It is crucial to understand that real estate cycles are both inevitable and complicated. What goes up, must come down and vice versa. All markets will experience highs and lows. Understanding that these cycles are inevitable will help investors time the market to buy low and sell high. It's only a matter of understanding the signs and characteristics of each cycle.
Many extraneous forces contribute to the progression of real estate cycles. However, all real estate cycles are driven by supply and demand. This includes supply and demand for buildings and well as supply and demand for the rental units themselves. I provide this oversimplified explanation to aid in the understanding of the causes of real cycle progression (specifically apartments) and the relationship of supply and demand to pricing increases and declines.
1. When jobs are plentiful, the economy is strong.
2. When the economy is strong, people spend money including money on housing increasing tenant demand.
3. Increased tenant demand drives rent prices up.
4. As rents rise, investors make more money and returns become more attractive.
5. As the result of higher returns, more property buyers enter the market.
6. With more buyers in the market, apartment prices begin to increase as the result of this increased demand and competition.
7. When prices increase to the point where it is cheaper to build a new building than to buy an existing one, many new builders enter the market and existing builders increase construction activity.
8. Eventually this new building activity creates a greater supply of apartment units than tenant demand can absorb. (This process takes many years because new supply does not materialize suddenly as projects take years to go through the permitting process and complete construction).
9. As the result of more units available for rent than there are tenants, rental rates begin to decrease as landlords compete for tenants.
10. This decrease in rental rates diminishes investor returns as properties generate fewer rental dollars.
11. Diminished investor returns causes property buyers to exit the market to investments with more attractive returns.
12. Because there are fewer buyers in the market, property prices begin to decline.
13. Additionally, as the result of the increased construction, there are more buildings on the market for sale, further causing apartment prices to decline.
14. Concerned lenders tighten underwriting standards on loan refinancing and originations as their collateral (the property) is being devalued which causes even more buyers to exit the market as they are unable to obtain financing.
15. Many builders can't sell their projects nor obtain money from refinancing to finish or carry their existing projects so many default causing banks to foreclose.
16. Banks need these assets off the books so they quickly liquidate by selling low causing a further decline in apartment prices.
17. As prices fall further, banks further tighten lending standards as they "write down" the losses causing even more buyers to exit the market.
18. New developments no longer pencil as the result of decreased pricing (cheaper to buy existing buildings than to build) and developers can't get financing on new projects so construction activity decreases as builders exit the market.
19. Lack of construction further slows the supply side of the equation down.
20. As prices go down, investor returns become more attractive.
21. As the result of higher returns, more buyers enter the market. And the process repeats itself.
Recovery begins when excess supply is absorbed (sold) so values can increase. Rents increase when excess rental units are absorbed and rents stabilize (stop decreasing). The more oversupply on the market the longer the recovery period as it takes longer to absorb the excess inventory. Oversupply can be from many sources including excess construction, job loss, foreclosures, lack of lender capital for purchases, etc.
This is an extremely oversimplified example to illustrate the cause and effect of changes to supply and demand. The entire real estate cycle takes years to complete and each stage in the cycle is not necessarily of the same time duration. Additionally, different cities will be in different stages at any point in time. Yes, even in recession which is a national phenomenon, some areas will be booming while others are floundering.
Notice that it all starts with jobs. Jobs create spending power and spending power creates demand. When considering any real estate purchase, it is important to conduct a complete market analysis to evaluate market demographics and to determine which state the real estate cycle is in.
In looking at market demographics, one element which is important to determine is whether jobs are growing or shrinking. Employment information statistics can be easily searched nationally or by individual city at U.S. Census Bureau, U.S. Bureau of Labor Statistics, U.S. Bureau of Economic Analysis. Familiarize yourself with these resources as they contain a wealth of FREE information which will help you make better investment decisions.
By understanding the mechanisms which contribute to real estate market cycles, investors can time the market to sell at the highest prices possible when demand is highest and buy for the lowest prices possible when demand is lowest.
The catch is that investors need to become proficient in determining not only which stage of the cycle a current real estate market is in but where the market is headed and how long it will take the market to get there.
"I don't skate to where the puck is. I skate to where the puck is going to be." - Wayne Gretzky
Investors can learn to time the market to forecast the next boomtown or emerging market. By adding this skill to an arsenal of sound investing principals, real estate investors can reduce risk and increase investing profits.
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Karen Hanover is well known as a Certified Commercial Real Estate Advisor, President of the National Apartment Investors Association, Chairman of the National Commercial Real Estate Advisory Board and Senior Instructor for both the Self Storage Education Institute and the Apartments Education Institute.
As a CCIM Candidate, a highly prestigious designation, often called the "Ph.D. of commercial real estate" Karen works as a busy commercial real estate agent with Marcus & Millichap one of the nation's largest and most highly regarded commercial brokerage firms.
Sought by industry insiders for their toughest deals, Karen has helped thousands to create wealth in commercial real estate with less risk even in today's uncertain economy.
Karen founded the Commercial Investment Education Institute which provides educational instruction for investors on multiple subjects including apartments, self storage, office buildings, retail centers, mobile home parks and more. Her courses are taught in a friendly and easy to understand manner.
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