I often get asked, “Is this the right time to invest in real estate?” It’s a legitimate question. As capitalization rates have steadily declined and property values have rapidly increased, this question becomes ever more important to answer. Other insightful questions asked are: “When will the real estate market turn?” and “Has the market peaked?” All good questions.
Before we can answer these, we need to determine where we are on the real estate market cycle. You may be aware that the real estate market cycle is cyclical with four distinct phases: Recovery, Expansion, Hyper-Supply, and Recession. The chart below shows these four phases and how each one impacts new construction and vacancy rates.
Before I explain the four phases of the real estate market cycle, let’s discuss the basics of the chart. The X axis (horizontal line at the bottom) represents Time and the Y axis (vertical line on the left) represents Occupancy. The horizontal dotted line in the middle represents the long-term average occupancy for the market. The vertical dotted line toward the middle represents when supply and demand are perfectly in balance. The black solid line that travels through all four quadrants represents the change in occupancy over time.
Now let’s discuss the four quadrants.
Phase I – Recovery
The Recovery quadrant of the real estate market cycle (shown in the lower left-hand corner of the chart) is characterized by high vacancy and no new construction. Though it’s not shown on this graph, generally rents are flat or declining during this phase. Owners offer rent concessions to avoid their property’s occupancy rate from further declining.
The mood of investors in this quadrant begins with panic: Oh, my, am I going to survive? (recall market conditions in 2009). As the occupancy rate improves to the market’s long-term average occupancy rate, investor attitude slowly turns to one of relief: Whew, I made it through the worst of the market.
Phase II – Expansion
The Expansion quadrant (shown in the upper left-hand corner of the chart) is characterized by declining vacancy and the start of new construction. As occupancy improves, concessions are eliminated and rent growth begins.
The mood of investors turns from relief—I dodged a bullet—to giddiness as vacancy rates decline and rents increase dramatically. Life is extremely good for investors at this point in the real estate cycle.
Phase III – Hyper-Supply
The Hyper-Supply quadrant (shown in the upper right-hand corner of the chart) is characterized by more new construction, and for the first time in a long time, vacancy rates begin to rise. Rent growth, though still positive, grows at a slower pace. And some neighborhoods start to experience rent concessions as new product that has recently come on line becomes increasingly more difficult to lease.
The investor mood turns from giddiness to one of caution and then denial that there is a problem brewing. The glass half full type of investors are still confident everything is going to work out just fine. They are thinking, The slow rent up is only a bump in the road that will self-correct as long as I don’t panic.
Phase IV – Recession
The Recession quadrant (see the lower right-hand corner of the chart) is characterized by the completion of more and more product, which results in a substantial decline in occupancy rates. Newly completed product is sitting there unoccupied so developers begin running “blue light specials” to get them rented up. Concessions are abundant. Even investors with established properties are forced to offer concessions to avoid wholesale move outs.
In this phase, investor mood goes from denial to one of outright panic. Developers begin to wonder, Am I going to make it? The truth is, some will not. Also, some investors who recently bought properties at premium prices and then loaded them with lots of debt realize their mistake. Because they are leveraged to the hilt, a small drop in vacancy results in properties that no longer generate positive cash flow.
Which real estate market phase are we in?
These are the four phases of the real estate market cycle. Understanding where the real estate market is on the cycle is critical to successful investing. Is the market climbing closer to a market peak or is it starting down the slippery slope to recession? How we answer this question may determine the difference between a successful investment or an albatross hanging around our necks.
So where are we today in the real estate market cycle? For the past several years (2013–2018), most real estate pundits have described the real estate market as being in Phase II, the Expansion Phase, which is characterized by high rent growth in a tight rental market. This time period can be best described by a quote from former Federal Reserve Chairman Alan Greenspan. He called it “irrational exuberance” when describing a euphoric stock market. I use a highly technical term to describe this part of the real estate cycle. I call it “The Silly-Stupid Phase.”
What Is the Cycle of Market Emotions?
Describing the real estate market as being in the Expansion Phase is kind of a Mr. Spock approach to evaluating market trends—all logic and no emotion. But emotions play a huge role in the real estate cycle. A useful tool called the Cycle of Market Emotions helps us understand how market phases are interconnected with prevailing moods, such as optimism, excitement, fear, panic, and hope. Imagine an emotional rollercoaster, and you’ll get the idea.
When the real estate market is at the very top of the incline, the predominant emotions are thrill and then euphoria. This happened in 2015-2017. And when it does occur, you can almost hear a big brass band playing “Happy Days Are Here Again.” During times such as these, investors in the real estate market usually have good justification for euphoria. Rents typically increase, sometimes dramatically, interest rates may hit new lows and remain there for some time, and developers may be slow to meet the demand. These conditions are great for investor return, both in appreciation of property values and increases of cash-on-cash returns. So why do I call this phase in the market the Silly-Stupid Phase?
Two Factors Fuel the Silly-Stupid Phase
The Silly-Stupid Phase is characterized by two factors:
The first factor is cap rate compression.
Cap rate compression happens when a real estate market gets stronger (i.e., investors are more confident) and the perceived risk of owning a rental property declines. Ken Griggs, president of the Real Estate Research Corporation, has talked about the precarious balance of value versus price in real estate. When assessing a most recent market condition, he said, “Our analysis showed upward pressure on pricing without a corresponding increase in value.” That’s a little scary. Now why does this happen? I believe buyers get caught up in the euphoria. They act as if this particular phase in the real estate cycle will continue forever. So they justify their price hikes, assuming rents will continue to rise and that their unrealistic pro forma projections will come to pass. But eventually, rents top out and vacancies start to rise.
The second factor associated with the Silly-Stupid Phase is lender aggressiveness.
What I have observed and my lending peers confirm is that outlier lending institutions provide rates and terms that are significantly better than what is typically offered by most lenders. They aren’t just competing for the business. In some instances, they outright buy it. And the larger financial institutions start offering rates and terms that are reminiscent of the years prior to the Great Recession—namely, interest-only loans, higher loan-to-value ratios, lower debt coverage ratios, and compressing of their spreads on interest rates. They hope that offering these “blue light specials” will help them hit their loan quotas.
You may be thinking, Why should I care if lenders are bending over backwards for my business? Let them. I don’t have to accept what they are offering. You’re right. You don’t. My advice is for you to take advantage of all these very favorable loan terms as long as you don’t overleverage your properties. When the market turns— and it inevitably will—make sure that your rental property can support the mortgage payment when vacancy rates rise to levels associated with the bottom of the real estate cycle. This way you can protect yourself and your property investment.
Are We in the Hyper-Supply Phase of the Real Estate Market?
So where are we today in the real estate cycle? Since I’m most knowledgeable about commercial real estate in the Pacific Northwest, I’ll speak to this question using the world I know best. As I have explained, the real estate cycle moves in definable phases, and while timing is a bit unpredictable, I believe the evidence suggests that in 2018 we started the beginning of Phase III, the Hyper-Supply Phase. Here’s why:
- After double-digit rent increases the past couple of years, rents are beginning to level off. They are still rising but much more modestly.
- As of this writing, construction is booming throughout the Pacific Northwest. Seattle and Portland are experiencing record amounts of construction. Seattle has more cranes dotting the skyline than any other city in the country. Portland has $2.5 billion worth of new development under construction.
- For the first time in a long time, rent concessions are being offered on new product.
These three factors are all classic indicators that the market is in Phase III, the Hyper-Supply Phase.
Should we still be investing?
So for the moment, let’s assume that the real estate market is, in fact, in this quadrant of the real estate market cycle. Does this mean that investors should stop buying real estate right now? Heck no. I’m currently in the process of buying a mixed use property with a group of investors so I strongly believe you can find good investments regardless of what phase of the real estate market cycle you are currently in.
If you know of future development that will have a positive influence on the property’s neighborhood that the seller is not aware of, or you have a vision for how to turn a property from a loser to a winner, it makes little difference what phase of the market cycle we are currently in. You can still make a good investment.
Even so, it’s still important to understand that some phases of the real estate cycle are more difficult for profitable investing than others. If we truly are in the beginning of the downward real estate market cycle, then I advise that you proceed with caution. Don’t be one of the Pollyanna investors who throws caution to the wind. Be prudent. Be alert for sudden changes in the market. If you do, you’ll increase your chances for success.
Those are my thoughts. I welcome yours. Where do you think we are in the real estate market cycle?