You probably heard it many times: real estate is a cyclical business Each cycle presents opportunities and risks, and knowing where we are in the cycle can help you evaluate the risk in each market and determine the worthiness of deals. The general economy goes through similar cycles, but the ones that are specific to real estate are the ones you need to learn about.
It’s also important to note that different markets can be in different cycles at the same time, meaning that not all markets are in the same real estate cycle, so, for instance, San Francisco can be in a Hyper Supply stage while Jacksonville can be in Expansion stage.
The Four Real Estate Cycles
What are the key real estate cycles? There are four that are often referenced:
3. Hyper Supply
These cycles follow market conditions and interact with each other, so they are fluid. The cycles are tied to long-term vacancy rates, and impact investment opportunities as they transition from one cycle to the next.
How can these different cycles impact real estate investments? It depends on whether the cycle is occurring when vacancies are declining or increasing, and whether new construction is happening. Let’s look at each cycle and its unique impact on real estate investing.
When there is minimal demand and no new construction occurring, you’re in the Recovery cycle. There is not much growth in rents either. To compound the problem, it’s hard to determine whether it’s the start of the cycle or not. This matters because if it is in fact early in the cycle, investors can still find bargain-priced properties that would be ideal “value-add” assets that could be repositioned and become profitable.
You should realize that while pricing on value-add properties may seem attractive, there might not be a quick lease-up until late in the Recovery phase or early in the Expansion cycle. There will be many opportunities to increase rents after repositioning or remodeling, but the rate at which new tenants sign leases may be slow until later in the cycle.
Purchasing core properties during the Recovery cycle can be quite profitable. For those not familiar with the term “core properties,” they’re the least risk investment available, as they are usually fully leased to quality tenants and require little or no major repairs or renovation (though often have lower yields than value-add deals). Some investors choose to purchase a core property in the Recovery cycle and then capitalize on the coming rental growth that will occur during the Expansion cycle. When fully leased, the property is then either refinanced or sold at a profit.
One other category of investment strategy is to purchase what are called “opportunistic” properties. These investments offer the highest risk and reward opportunities available, but they require major work. Either they’re being built from scratch or they need extensive rehabilitation. Because of this, opportunistic properties offer investors the chance to obtain the highest rate of return available. However, there is often littler or no cash flow when they are acquired.
During the Recovery cycle opportunistic properties can be purchased at bargain-basement prices. They’ll be in various phases of distress and will require major repositioning. Opportunistic properties are often held until the Expansion cycle when they are often sold after going through a complete repositioning.
What happens during the Expansion cycle? The market is growing, and there is demand for rental units. Occupancy is improving and rents are increasing to levels that would justify new construction. During this cycle demand and supply are just about even, but it’s a strong real estate market.
The strategies for investors during the Expansion cycle are varied. A property could be developed or redeveloped during this cycle profitably. Properties tend to stabilize faster and rents will be going up to levels not seen before.
If the investment strategy is to look for core and core-plus properties, the Expansion Cycle is a good time to invest. This cycle tends to have high rates of tenant retention along with continued rent growth. That means lower levels of risk with more profitability for investors.
For value-add strategies, the Expansion cycle is a terrific time to invest. This cycle lets savvy investors acquire properties with substantial deficiencies at discounted prices. They can then make the needed capital expenditures and reposition the property quickly thanks to the strong demand that is associated with the Expansion cycle. After the property is repositioned, it can regain its full stabilized value, and if desired can be refinanced or sold.
During the Expansion cycle supply and demand often reach equality. But during the Hyper Supply cycle, that equality tips over into over supply, which happens due to overbuilding or a major shift in the economy. The hallmarks of Hyper Supply include rising vacancy rates and declining levels of rent increases.
How do these factors impact investors? It depends on the strategic investment categories. Investors in core properties watch for signs of Hyper Supply and often try to liquidate their properties before the downturn is widespread. However, if the property has a high occupancy rate with top tenants, investors may choose to hold on to their assets and wait until the market rebounds.
During this cycle core buyers and value-add buyers may simply sit on the sidelines and wait to see what happens. Investors with a key strategy of seeking out opportunistic properties may look for just about any type of asset rather than only looking at very distressed properties. The investors will work on finding a pricing advantage during the Hyper Supply cycle, going after property owners who aren’t fully equipped to weather the impending downturn and would rather liquidate their assets than struggle through the cycle. This gives opportunistic buyers leverage and they can often acquire assets well below their real market value.
It’s easy to spot this cycle. Supply far outweighs demand, leading to higher vacancy rates. And rents in the recession cycle are often negative or fall into levels far below the inflation rate. This is when property owners tend to offer rent reductions and concessions to retain their tenants, damaging their cash flow in ways that can last for a long period of time.
Which investors benefit from the Recession cycle? Opportunistic investors who are well capitalized often come out as the only “winner” during this period. They purchase distressed properties at deeply discounted prices, and wait for the Recovery cycle to begin. That’s when they will start to reposition the property with the intent of selling it towards the end of the Recovery cycle or at during the early phase of the Expansion cycle.
Investors who focus on core or value-add properties wait for this cycle to run its course before investing again.
Other Factors to Consider
There are a couple of factors that can influence investment decisions during the different cycles. Just remember that the different cycles don’t always happen in equal periods of time, and often are quick to transition from one cycle to another. On the other hand, one cycle may last for a long period of time, even though it never performed that way before. There is no way to predict this.
The other point is that where you invest and your investment strategy may impact the transition time from one cycle to another. The important thing to remember is that a diverse asset portfolio will help to balance out the different performance results during different real estate cycles.
It’s clearly important to understand the different real estate cycles and how they can impact different types of investment strategies. By watching for signs that signal the start of one cycle or the end of another, you’ll be ahead of the game in terms of investing in your particular overall strategy. Unfortunately, there is no crystal ball to tell you when cycles will start or start, but keeping a close watch on the various hallmarks of each cycle will give you an advantage over others who don’t pay close attention.
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