing this lagging market we must start by identifying where we are in the real estate cycle. There are four main categories used to describe the cycle, those being: Recovery, Expansion, Hyper Supply, or Recession. Each category has different effects on market dynamics and investment strategies.

Recovery

What does a recovery period look like in the real estate cycle? Recovery comes after a large downturn in the market, stagnant rental growth, low amount of construction starts/entitlements. This phase will follow a recession period and starts in the midst of low property values, high vacancy rates, and slow but positive economic growth. What does that mean for investment strategy? This is the time to buy, with so many distressed properties at extremely low values investors hope to get in the market at this point in time. When doing so they plan to hold until the market top.

Expansion 

An expansion period is when we see a big market upswing  with high levels of demand, an improving economy, decreasing vacancy rates, increasing rental rates, increased construction starts, rising property prices, and positive job growth. So what does it all mean? This expansion period indicates that consumers have more confidence in the market and buyers are much more active during this period. Developers are also actively building units to meet the growing demand. The investment strategy during this time in the cycle is in both buying and development as the values are steadily increasing. During this period investors can expect positive returns.

Hyper supply

After the previously mentioned period of expansion the cycle will eventually reach a period of hyper supply. Demand begins to slow with all the new supply hitting the market, market vacancy rises, rent growth remains positive but slows, construction slows, and the return plateaus or in some cases decreases. One thing that tends to indicate this period is an increase in speculative development (or development without a guaranteed buyer or tenant). The investment strategy will shift during this period, many investors realize what is coming and will try to sell as a recession is on the horizon. Some investors look for properties with long leases because they believe that the stable cash flows from the property will outlast an inbound recession. 

Recession

Finally, some call this the worst part of the cycle but professionals who saw it coming are extremely excited for a Recession. The oversupply has led to decreased property values, vacancy rates are high, tenants have more options, and rental growth is either negative or below inflation. During this period construction slows drastically as demand has decreased significantly. Investors focus on very defensive strategies, like acquiring underwater assets at a great discount to replacement cost, shifting investment to more resilient product types, or reducing leverage and maintaining liquidity. Opportunistic investors will buy preparing for an upcoming recovery period, however financing(loans) are much harder to get during this period. 

Understanding the Recovery, Expansion, Hyper supply, and Recession phases of the real estate cycle enable investors, developers, and anyone interested in real estate to make informed decisions when it comes to analyzing real estate. By recognizing where we are in the current real estate cycle, professionals can tailor their investment strategies to manage risk, meet return goals and take advantage of real estate's cyclical pattern.