Why the Real Estate Cycle Matters
With 4 unique stages of the real estate cycle, it is an important indicator of the health of our economy. Real estate has been an integral part of American History since its inception, and it’s still one of the most widely owned assets in this country today. Not only does real estate affect everyone when they’re buying or selling a home, but it also drives many other industries that impact our daily lives.
In addition to the millions that earn a living in the real estate industry, it is the largest GDP of any industry in this country. The National Association of Realtors estimated that 17% of the American economy comes from the real estate industry. It also has the potential to affect countless other industries such as insurance, construction, trades, and banks.
While everybody needs a place to live, it affects business as well. Most businesses require some form of real estate for retail stores, manufacturing plants, or office buildings; therefore, having access to these properties helps keep them afloat during hard times.
As one of the most impactful industries on our total economy, when this industry falls it can cause unemployment, credit crises, and failed retirements as we saw in 2008.
Stages of the Real Estate Cycle Impact Your Investments
Because this industry is so expansive, it has the potential for bad situations, but it can also be a prime opportunity for investors to profit from the laundry list of benefits that you can implement for yourself.
As an investor, you need to understand the real estate market to know where you are and where you stand. The current state of the real estate market will have a direct impact on your investment strategy, your property valuation, your project forecasts, and how successful your project will be.
The availability of capital also depends on the market conditions. Certain investment strategies can only be executed well if the corresponding capital strategy is available. If there’s a lot of capital available, you can use it to scale up for larger projects. When money is cheap, you have access to opportunities that would otherwise go beyond your reach.
In addition, having better forecasts for your real estate investments will allow you not only to make better decisions about what real estate sector will succeed (e.g., if office space suddenly becomes overvalued), but also help you find properties with undervalued price tags so that they can potentially become profitable investments later down the road. By understanding how the real estate market works and how it cycles through stages over time, you can position yourself better to make sound investments and play your cards right when it comes to making money off real estate.
Factors Influencing Market Supply & Demand
- Location – The real estate market is entirely localized. Two nearby cities nearby could be in completely different stages because of other factors.
- Population growth and demographics – Your city or town will have different trends based on its population over time; for example, if it has had steady growth over time then we might expect housing prices here would increase at a higher rate than those in other areas with less overall movement. Other factors include income, employment status, education status, and age.
- Interest Rates – Interest rates set by central banks can have a significant impact on real estate prices because they affect borrowing costs.
- Building permits—the number of new homes being built reflects consumer confidence and the demand for properties. If there are more permits, it can indicate an increase in property values.
- Consumer confidence—a measure of how consumers feel about their financial future; if people become more confident, they may feel more secure about buying a home or investing in real estate.
- Economic Cycle: The economy goes through cycles of growth, contraction, and recovery which affect real estate in different ways at different times. The economic cycle will dictate job availability, discretionary income, and business investment. Although this can correlate with the real estate market, both markets are independent as they could be in respective booms or busts at any given time.
- Government policies – Laws such as tax deductions/credits or zoning policies can also affect whether someone decides if they’ll buy or sell their property during certain times within each stage of the real estate cycle.
How Long Does the Real Estate Cycle Last?
Neither the stages of the real estate cycle or the entire cycle have a fixed timeline. The markets in which we operate are complex and dynamic, making it difficult to predict when the market will turn in any given year. A typical real estate cycle lasts 7-10 years, though cycles can last longer or shorter than this range.
Analyzing the Stages of the Real Estate Cycle
There are several ways to analyze the stages of the real estate cycle. One of them is by looking at the vacancy rate, which measures how many units are available in a region compared to how many units were constructed. A high vacancy rate signals that more units have been built than people want, while a low vacancy rate indicates that there aren’t enough properties on the market.
Another measure of the real estate cycle is the absorption rate, which calculates how quickly homes are being bought up by new buyers or renters once they come onto the market. If it takes six months for most houses on sale to be sold off, then it means that it’s taking longer for purchases to happen – and this can signal an upcoming downturn in demand for housing sales or rental properties when it gets high.
You can also look at active construction projects as another way of gauging what’s happening with your local real estate market: if there are few sites being developed nearby then chances are prices will go up because not enough new homes will be available over time; however, if too many developers start building new communities around yours then this could lead prices down again since supply would outpace demand.
Recession Stage
A recession is a period when the real estate market is contracting. In this stage, property values are the lowest and vacancy continues to grow. During this time, you’ll see fewer construction projects, low or negative rent growth, and a low absorption rate (the time it takes for all your units to fill).
The best time to find an undervalued property is during a recession since distressed sellers will have no other choice than to sell their properties below market value. Foreclosures and REO properties will be very common at the end of this stage.
Recovery Stage
In the post-recession period, it’s a sign that market fundamentals are improving. After the recession, when prices were at their lowest point and vacancies were high, this is when buyers start to come back into the market. It’s also when construction starts to pick up again to meet demand and rent grows at the average rate. As a result, absorption rates (which measure how fast homes are selling) increase slightly from their previous low point but are not enough to cause concern for sellers or buyers.
This stage is characterized by gradual improvements in home prices and rents; however, it does not occur at the same time across all markets or locations within them—which means there might be geographic differences in when each stage occurs within your specific local market area.
It is hard to go wrong when you invest in property at the beginning of the recovery stage. Investors who used extensive debt on their property may be forced into a sale or another exit strategy as the peak vacancy rates from the previous recession can turn their property unprofitable. These deals provide excellent opportunities for a value-add strategy (VAD).
Expansion Stage
The third stage of the real estate cycle is the expansion stage. Real estate prices are rising quickly, and buyers are out in force, as they compete for properties. There is a lot of competition for properties, causing vacancies to decrease and rents to rise quickly. The absorption rate in this stage is very high. Developers are active in construction as the increased demand exceeds supply, which makes their work more profitable than it would be otherwise.
In the early days of this stage, it is hard to go wrong with any investment strategy. It is the peak of buying real estate. But as the market progresses towards the final stage of the cycle, comparing investment opportunities becomes more important as you get closer to the next recession.
Hyper-Supply Stage
If a developer is investing in new construction, they will start to build up to meet the demand. They may decide that there is a lot of demand for their product and build more than necessary. When supply exceeds demand, it’s called hyper-supply. In this phase of the real estate market cycle, developers are building too many properties at once, which increases supply and keeps prices from rising too quickly or falling too far. Even though supply exceeds demand, developers still have active construction projects that need to be finished which could bring values down even further.
During hyper-supply stages of the real estate cycle:
- Increased supply causes increased competition among property owners.
- Prices and rent growth fall as inventory grows.
- The risk is that prices continue falling as inventory grows.
- Because demand can’t meet supply, absorption is negative.
With recession as the next step in the cycle, any short-term investments should be avoided during hyper-supply. However, an investor still may be okay with a long-term buy & hold if they feel they get it for a fair long-term value. Proper financing will become a point of emphasis with an impending recession. High-debt projects carry more risk and may not survive through the hard times ahead.
Forming Your Cycle-Proof Investment Plan
Knowing the current stage of the real estate cycle can help you know how to position yourself for investing success and minimizing risk. Knowing when to invest, sell and where to invest are all things that come into play with these four stages.
Once you understand these four stages, making overall decisions about anything related to your real estate portfolio becomes easier with the market framework for thinking about different aspects of whatever it is you may want to do (i.e., buying/selling property).
While you can make great real estate investments at any stage of the real estate market, you need to understand where your market is to match it to your own financial goals and investment strategy. For help with navigating the stages of the real estate cycle, you can always reach out to us at invest@eikoninvestments.com.
Happy Growth.
