Interested in getting into Real Estate but not sure if the timing is right? How can anyone possibly know if the market is likely to rise or fall? Thankfully, there is a regular cadence to the movement in the real estate market that has been regularly repeating itself over and over again. Let's take a few minutes to better understand this cycle, why it keeps happening and how you can use it to boost your gains and avoid a lot of heartache.
A major risk to any investment is that of a secular market crash. The term "secular market" refers to long-term trends that develop over many years. Sometimes, the market dynamics based on historical precedent and forces that have been at work for years or decades forces a market to rise or fall. The last secular market crash was about eleven years ago and, as I'm sure you recall, effected every market.
In Real Estate, there is a market cycle at play that is well documented for over 150 years. I have attached a chart that traces the cycle.
It is very important to understand where we stand in the cycle, for a given asset type and location, and invest accordingly. This means, that our location on the curve will vary based on the type of properties we are assessing (i.e. - Multifamily, Retail etc.) in where the property is located. For example, if office properties in Los Angeles are in the recovery phase, they make a much better investment opportunity than a strip mall in an area where Retail properties are well into the hyper-supply phase.
UNDERSTANDING THE CYCLE
Let's set aside a few minutes to understand why this cycle keeps repeating.
In order to do that, we need to understand exactly what it is. Let's start at the bottom of a recession. There are many vacant apartments and buildings. Supply is much higher than demand. This has led to rental prices and, subsequently, building valuations to drop. Developers, by this stage, will not be starting any new projects as there isn't enough interest in renting new locations. This is rock-bottom. This is the diamond labeled 1.
At this point, the population continues to expand, and the vacant apartments begin to fill up. New businesses open and the empty office and retail space are a bit less empty. Developers are still waiting in the wings but demand starts to build up as supply remains steady. This is the Recovery phase and it is points 1-6.
At this point, vacancies begin to decline a bit more rapidly and developers, seeing a growing need, start building new apartments and commercial buildings. Both supply and demand grow in this phase. This is known as Expansion (6-11).
At a certain point, supply and demand reach a perfect equilibrium. The anticipated need is matched by an anticipated amount of buildings coming to market. This can last for a number of years (we are pretty much there nation-wide in Industrial buildings).
And then, because development takes time and people don't learn from the past, growth in supply begins to outstrip demand. Housing starts accelerate and many new buildings are being completed. This leads to an oversupply, or Hyper-supply, of buildings. Now, landlords need to lower their rent to avoid vacancy and prices start to fall. Hyper-supply very quickly gives way to Recession, and the market remains low while old developments finish up and we wait for demand to regrow.
One point that's worth adding is that while most charts will show this is a circle, I very much prefer Dr. Mueller's chart (below). You will notice that the recovery and expansion phases are much more drawn out than the hyper-supply and recession phases. This is quite accurate, as markets tend to rise slowly and fall quickly. As the phrase goes "markets don't fall up". Rapid movement is almost always down. (In the rare instances when you do see rapid upward movement, it is almost always a bubble and you should be prepared for a crash. Even then, the upward movement is typically more protracted than downward correction.)
USING THE CYCLE
The question remains: how can we, as real estate investors, use the knowledge of this cycle to minimize our risk and maximize our returns?
The first step is to determine where we are in the cycle. While information in real estate is typically somewhat lagging (meaning that it takes time to gather and analyze data so today's conclusions are based on data that may be a few months old) the market also moves slowly, so as long as we keep this in mind and focus on trends and not specific data points, we should be fine.
There are many excellent resources that estimate where we are in the cycle given a specific type of property and location. IRR.com does thorough research and publishes many of their reports for free. Another is just to talk to people in the field and hear what they are saying.
Two years ago, when I was raising for a retail center in Tulsa, OK, I kept running into people (non-sophisticated investors) saying they only invest in multi-family. This type of thinking usually is prevalent before crashes, so I did a lot of research into the multi-family sector. What I found was that multi-family was much further ahead of the curve than other sectors. This makes sense, as people will find a place for themselves to live before opening a business. What had me concerned was just how far along the curve we had gone. Over the next year, I heard of many multi-family operators that returns were going down, as valuations were very high, and it was getting harder and harder to find good deals. Quite a few shifted from purchasing into developing. (See where this is going?) As the number of developments increased, the sector moved further and further along the curve, to the point that some charts showed that in some markets multi-family was actually dipping into hyper-supply. My concerns were recently further bolstered when I heard that a number of larger players in this space have decided to stop buying and instead are holding cash and waiting for the next crash. This is why most of our deals have not been in the multi-family space.
Did we not invest at all? No, the charts don't warrant that. But we were much more selective, and advised our investors to allocate capital differently, than if we have been at the start of an upmarket and not somewhere in the middle of one.
Conclusion
As you can see, by understanding how the real estate market cycle works and using clear data to understand where we are in the cycle, you can adjust your strategies to increase your chances of profitable real estate investments, and minimize, or even fully avoid, crashes brought about by excessive development and lagging supply.
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