This article was originally posted on Keith Knutsson’s weebly blog.
Anyone looking to invest in real estate needs to understand that the real estate market has cycles, four to be exact. Being able to properly identify investment opportunities comes with the knowledge of the progression of each phase. Investing can be successful in each phase. However, understanding the market factors is important, either the cycle is climbing towards peak market or on a downward slope towards market low. Keith Knutsson advises that this will affect a variety of factor, such as:
●Proper phase to investment strategy pairing
●Exit strategies and holding periods
●Capital improvement timing
●Expectations on returns
●Income and appreciation performance
The challenge lies in predicting movement from one phase to the next. The objective of the buyer or the advisor is to maximize risk-adjusted returns. Therefore, the timing of the buy/sell decision is essential.
Let’s jump into the four phases:
Phase 1: Recovery
Recovery begins at the lowest point in the market. During recovery, the demand for homes slowly grows, which reduces the oversupply that exists. New construction begins, vacancy rates decline, and rental rates stabilize.
A savvy investor would try to take advantage of this phase. However, overall sentiment can be weak and securing financing is often a challenge. Identifying the start point of this phase can be difficult as the market still feels like it is in recession.
The recovery phase of the cycle is represented by elevated (although stabilized) unemployment, a high number of home foreclosures, and increased fear in the general population. You may hear people say, “I’ll never invest in real estate at this time. My aunt did and she lost a fortune.” However, this may be the best time if you keep in mind that if you buy low, you can sell high.
Phase 2: Expansion
Keith Knutsson advises investors on how the economy plays a major role during the expansion phase of the real estate cycle. Confidence in real estate begins to grow as businesses start to add employees to their payroll, which means that housing becomes more in demand. Because of the increase of employees, there is also an increase in the amount of required office space, which creates a shortage of available commercial buildings. However, rates begin to rise more rapidly, creating the real estate bubble. When supply catches up to demand within the market, called the equilibrium, the expansion phase ends.
Phase 3: Hyper-Supply
New construction typically continues, after the equilibrium. This is mostly because the market does not recognize that the equilibrium has occurred. Supply begins to exceed demand, moving the market into the hyper-supply phase of the cycle. During this phase, occupancy rates begin to decline. Those within the market begin to recognize the shift in phases, and new construction begins to slow. Many factors determine the outcome of this downturn. For example, if it happens fast after the equilibrium, it may cause the market to revert to one of the previous phases. However, the market will most likely remain in this phase for a long period of time.
Phase 4: Recession
Recession happens when occupancy falls below the long-term average and has a major impact on the changes in supply and demand. This will show a clear economic impact on the market and on society. The price to maintain or expand will exceed what is available from mortgages and rents. In a recession, changes will be seen in the economic dynamic throughout the nation. This is the unfortunate phase that sees the highest amount of foreclosures. Once the recession phase hits its bottom, the phase will shift once again, starting over in the recovery phase.
What does this mean?
Economic, social, and political factors can have a small or dramatic influence on the real estate cycle. Being able to identify which factor is having an effect will allow you to understand each phase, giving you a better understanding of the future of the market.
Up-cycles and down-cycles are the most important indicators of the shift of a phase. Identifying each shift in its early stage, allows those in the real estate market to effectively prepare and understand how the market will progress. There is no way to ensure a correct prediction of the market, but a careful and watchful eye increases how well you predict the progressing, which can impact the ability to make wise investment decisions.