Understanding Real Estate Market Cycles
Choosing when and where you are going to invest in real estate is a very critical decision. It can determine how much appreciation or depreciation you will receive during property ownership. It will also influence the type of property you invest in and if you will experience rental rate increases or decreases. Understanding real estate market cycles can help you navigate the waters and make the most of your investments. Paying attentions to the signs that signal market shifts will help you anticipate the future and stay ahead of the masses.
Real estate markets go up and markets go down. The key is to buy the right assets in markets that are poised to grow, providing you with greater appreciation than the average market. You want to avoid depreciating markets where your investment might lose value and invest in appreciating markets where your property has a better chance to increase in value.
There are two major things that happen during real estate market cycles, and they are characterized by growth or contraction. We call them “appreciating growth markets” and “depreciating declining markets.”
Don’t worry; you don’t have to be a market expert to keep on top of the market cycles. There are companies out there that dedicate a great deal of their business to understanding the market cycles and as an investor you can see their research. One such company that I receive updates from is Integra Realty Research, and the chart below is one that they just released on the apartment market and where major cities in the US are in the cycle. You can find out more about them here.
There are 4 Market Cycles: two represent appreciating markets and two represent declining markets.
The two appreciating market cycles are called Recovery and Expansion. The two declining market cycles are called Hypersupply and Recession. The main characteristics driving market cycles are vacancy rates, new construction, employment growth and rental rate growth. Let’s take a closer look at all 4 market cycles and how each of these areas changes with the market cycle.
Recovery: The Recovery market cycle starts at the point that most people call the “bottoming of the market.” It’s the moment when the market stops declining and slowly starts to level off or grow slightly again. During a recovery you will see vacancy rates stabilize and actually start to decrease a little. One of the main reasons for the drop in vacancy rates is due to very low or virtually no new construction. During most recoveries there is very little new supply coming on the market and current property occupancy rates start to stabilize. There is usually low employment growth, but the decrease in jobs has ended. During a recovery you will see very low rental rate growth and it may even go down a little. The good thing about this market is that it signals the end of a declining market.
This is a great time to buy properties for cash flow. If they cash flow now, when the market really improves you can see major jumps in rental rates, occupancy, and value. We feel most of the US is in this market phase right now.
Expansion: The next market cycle is called Expansion. Expansion is a very exciting market cycle because it’s where the economy starts to get rolling again. During expansion you will start to see vacancy rates decreasing. You’ll start to see a little new construction at first and a great deal more toward the end of the cycle. Absorption rates pick up as more people go back to work or upgrade jobs. Job growth picks up as well as income. This leads to moderate to high growth rates in rents. Property values start increasing until the end of the cycle where they hit the peak.
You want to buy at the beginning or middle of this cycle and look to sell toward the end before the market starts declining again. Property values hit their peak at the end of this cycle and then will start to decline again. The US experienced a lot of this in 2006 and 2007 when property values hit their peak. Those who sold during those years made a killing while those who bought at the peak and overpaid will take years for their properties to get back to the value they bought them at.
Hypersupply: The market cycle following Expansion is called Hypersupply. Hypersupply happens when the market gets oversupplied during expansion and job growth slows down. Due to the amount of new construction, the supply now outweighs demand. You start to see vacancy rates increase again. There is still new construction happening, but absorption of new homes and apartment units starts to really slow down. Employment also starts to slow down as companies have already done their major expansions. Rental rates may still be growing, but they are definitely starting to grow at much lower rates or stop all together.
You don’t want to buy during Hypersupply unless you buy for major cash flow that can withstand prices going down and weathering the storm that follows next. You need to be very cautious and sell marginal properties before the market starts to decline more rapidly.
Recession: Recession is the last stage of the market cycle. Most of the US and the world has experienced recession over the last 4-5 years. During a recession, vacancy rates increase as jobs decline, as well as income. New construction slows to a halt. Fewer apartments or houses are absorbed. You’ll also see low to negative growth in employment as salaries level off or companies even have layoffs. The economy slows down and you’ll start to see many more specials offered, or rental rates will actually go down, as there are fewer people willing to pay as much for units.
During a recession you want to focus on buying quality properties that provide strong cash flow. While your value will probably not increase anytime soon, you can still find properties that will provide a strong cash flow again.