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Understanding Real Estate Cycles to Find Profitable Investments in Any Market

By: , Contributor

Published on: Oct 07, 2019 | Updated on: Oct 13, 2019

Do you know how to find profitable real estate investments regardless of the real estate cycle? There is always an opportunity, it’s simply a matter of understanding what investment opportunities lie in the current market.

I started my first semester of college in 2008. While I was blissfully enjoying university life, the U.S. economy was experiencing one of the worst recessions our country has ever seen. Approximately 8.7 million jobs were lost between 2007 and 2010.

Mortgage delinquencies were skyrocketing, foreclosures were happening at an alarming rate, and investment and retirement accounts had been drained. While I am thankful to have not been personally affected by the downtown, it was a rude awakening as to what could happen, and likely will happen again in the future.

Understanding how our economy works on a macro and micro level means you can identify potential triggers, make informed decisions to increase profitability and mitigate risk, while still finding profitable investments regardless of where we are in the market cycle.

To help you stay ahead of the curve and find profitable investments -- regardless of the real estate cycle -- we’ll explain how real estate cycles work and discuss some of the ways to seize opportunities for investing in real estate in those specific periods of the cycle.

Market Quadrants Cycle

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Source: www.MarshallCF.com

Phase I: Recovery

The recovery phase is the first stage after a recession or pullback in the market. In this phase, there is a low demand for housing and high vacancy rates. This is a great time to purchase properties as the price of real estate is low. This can initially be a hard phase to identify, as it often still feels like a recession. However, if timed well, there are a lot of opportunities to buy real estate at rock-bottom prices. If we think back to our most recent cycle (The Great Recession), this recovery period likely fell around 2010-2015.

Indicators:

  • Home sales and leasing are flat. Over time, there is slow upward growth for both rentals and property sales.
  • Very little new construction is being built.
  • Interest rates tend to be either declining from rate cuts or holding steady at low rates.
  • Emotions are often fear, panic, and depression. Eventually, over a period of several years, as the market slowly recovers, emotions become more positive and hopeful.

Opportunities:

  • Typically low-interest rates. This is normally a great time to borrow on new real estate acquisitions or refinance a property you may already own. If you can get a lower interest rate and shorter term, you can eliminate your debt at a faster rate. However, bank lending is often restricted post-recession and bank financing may not be an option. For that reason having liquidity means you will have funds available to buy investments during this period.
  • Buying properties below value. This is a great market to find value-add properties that you can sell for top dollar in the next real estate market cycle, or hold for long-term cash flow.
  • Having liquidity is the number one way to take advantage of this cycle. Without the available cash to invest, you could be sitting on the sidelines when price and opportunity are at their best.
  • The sooner you can identify the recovery period, the better!

Risks:

  • While there are always risks in any investment and any market, when a market is recovering from a recession, the purchasing risk is greatly mitigated because prices tend to be at a deep discount. Always conduct thorough due diligence on each asset you acquire -- and don’t buy an investment just because prices are low, make sure the numbers actually work.
  • Vacancy rates are typically high and rental rates are often low in this period. If you already own assets, this could mean you have to hold on to an asset longer than anticipated. Having liquid cash can keep you from going under during this time as you wait for the market to recover.

Phase 2: Expansion

The expansion phase is when the market is showing signs of recovery, growth, and expansion. GDP has stabilized back to normal levels, job growth is steady, housing is in a balanced supply and demand, rental rates are increasing, and new construction ramps up again. Confidence is being rebuilt in the economy and spending across the board begins to accelerate. Investor activity is typically high at this time.

Indicators:

  • Home sales and leasing have increased greatly. There is a balanced or high demand for housing, and prices for both rentals and houses are rapidly rising.
  • New construction begins again and there is flipping activity in the single-family market.
  • A stable or modestly increasing interest rate environment.
  • GDP returns to ideal, “healthy” levels, around 2% - 3%.
  • Emotions tend to steer toward optimism, confidence, and excitement.

Opportunities:

  • Interest rates remain low and lending criteria may start to loosen, although bank loans may still be difficult to acquire. Since housing prices have also increased, this can be a great time to refinance and capture equity you gained through your value-add. Then you could use those gains to invest in other properties that could similarly benefit from a value-add strategy.
  • Strong opportunities for new development, re-development, or acquiring value-add investment properties.

Risks:

  • Higher chance of overextending with leverage. Make sure you are not incurring too much debt. If the goal is to hold long term, you should be confident the property will remain profitable throughout future cycles.
  • When the economy looks and feels recovered and is in a stage of growth, prices are typically on the higher end of the cycle. Investments that are predicated largely on price appreciation could be in trouble.

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Phase 3: Hyper supply

In the hyper supply phase, we see a tipping point from a balanced supply and demand to oversupply. There are more houses for sale than the market demands, which causes prices to slowly lower. Construction slows as market inventory remains high and rental rates remain high while demand decreases, although we often see new construction continue through a hyper supply market. Job growth, GDP, and interest rates remain stable. Prices typically peak in this phase, just before the tipping point where we enter a market decline.

Indicators:

  • There is an oversupply of housing, meaning supply exceeds demand which causes prices to lower. This can happen on a micro level, in just one market, or at a macro level.
  • Rental rates remain high, but demand for rental housing decreases.
  • GDP, job growth, and interest rates remain stable.
  • Emotions tend to reflect overconfidence in what the market is delivering and believe the high prices, rental rates, and growth will only continue. Eventually, as indicators become too strong to ignore, emotions shift to anxiety, fear, and possibly denial.

Opportunities:

  • Selling your assets, capturing any forced equity you may have gained. Prices will peak in this phase, and timing the market will almost never be perfect. If you can get a fair but higher price for your asset, you should likely sell.
  • Great opportunity to buy a fully stabilized asset that can provide long-term positive cash flow, and can hold you over until the next recession and recovery phase.

Risks:

  • Trying to time the market perfectly. Many people feel the decline of the market is coming and will sell their assets too soon. This means they leave money on the table that may sit idle for many months or possibly years before the next recession. Another error of trying to time the market perfectly is waiting too long to sell -- believing prices aren’t at the peak yet. If you wait too long and the market starts to decline, it’s often hard to cut the cord on your losses and you end up selling in panic during a recession.
  • Overconfidence and not heeding the warning signs. Most savvy investors are getting out of the market or investing in stable assets that will carry them through the next downturn. This typically is the worst time to buy, as prices are at their peak.
  • Continuing to build new construction when demand is slowly decreasing. This contributes to the oversupplied market and can end up in disaster for the investor.

Phase 4: Recession

The recession phase is the result of over-inflated growth. We enter a declining market where prices, jobs, rental demand, and new construction plummet. Default rates on mortgages, loans, and credit cards increase. Businesses close, unemployment rises, and foreclosures increase. We will eventually hit rock bottom for this cycle, where prices for real estate will be at their lowest.

Indicators:

  • Housing prices and rental rates decrease rapidly as housing demand is reduced and supply is increased.
  • Unemployment rates and defaults increase. Many businesses shut down.
  • Spending halts as people try to save what they can in a moment of panic.

Opportunities:

  • This is when pricing will likely be the best. If you are liquid and have available capital you could have the opportunity to purchase properties at extremely deep discounts. This is the cycle where people can change their financial circumstances.
  • The biggest opportunities are in value-add. Buying non-performing mortgages, REOs, short sales, or other types of distressed sales.

Risks:

  • Not having enough capital reserves or liquidity. When a homeowner or investor sells real estate during a recession at rock-bottom prices, it’s typically because they need money. They did not have enough capital reserves, stable assets, or liquidity to ride through the economic downturn.

Can you really time the market?

There is always a debate where we are exactly in the cycle at any given time. The economists at Epoch Times believe the cycles change on average every 18 years, with mid-stage mini-recessions about halfway through the cycle. The interferences of World War I and II are the exceptions. Although it’s important to note their sample size is small from a statistical analysis.

The Great 18 Year Real Estate Cycle

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Sources: Fred E.Foldvary. The depression of 2008 Berkeley. The Gutenburg press, 2007. The Cato Institute.

Some say trying to time the market is a lost cause. "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections than has been lost in corrections themselves," goes the famous quote by Peter Lynch.

While others say that there you can time the market with certain indicators. Even if you learn the cycles, keep an eye on indicators, and feel you have a firm understanding of where we are in the cycle at the given moment -- applying the theory of market cycles to the actual market is much harder than it seems. In fact, timing the market is extremely difficult. It’s less about timing the market perfectly, and more about being as informed as possible.

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