Navigating the 4 phases of the Real Estate Cycle

Real estate investment can be a great way to grow your portfolio while keeping risk relatively low over the long run. But not all times are equal when it comes to investing, so knowing the ebbs and flows of the real estate market is key for making smart choices. Let’s explore the four phases of the real estate market cycle.

Recovery

The recession phase ends with an oversupply of housing units. During recovery, demand for housing starts to catch up with supply. Vacancies are high initially but slowly decline, and rent growth stays stagnant. Most investors see limited profit in real estate at this stage, so only serious buyers remain active. This creates a buyer's market with property values at their lowest and numerous buying opportunities. Savvy investors take advantage of this phase by acquiring properties with strong growth potential at low prices.

Expansion

As demand increases it eventually catches up with supply. Vacancies stabilize at historic levels for their respective markets, and rents begin to rise. This period features strong rent growth and increasing real estate values. As demand surpasses existing supply, builders start constructing more housing.

This phase typically aligns with stable interest rates, low unemployment, and robust economic growth. With a strong economy investors gain confidence, creating a healthy investment environment. It's a good time for property acquisition, especially when adding value.

However, risk levels rise toward the end of this phase. Investors should stay alert for signs of the phase's conclusion, such as rising inflation and historically low unemployment. Rising economic risks may prompt the Federal Reserve to raise interest rates to manage economic growth. Higher interest rates can dampen real estate activity.

Oversupply

As the economic growth stalls, demand may begin to drop. However, housing construction takes time. By the time new construction is completed, demand may have declined, resulting in an oversupply of housing. Alternatively, the factors driving the expansion phase may lose momentum, causing rent growth and property values to plateau. Signs of distress may start to appear in the market, often because rent growth doesn’t meet business plans or rising interest rates strain operators' cash flow and property values.

In either scenario, the chances of further property appreciation decrease, and the risk of a downturn is high. It might be a good time to exit existing investments if possible. While savvy investors can still find good deals, they’re harder to come by. This phase is marked by slower rent growth and potentially higher interest rates.

Recession

As housing units continue to saturate the market, rent growth may decline and even become negative. This phase often begins when the Federal Reserve raises interest rates to prevent the economy from overheating. Higher interest rates put downward pressure on property values and may cause a surge in distressed sales, flooding the market.

Many investors lose interest due to fear, while others are stuck in risky investments. This period is challenging for current investors, and few investors are actively buying because no one wants to catch a falling knife. New investments require careful evaluation, while existing investments should prioritize preserving cash flow.

Conclusion

The model above provides a basic outline of real estate cycles based on supply and demand, but there are many other factors at play in the real world. It can be tricky to pinpoint exactly where we are in the cycle, but having a general sense of the market's movements and our current position can help us make smarter decisions and improve our portfolio. Partnering with an experienced sponsor who knows the intricacies of market cycles can significantly benefit investors.