Understanding the Four Stages of the Real Estate Cycle

The real estate market operates in cycles, experiencing periods of growth and decline. These cycles can vary in duration and intensity across different markets. This article aims to provide a comprehensive understanding of the four main stages of the real estate cycle and highlight additional factors that influence these stages.

Moreover, we will explore various strategies that you can employ within each phase to capitalize on the opportunities presented. At the end, I will discuss the phase we are currently in and how it has affected the commercial real estate market.

The recovery phase marks the beginning of the real estate cycle. During this stage, home prices start to rise, while inventory levels remain relatively high. Buyers have a broader range of options, and they can often negotiate favorable prices. The recovery phase is often characterized by low interest rates, increased job growth, rising consumer confidence, and a growing demand for housing. In this phase, you can consider the following strategies:

1. Buy-and-Hold: You can acquire properties at relatively lower prices and hold onto them for long-term appreciation. Rental income can provide a steady cash flow while waiting for the market to further improve.
2. Value-Add: Identify properties in need of renovation or upgrades. By improving the property’s condition, you can increase its value and potentially generate higher returns when selling or renting it out.
3. Opportunistic Buying: Look for distressed or foreclosed properties available at discounted prices. These properties may require more effort to rehabilitate, but they offer potential for significant gains when the market rebounds.

The expansion phase represents the middle stage of the cycle. Home prices rise rapidly, and there is a shortage of available inventory. Buyers face increased competition, leading to prices often exceeding asking prices. The expansion phase is often characterized by rising interest rates, robust economic growth, continued job growth, and a sustained demand for housing. In this phase, you can consider the following strategies:

1. Quick Flips: Purchase properties below market value, make minimal improvements, and sell them quickly for a profit. This strategy takes advantage of rising prices and strong demand, allowing investors to capitalize on short-term gains.
2. Development Projects: Consider investing in new construction or redevelopment projects to meet the increasing demand for housing. This strategy requires thorough market analysis and feasibility studies to ensure a profitable outcome.
3. Rental Investments: With rising prices and limited inventory, acquiring rental properties can provide a consistent income stream. Conduct thorough rental market analysis to ensure favorable cash flow and consider long-term appreciation potential.

The hypersupply phase occurs in the late stage of the cycle. Home prices begin to decline, and an oversupply of inventory emerges. Buyers have an abundance of options, which enables them to negotiate more favorable prices. The hypersupply phase is often characterized by rising interest rates, slowing economic growth, job losses, and a decreased demand for housing. In this phase, you can consider the following strategies:

1. Value Buying: Identify distressed properties with motivated sellers who need to sell quickly. Negotiate favorable prices, potentially below market value, and focus on properties with strong potential for improvement or alternative uses.
2. Rental Stabilization: Shift focus to stabilizing existing rental properties rather than acquiring new ones. Optimize property management, tenant retention, and cost management to maintain profitability during the downturn.
3. Diversification: Consider diversifying investments beyond traditional residential properties. Explore opportunities in commercial real estate, mixed-use properties, or alternative real estate assets to mitigate risks associated with oversupply in the residential market.

The recession phase represents the end of the real estate cycle. During this stage, home prices experience rapid declines, and there is an excess of available inventory. Buyers become scarce, resulting in prices often falling below the asking price. The recession phase is often characterized by high unemployment rates, falling consumer confidence, and a decreased demand for housing. In this phase, you can consider the following strategies:

1. Cash Positioning: Preserve liquidity and maintain a strong cash position to take advantage of distressed opportunities that arise during the downturn. Be prepared to act quickly when favorable deals become available.
2. Distressed Property Investing: Look for distressed properties, including foreclosures, short sales, or properties facing financial distress. These properties can be acquired at significant discounts and offer potential for substantial gains during the recovery phase.
3. Opportunistic Investments: Consider alternative real estate investment opportunities, such as distressed debt investing or real estate investment trusts (REITs), that can provide exposure to real estate while mitigating some of the risks associated with direct property ownership.

Understanding the four stages of the real estate cycle—recovery, expansion, hypersupply, and recession—provides valuable insights for you to make informed decisions about buying and selling properties. However, it's important to note that these stages can vary in duration and intensity, depending on market conditions and external factors.

Additionally, considering economic conditions, interest rates, government policies, and demographic shifts allows investors to gain a more comprehensive understanding of the real estate market and make better investment decisions.

It's crucial for investors to adapt your strategies to each phase of the real estate cycle. Whether it's buying and holding properties, adding value through renovations, seizing opportunities during expansions, or identifying distressed properties during downturns, a tailored approach is essential for success.

Although this article describes a classic real estate market cycle, we are in a strange market adjustment period right now, with supply being very short. We are not in the hypersupply phase yet because supply is very limited:

• Sellers don't want to sell because they have locked low interest rate mortgages and have no pressure to sell for many years.
• New construction is lagging too with higher interest rates.
• Demand is softened with a higher interest rate environment.   
• Affordability is very low due to high interest rates and limited supply (sellers not discounting much).
• Foreclosures are very low and there is very little distressed inventory.
• Unemployment is at historically low levels, so people still have income to pay mortgages.

In my opinion, we are somewhere at the end of the expansion phase, moving towards the beginning of the hypersupply, but it is not a normal/classic cycle. We are dealing with a very dislocated, strange cycle that the world hasn't seen before.

Theoretically, we've met a few requirements of the hypersupply phase:  "The hypersupply phase is often characterized by rising interest rates, slowing economic growth..." Maybe it is the start of hypersupply in a weird way. On the commercial side, things really depend on the asset class. Office is already in a recession phase as COVID massively destabilized the demand for that sector.

Multifamily housing is in very short supply and it is likely to be somewhere at the end of the expansion phase, the beginning of the hypersupply too...  Some distressed seller situations are beginning to surface mostly due to the maturing loans/rate CAP expirations, and poorly executed value-add plans.

Self-storage still appears to be in the expansion phase (late in that phase) and may be starting to move into the hypersupply phase. Hospitality is still doing well, but there are future concerns that the consumer has taken on a lot of debt and will be running out of buying power.    

The times are unprecedented as we've never seen interest rates spiking from zero FED funds rate to 5-5.25% range in 1 year. This is a lot of uncertainty about how much damage it'll cause and how fast. The fear is that we might fall fast into the recession phase, without spending much time in hypersupply. Most investors are sitting on the sidelines and waiting to see what's going to happen. Commercial real estate transaction volume is down 70-75% from a year ago, as bid and ask spreads widened massively. It feels quiet before the storm. 

We are certainly entering a later part of the real estate investment cycle, but it is not a normal cycle. Classic models don't appear to work well in this environment. We are writing the history of the "post-pandemic economic cycle" now, combining that with the interest rate spiking rapidly to fight inflation and the economy that has been addicted to the low interest rates for a long time.

Unemployment is at historically low levels, and that makes it difficult to see a severe recession ahead unless a massive number of layoffs start taking place. We certainly can conclude that the economic growth is slowing and we are likely to hit a technical recession (2 negative quarters of GDP) in late 2023 and into 2024. The rest we have to observe and respond dynamically.

"Big Mike" Zlotnik