Like the broader economy, commercial real estate is cyclical. The overall real estate market ebbs and flows for both residential and commercial properties driven in part by supply and demand. Understanding the real estate market cycle can help investors project potential income and capital appreciation of a property and make more informed decisions. It can also allow investors to apply their knowledge of the real estate cycle in order to identify the correct phase and use the right investment strategy to maximize returns.
It is a 4-phase series that identifies the state of both commercial and residential real estate markets. The real estate cycle can be highly nuanced and hard to predict at times, with irregular periods that are rarely consistent in duration.
In real estate, there are four phases to the market cycle:
The four phases move in a wave pattern that rises and falls. Understanding the cycle can help investors predict upcoming trends and make informed decisions about their investments.
A unique aspect of commercial real estate, when compared to traditional investments, is that investors have the potential to invest successfully across all four phases of the cycle. Understanding the progression of each phase within the cycle is important for identifying investment opportunities and increased awareness of transitioning between phases.
The real estate cycle and its phases may provide reliable information about the possible returns of an investment property. Investors determine if their property is in the recovery, expansion, hyper supply, or recession of the cycle. This may provide an accurate estimate for the length of time to hold a property, what they should pay to achieve certain returns, and which exit strategy to take.
The real estate market cycle is made of four main phases: recovery, expansion, hyper supply, and recession. Historically, there has never been sustained expansion or hyper-supply periods without an eventual recession, followed by a recovery. Though the length of the phases can be unpredictable, investment strategies may make it easier to invest successfully across all four.
The recovery phase is the bottom of the real estate cycle wave. It is the first stage after a recession or pullback in the market. During this phase, occupancies are most likely at or near their low pint, with low demand for space and minimal leasing activity. There may also be minimal new construction underway and rental rate growth may be negative or flat.
The first strategy to potentially benefit from this phase is opportunistic. If you move early in the phase, you may have a variety of opportunities to buy bargain-priced properties in varying states of distress. You can then begin to reposition those assets as the recovery phase continues.
Holding periods are often, but not always, targeted at two to four years with plans to improve the acquisition from its current state of distress. You may be able to sell that same property for top dollar in the next real estate market phase or hold for long-term cash flow. Investors who choose to achieve profits tend to consider selling during the expansion phase if the property has increased in value.
Investing in core properties during the recovery stage can be highly profitable, especially if the targeted asset has stabilized occupancy over the next two to four years. Investors typically use this strategy to acquire an asset in a desirable location and then capitalize on the strong rental growth of the next cycle through a combination of lease renewals and lease up of any vacancies from the previous recession phase. The asset may then be positioned to be refinanced or sold during the expansion phase.
During this phase, the market shows signs of rebounding, growth, and expansion. GDP typically stabilizes to normal levels, job growth is steady, housing is balanced in supply and demand, rental rates are increasing, and new construction also increases.
Investment activity also sees an increase as people regain confidence in the economy. Those who invested in discounted properties during the recovery phase may now sell their properties for profit, since prices and rents typically reach a peak in this phase.
The expansion phase sees an increase in strategy of development. This time, the demand for built spaces is on the rise and opportunities for new construction also increase. This is the ideal time to develop or redevelop properties, especially if the timeline for the project and sale of the property lines up with the expected duration of economic expansion. Investors can take advantage of developing or redeveloping properties catered to the current market’s needs and then potentially sell them for more than market value. Current demand for space and leasing helps properties stabilize more quickly upon delivery at market rental rates.
Those looking for lower levels of risk can look to acquire core-plus properties. These typically have high rates of tenant retention with continued rent growth. With this strategy, core-plus property owners typically have the ability to increase cash flow through minimal property improvements, increasing management efficiency, bring rents to market or increasing the credit quality of tenants. As with core properties, core-plus properties tend to have higher occupancy rates.
Investors may continue to use the core strategy during expansion. This includes capitalizing on the continued strong rental growth or choosing to sell the property. At Avistone, our strategy is to create drive by purchasing properties below replacement costs with stabilized occupancy. This allows us to increase rents to market levels, thus driving strong cash flow, though there aren’t the same levels of capital appreciation on these properties as others.
The value-add strategy is also applicable here. Investors can acquire properties with current deficiencies at discounts to peak pricing, invest in capital improvements, and reposition assets with the help of the strong absorption that is part of the expansion period of the cycle. Once a property is repositioned, the asset may now be worth the full, stabilized value, which can lead to refinance or sale. In most cases, this strategy mirrors the opportunistic strategy.
If an investor wants to look for opportunistic investments during this phase, there are typically a few available as assets that remain in this state during this phase. They often have issues beyond improvement. In this case, an opportunistic strategy may be highly profitable, but must be followed by a short holding period, unless the business plan is to refinance and hold the asset until after stabilization.
This marks the tipping point between balanced supply and demand to oversupply. More properties are for sale than the market demands, which causes prices to slowly lower. Construction also slows as market inventory remains high.
Rental rates remain higher while demand decreases. Job growth, GDP, and interest rates remain stable as real estate pricing peaks just before entering market decline.
Investors can use the core strategy during this phase. Some investors may decide to sell assets ahead of a coming decline in property values and a more challenging leasing market. Other investors may instead seek opportunities to prepare for the coming economic decline.
For example, a core property with high occupancy and stabilized occupancy with lease terms lasting for more than five years may perform well during an economic downturn.
Core-plus strategies may also perform well during this time. Investors choose to focus on acquiring assets that will weather them through the coming recession. Like the core strategy, investors might look for properties with low risk, stable tenants, and long-term leases in place. These fixed term assets can provide security when the next recession hits.
Investors might also choose to be more opportunistic. At this phase, owners who are not prepared to operate through an impending recession may liquidate assets at prices near approaching recession levels. The buyer then acquires a solid asset they are confident will perform well in the next cycle at a recession-level price.
The recession phase is the result of over-inflated growth, as the supply of properties overshadows demand, causing prices to fall. Enter the declining market, where prices, jobs, rental demand, and new construction demand all plummet. Most property owners will suffer from lower rents, especially as tenants may demand rent concessions or reductions. Default rates on mortgages, loans, and credit cards increase. Businesses close, unemployment rises, and foreclosures also increase. Eventually, the market hits a bottom, where prices for real estate are at their lowest.
The opportunistic strategy is most prevalent during this phase. This is an ideal time to buy distressed assets at steep discounts when compared to replacement costs. During this phase, buyers may also have the best opportunity of acquiring assets in distressed scenarios such as lender foreclosures. This strategy uses a patient and well-capitalized business plan, so that when the recovery phase begins, the investor can then begin repositioning the asset to sell it during the next expansion phase.
Once you understand the four phases of the cycle, it is important to understand the variances of the four phases. Phases do not necessarily happen in equal periods. For example, the recovery phase may be quick or drag on for years before transitioning to the expansion phase.
In addition, just because the expansion phase lasted nine years last market cycle does not guarantee the next expansion phase will also be nine years. It is difficult to project how long each phase will last.
Cycles also vary depending on geography and asset class. Certain markets, such as gateway markets, may lead the transition from recession to recovery of the next cycle, with secondary and tertiary markets following suit. These gateway cities are likely to see recovery first, due to the fact they act as the hub for the greater regional areas they serve.
Also, different asset classes recover, expand, oversupply, and decline at different rates. For example, suburban office markets may still be in the expansion phase while urban office markets may be reaching oversupply.
These variances highlight the importance of diversifying your portfolio across assets in order to balance out the highs and lows of the real estate market. Avistone can help you diversify your portfolio with its offerings.
We are a rapidly growing commercial real estate investment firm that focuses on multi-tenant flex/industrial properties and hotels nationwide. In order to provide the best possible outcomes for our investors, we acquire properties located in dynamic markets with proven demand, strong economic indicators, and historically high occupancy rate.
Since our 2013 founding, we have acquired 24 commercial and industrial projects with more than 3.9 million square feet of space consisting of office, warehouse, R&D, high-tech and retail use in California, Georgia, Texas, Florida, and Ohio.
If you are looking to diversify your portfolio, contact Avistone today to learn more about our current offerings.