Having a thorough understanding of the real estate cycle enables you to time your move accurately and maximise your returns. Most real estate investors face many challenges in building a profitable real estate portfolio.
Determining whether to purchase or liquidate, raise or lower rents, or deciding which sector of real estate to participate in can be determined more easily and profitably by understanding the real estate cycle and the important attributes of its behaviour.
It is tough to be at the beginning of a trend. People tend to follow the crowd (or the media) and consequently buy yesterday’s deals. It is much easier to profit when you are buying at the beginning or even in the middle of a cycle. If you can accurately time a rising market, you can benefit from higher rental income due to higher occupancy which results in upward pressure on property values and conversely liquidate when the opposite is evident.
Fortunately for real estate investors, the movements of real estate prices are slower and more predictable than the stock market due to the slow response to promising or discouraging economic movement. The real estate cycle displays different characteristics based on whether the property is a free-standing house, a high density unit or a commercial property. Property values in office buildings are generally more susceptible to swings in a cycle than industrial buildings, retail buildings, apartment buildings and residential.
Demand drives each of these sectors. In the case of office buildings, the demand for office space is tied in directly to employment and the financial sector. Demand for industrial space is powered by manufacturing, transportation and the need for warehouse space. Demand for retail space and apartment units is stimulated by population and growth of income.
All cycles are local
The real estate cycle can vary significantly from city to city and even down to suburb, compared to aggregate national statistics. A local real estate cycle can react differently based on economic demand for housing and can have longer or shorter peaks or troughs than the national cycle and nationally reported statistics.
It is important to understand the local real estate cycle wherever you decide to invest in order to make decisions that will be profitable. Being able to predict what will be happening in your local market based on specific key indicators will allow you to analyze expected returns, forecast property income and potential value increases or decreases. This can also aid in buy or sell triggers in your portfolio based on over or undersupply in the market.
Stages of the real estate cycle
There are typically four stages to each real estate cycle. In order to properly analyse, you need local data describing historic appreciation or depreciation which ultimately boils down to supply and demand. For instance, demand for office space increases as a result of higher employment which in turn stimulates retail and residential demand. Conversely, demand for office space decreases as the value of market rents goes up. This factor spills over to retail and residential.
One must be aware of other indicators that are prevalent in each of the four stages of “top”, “down”, “bottom” and “up” of the cycle, specifically pertaining to residential properties.
Top of the Market
Many Australian metropolitan cities today have been touted as being at the bottom of their market whereas others are on their way back up, some are booming and yet others remain stagnant. Historically cycles last from seven to 10 years, which allows us to learn from the past and better prepare for what and when our next move should be.
There are key indicators that are indicative of any real estate cycle. At the top of a market, prices are high. This sounds like an obvious statement, but what contributes to factors driving prices up?
Typically when there is high demand, the price goes up. This is usually triggered by employment opportunities, an enticing lifestyle or a retirement destination.
To properly analyse a residential market, you need to know the if the number of sales are increasing month to month, the number of days on the market it takes for a property to sell, if multiple offers on properties are becoming common – this drives property prices up even higher.
Other indicators can be observed just by driving around observing the construction industry. If stock is low and demand is high, people are generally very optimistic. Vacancy rates will be lower so there will be less “For Rent” signs evident.
- If you can raise your rents, now is definitely the time. Renew leases. With low vacancy and high migration to the area, there is high demand for properties. However, if interest rates are low, renters may be jumping into new homes.
- Once over-building is evident, you may consider liquidating one or more of your properties, particularly any under performing properties, which may sell for a great price.
- Buy-reno-sell strategies can work well at the beginning of this phase provided the property is acquired under fair market value.
- You may consider selling later in this cycle.
A Down Market
A downward trending market happens after the top of a cycle. This move can be subtle at first. Many inexperienced investors can “get caught” during this shift, resulting in potential losses.
This can result from maintaining a selling price higher than the market will bear rather than anticipating the downward trend and unloading the property with good pricing or speculating in pre-construction.
A downward trending market occurs when new construction exceeds demand and/or prices hit maximum affordability. Once this happens, prices begin leveling off, demand slows down, and public optimism becomes uncertain.
When a market has too much inventory, sales decrease, ultimately triggering the amount of listings to increase. This causes the average “days on the market” (DOM) of each property to increase, naturally triggering a downward pressure in prices. The market ultimately dictates when the decline will stop and what prices are reasonable. Vacancy rates begin increasing as tenants have more choice of units and landlords begin offering discounted rents or move in specials.
- If you missed selling at the top of the market, sell fast and don’t hold out for top dollar.
- You may need to decrease rents or offer incentives to attract or keep tenants.
- Many landlords will have higher vacancies and may be highly negotiable on price (wait until later in the cycle).
- If you don’t sell now, hold your existing properties until the market corrects.
At the bottom of a market, general public perception of the economic outlook is negative. Higher unemployment prevails and the banks’ lending criteria becomes more stringent. Prices tend to decline and it is not until prices ultimately begin to increase and vacancies begin to decrease that you will know where the bottom is (or was). Foreclosures or power of sales become more frequent and economic pessimism prevails as demand continues to slow.
New construction during this time drops. However, new builds already underway still come on line. Many contractors either become renovators or get out of the business.
- Take buying slowly but start buying distressed properties later in the cycle.
- Holding and waiting for the “up market” indicators if you are looking to ultimately sell.
- Provide furnished rentals to keep your unit rents up.
- Approach builders who have unsold inventory and purchase one, several or all of their unsold inventory at a discount or with a purchase option.
The Up Market
During this time falling housing prices have bottomed out and are stabilising and demand is slow. New inventory is down as new construction is almost at a standstill. However, as the cycle continues and demand becomes more evident, new construction begins as does pre- construction speculation.
In an “up” market prices will begin to increase based on stimulation of the local economy, thus increasing demand. With less property available, there are less listings, the days on market decrease and multiple offers on property become prevalent. From a rental perspective, this creates a diminishing supply of units, which triggers lower vacancy and higher rents.
- Buy for bargain prices from other investors who still haven’t realised a new cycle has begun.
- Increase rents.
- Buy, reno and sell.
- Refinance existing properties to buy more.
- Sell if you can move the equity into a more valuable property.
The public is usually driven by the media who are usually trailing the middle or even the end of a wave. This gives those who are studying the key market indicators a distinct advantage. However, acting when no one else has acted takes knowledge, courage and sometimes trusting your gut.