Understanding the four phases of market cycles will improve your investment strategy.
Since the real estate crash in 2007, we have seen dramatic recovery in most markets. Many experts are saying that real estate is a bubble that will soon pop; they seem to be shouting, “Buyer beware!” The pundits argue, that since real estate market cycles typically last eight years and we are in the ninth year of successive price gains, a correction is well overdue. Interest rates have risen 2.25 percent since December of 2008, and many may wonder if the party’s over. Is this the case? And how can you make your own informed decision?
When we understand market cycles, we get a better feel for what to do with current assets and whether or not to buy more. Investing wisely now can help you and me maximize returns and avoid ending up underwater as many did in 2006-2007. Let’s dig into the real estate market cycle and learn to gauge where a given market is in the cycle, and what strategies to use in each phase of the cycle.
The real estate market cycle consists of four phases. The first is Expansion or the phase during which most growth happens. Next comes Equilibrium or a time of slowing and stabilization. The third phase is, of course, Decline or the phase where values inevitably drop, sometimes a little, sometimes a lot. The final phase, then, is Absorption or the phase where property values begin to bounce back and recovery begins, but where growth is still slow.
Let’s look at each of these market cycle phases in more detail. Below, I discuss how to better recognize the beginning of each phase and I give a strategy or two to use during each phase.
Phase 1: Identifying an Expansion Market
Real estate markets in expansion are typically areas experiencing population and job growth. Favorable tax incentives, government initiatives, right-to-work policies, and low or no state income tax can lead to economic benefits. For example, when conditions are right in a market, corporations may be more likely to move to or expand in a market. Factory expansions and other infrastructure growth bring jobs. More jobs lead to population growth which leads to more building permits, new subdivisions, new roads, schools and shopping centers. A “path of growth” emerges where certain areas of town boom.
During the expansion phase, desirable locations closer to downtown and areas with older homes with architectural or historical significance can see renovation and gentrification. Housing inventory can become tight. There will be more buyers than sellers and sellers will see multiple offers with prices often going higher than list prices. Inventory doesn’t sit on the market for very long during expansion. Often properties sell in days or even hours. Prices climb during expansion and appreciation is strong. Finally, developers with dollar signs in their eyes often overbuild as they try to get into the action.
Moves to Make During Expansion
The early part of the expansion phase is the time to build new homes and spec homes, and to make money doing flips. During the latter part of expansion, I recommend selling or preferably exchanging properties that were bought low during decline or absorption. Then with that money in hand, purchase in other markets that have better cash flow and more room for prices to rise.
Phase 2: Identifying a Market in Equilibrium
In the early stages of the equilibrium phase, lots of new inventory hits the market as people sense that things are slowing down and work to cash out. There are fewer buyers as company expansion and job growth have slowed by the time equilibrium arrives. Real estate listings start to age and sit on the market for 90-120 days or longer. Prices start to drop and sellers pay more concessions as the market begins to favor buyers rather than sellers. During equilibrium, builders offer incentives and start lowering prices. New shopping centers have vacancies and apartment complexes begin to offer incentives.
Moves to Make During Equilibrium
Don’t get greedy. If you want to sell and you have good equity, this is the time to sell. You may need to sell 10 percent below market value to ensure you get out before the flood of people who will inevitably ride the market into decline. For those wanting to increase their holdings, equilibrium is the time to buy off-market properties from distressed sellers where you can still get pricing that makes sense.
Phase 3: Identifying a Market in Decline
One of the surest ways to spot a declining market is to watch employment trends. In decline, unemployment increases, jobs are harder to find, companies reduce their workforces. Schools may even let teachers go as people move out of the city to other markets. Sure signs of decline eventually become evident. Lots in subdivisions, only half built out, may sit and become overgrown as developers default and go into foreclosure. In the latter parts of decline, real estate prices drop significantly and foreclosure inventory jumps. In decline inventory can sit for a long time. Offers are very low and there is room for negotiation. Local governments may try to jump start the market by instituting improvement zones and other development incentives.
Moves to Make During Decline
If you sold during an earlier market phase and didn’t reinvest in another market, you may have cash in hand. If so, decline is the time to buy steeply discounted properties, especially A and B+ assets. Higher class properties will appreciate the most when the bounce comes and decline is the best time to get these gems for prices that will result in cash flow during a down market. Leave B- and C assets alone until the absorption phase. You may also want to find apartment complexes during decline. Just be sure there is enough rental demand and that population loss is not continuing in your chosen market if you do.
Phase 4: Identifying an Absorption Market
Absorption begins as prices stop falling. The bounce becomes obvious to many investors only when foreclosure inventory begins to get competitive again. Absorption may see the return of multiple offers as major REITS and hedge funds start to compete for inventory. Prices increase as market conditions begin to favor sellers once again. Absorption sees jobs beginning to return and unemployment easing. A good way to look at absorption is though it was the early springtime. There may still be snow on the ground, but it is melting, temperatures are warming, but it is still a bit early for shorts and sandals.
Moves to Make During Absorption
Absorption is the time to buy great cash flow properties as you can, as the A and B+ inventory becomes too expensive to cash flow. Focus on C+ and B- homes that will have high returns. Stick to solid neighborhoods. If you increase your portfolio during absorption, you’ll often cash flow well and get a bump from appreciation later during the coming expansion phase.
Remember that all real estate is local and that typically there are markets in each of the four phases of the market cycle somewhere across the country. You’ve heard the saying, “Location, location, location!” It is really is about buying low and selling high. As you learn to identify the phases of the market cycle and make the right moves during each one, your real estate success will soar.