The Four Real Estate Market Cycles

In order to make profitable investments, it’s vital for investors to understand the four real estate market cycles because they directly affect the price of the properties you may want to consider, or the properties you currently own.

If you missed last week’s episode, be sure to listen to The Wealth Creation Formula.

Enjoy the show!

– – – – – – – – – – – – – –

Download your FREE copy of: The Ultimate Guide to Passive Real Estate Investing.

Get your FREE coffee mug by leaving us a Rating and Review on iTunes. Here’s how.

See our available Turnkey Cash-Flow Rental Properties.

Please give us a RATING & REVIEW (Thank you!)

SUBSCRIBE on iTunes | Stitcher | Podcast Feed

[spp-player]

Today, we’re going to talk a little bit about market cycles. In order to make a profitable investment, it’s vital that you understand the cycles of the real estate market because they actually affect the value of the properties that you want to consider or the properties that you own. Let’s be clear right from the beginning, I am not suggesting or implying that you focus on appreciation or potential appreciation in lieu of cashflow. For me, cashflow is still the number one priority, it’s at the top of the list. It is the most important factor that I look at. I look at cashflow in terms of dollars, but I also look at cashflow in terms of what’s my cash-on-cash return? That’s how I judge a good performing asset.

In terms of market cycles, the first thing to understand is just as the weather has four seasons, so does the real estate market. It has four general cycles. An upmarket, a peak market, a down market and a bottom market. In other words, just as temperatures fluctuate during spring, summer, fall and winter, so do property prices in residential real estate. They go up and down in their cycles. However, unlike weather seasons, market cycles tend to last longer at approximately seven to ten years. That’s an entire cycle from beginning to end. Keep in mind that these cycles are normal functions of dynamic markets. They’re affected by factors within those markets. For now, let’s take a closer look at these four general markets and what goes on in each of them. We’re going to consider a little bit more of a technical definition later, but let’s just talk about this in general terms.

PREI 55 | Market Cycles — Market Cycles: When you’re in a rising market, it’s exciting because the tide floats all ships.

First and foremost is our favorite, an upmarket. This occurs when home prices are rising. It’s also called a “sellers’ market.” I’m sure you’ve heard that term before. It’s called the sellers’ market because sellers can pretty much get the price that they want when they want it and there are so many people who are buying properties at these higher prices that it continues to push the price up. In essence, demand exceeds the supply. What are the signs of an upmarket? Prices are appreciating, that’s obvious. But inventory levels are low or that trend is dropping. You’ll see inventory start to dry up. Tied in with that is you’ll see a shorter number of days on market. This is referred to as the DOM, days on market. You will see that properties don’t sit on the MLS or on a street for very long before it goes into a pending and sold status. There are multiple offers on properties. Often, you will see people bidding against the same property. That just further drives prices up. There is optimism and excitement or a buzz among people and within that market. You can tell that there’s some sort of euphoria going on. This is what sometimes leads to that irrational exuberance as the book talks about. Investors feel good about investing. There’s that general feeling of, “This is the right thing to do and the right place to be.” When you’re in a rising market, it’s exciting because the tide floats all ships.

After a few years of an upmarket, what we find is we reach a peak market. As the name indicates, this is when prices have basically reached their maximum point. It’s also known as a bubble market. The reason is because prices can’t go any higher. Once that so called bubble bursts, it sends the market down into its next cycle. This is not an overnight phenomenon, but when you reach a peak, what tends to happen is you reach a plateau and prices tend to stagnate for a while. Often, what happens is you start to see that demand dry up. That’s the sign where you’re going to transition from a peak to a downcycle.

In a peak market, the signs that you typically see are demand and supply are going to be in balance. This is what we call equilibrium. Prices are/or have leveled off. Again, you have a plateau. There is still euphoria in the market and amongst people, but this has reached a point of irrational exuberance in the marketplace. Offers on properties are starting to flatten and decline so we don’t see that multiple offer situation. The days on market in time is now increasing. We’re now starting to see properties sit on the market for longer and longer periods of time. Inventory levels start to increase. Investors feel the market will keep on going so this is the problem is that investors feel that the markets keep going on forever. This is the problem that we’ve seen back in 2007, late 2006 and into 2008. In fact, if you haven’t seen that movie, The Big Short, I highly recommend it. It’s one of my favorite movies. I’ve watched it several times. I bought the DVD. It really gives you a good understanding of what happened in a real bubble situation back in 2007.

In terms of a peak market, it’s the point of maximum financial risk. I’m talking about risk in terms of price volatility. When you have a property that has peaked in price and now the likelihood of that property’s price coming down is at its peak, that may not affect you as a long term real estate investor. Keep in mind that if you’ve purchased a property and it’s cashflowing and generating a good rate of return and it’s gone up in value and you happen to be in a market where that cycle is now turning around and you expect to see property values decline, it doesn’t mean you should sell that property. It’s probably still worth holding on to because again, number one, your time horizon is long term. If you’re a long-term buy and hold investor and you’re getting cashflow and a good rate of return from that property, it probably makes sense to keep it. Don’t be in a rush to be selling those properties. Again, this is something you need to pencil out, the math will help determine what you need to do.

If you got a situation where you’ve got lots of equity in a potential bubble market, talk to one of our investment counselors, we can help give you some guidance as to whether it makes more sense to do a tax-free exchange out of that market and into other safer markets where you protect your equity, but also maintain that cashflow and that rate of return or potentially increase your cashflow and rate of return. A peak market is basically speaking, the point of maximum financial risk in terms of property crisis.

The third market cycle is what we call a downmarket. This is when property prices start to drop. Then you have what is referred to as a buyers’ market. In a nutshell, sellers are now outnumbering buyers. Demand is drying up and this leads to supply in excess of demand. This creates a downward pressure on prices. While buyers can find some great deals, you can still find great deals, sellers have to accept less money for the properties than they might like. The characteristics of a downmarket are these: the offers on properties are starting to decline and sometimes rapidly, especially if you’re in a cyclical market as we’ve talked about in a previous episode. If you haven’t listened to that episode, go back to that episode about linear and cyclical markets. Prices decline due to the lack of demand. Now, there is anxiety, denial, fear, desperation and sometimes even panic. All emotions come into play when you are in a downmarket. It’s clear. You see it all around you. There’s no question about it.

The days on market tend to lengthen considerably. Inventory levels increase substantially. Many investors get caught using the wrong strategy in this market. This is not a market where you want to necessarily be finding a fix and flip type of property. If you’re a flipper, you want to be in a market that’s appreciating ideally or flat where it’s just continually flat. Like a market like Memphis, in general terms, where you don’t see much in terms of price change from year-to-year. You always have to understand the big picture and look at what market you’re in.

Then the last of the four cycles is the bottom market. This is when housing prices hit that rock bottom and they can’t plunge down anymore. You’ve basically hit the bottom and you’re flat lining for a while.

We’ve seen this in 2012 in many markets around the United States. At this point, again, you have equilibrium. You have an equal number of buyers and sellers in the market and supply and demand are back in balance. This situation starts the cycle all over again. Prices will start to rise again. It might not happen right away, you could be in a bottom market for a few years before you see any change. The characteristics of a bottom market are that offers on properties are fairly sparse, prices have reached a low point and they will eventually flatten if they haven’t flattened already. The days on market are near its high point. Capitulation, despondency and depression occur. You’ve reached the bottom point. Prices have gone as low as they can possibly go and things are just dragging along until something, some driver pushes that market back up. Bottoms usually last a few years. It could be one year, it could be three years, but you tend to see a one to three year lag.

In some markets, you see a bottom for a long, long time. I hate to pick on Detroit, but Detroit has been one of those markets where there have been too many drivers keeping that market down and nothing coming in to drive demand and prices back up. You’re actually in a bottom market for a long time. This is the point of maximum financial opportunity. Keep something in mind, I’m not suggesting that you find a market that is flat lined at a bottom just because it has the maximum potential for upside growth in prices. What I’m saying is that you get the best prices, but not necessarily the best opportunities. I personally think the best place to be buying is a market that has come off the bottom and is trending upward. In other words, in an upmarket, the early phases of an upmarket. Again, if the numbers make sense, if you can get that 1% rent to value ratio, it doesn’t matter all that much where you are in that upcycle because you can get yourself a good deal and you could be in a good market, and it’ll work out for you in the medium term and the long term.

Be aware of these prolonged flat bottom phases. This is a situation where markets don’t recover and they remain depressed for a period of time. Many of the rust belt states, the northeast US have found themselves in a prolonged bottom phase for many years. A lot of those markets have started to turn around. I’m talking about the cities and micro markets. However, bear in mind that money can still be majoring any phase if you’d use the right strategy.

A more technical look at these cycles is what economists and real estate professionals and others use to describe market movements. What we’ve talked about are layman’s terms. If you want to look at this from a slightly different angle, we can refer to these as the expansion phase. This is the phase where real estate professional like builders, contractors and the public observe that economic conditions are favorable for new construction. Therefore, building permit activity increases, which leads to more demand for construction and construction workers and contractors in that industry. Also, the general population feels pretty good about the direction of the economy and goes out to spend on discretionary items including housing. This creates again, that sellers’ market, as I mentioned earlier. The available inventory is now being absorbed and it creates higher demand for residential properties. Several buyers may end up bidding for a particular property. Again, that generates higher list prices and therefore, higher sales prices and it pushes property prices up. That’s the expansion phase. That’s usually that euphoric phase where things are growing.

There’s an equilibrium phase. In this phase, growth is no longer explosive in the market. I say explosive in loose terms here. I’m talking about growth. Economic indicators point towards factors such as sales price, construction starts, migration movements, appreciation and many other things. You start to hear this in the media about growth being there, but not necessarily explosive, but things are all pointing in a positive direction. This is also the phase when the market tends to peak. Although it’s still a sellers’ market, demand has begun to wane and owners may need to adopt more aggressive strategies in terms of pricing and deal making in order to get their properties sold. That’s that transition point. We’ve gone from expansion to equilibrium.

What happens after an equilibrium phase? Now, we get to the decline phase. In this phase, inventory levels and the days on market are at their highest point, plus due to poorer economic conditions, employment will fall, there will be fewer new construction jobs and new construction homes. There will be an increase in foreclosure rates, short sales, deed in lieu of foreclosure and so forth. This phase results in further reduction in property values. It’s definitely a buyers’ market when you’re in the decline phase. The decline phase becomes a boom for rental units since homeowners may lose their homes. Not that that’s a good thing, it’s an unfortunate thing, but they tend to now search for rental housing, which you as an investor and a landlord are in a good position to be there. That’s what we’ve seen happen over the last ten years or so. From 2008, we’ve seen in drop from about 69% to about 63%. That’s a huge difference because a drop of 1% means that there are one million more rental units required in the rental pool. Some home buyers may become leery of purchasing a property because they’re not sure what the market will do or when will it hit bottom.

Last but not the least, the absorption phase. In this phase, economic conditions show signs of improvement because of local, state and national initiatives and other driving factors. This motivates the restoration of confidence in builders and developers and the general public. Now, they’re coming back in because they see that there is demand for new homes, new housing. When employers start hiring again, unemployment drops and that over supply of properties begins to get absorbed. This is still a buyers’ market before the cycle starts all over again.

Let’s look at a few subtleties within these cycles. There are really two. One is a linear market. That occurs when there’s a slow and steady appreciation in a market, a local market over time. Again, I’ve talked about all these in a previous episode in great detail so I suggest going back, but this is just a quick summary.

A linear market, the cycle size is smaller. It tends to be smaller. There’s single-digit average appreciation. In other words, the booms and busts seldom happen and local changes may push prices slightly up or down, but there’s no drama involved in terms of fluctuations in price. This is a key thing because most of the properties that we offer our clients on our website and through our network are in linear markets. The bulk of them tend to be in linear markets or hybrid type of market. The reason for that is these are very predictable, easy to invest in markets. They may be boring to some degree in terms of market and price changes, but at the end of the day, you know what the market has done? You have a good prediction of what it will do. You can sleep well at night and you know that in general terms, these markets will keep pace with inflation. That’s really what you wanted to do. Because the second type of market is a cyclical market.

Unlike a linear market, the cyclical markets have larger fluctuations in price. Appreciation can vary from single to double digits. This market may involve a boom and a bust cycle and often, it does. You really don’t like to be in a market that tops out and becomes a bust market. This is why a lot of smart investors from California, New York, New Jersey, Hawaii, these pricey markets, recognize these and sell their properties using a 1031 exchange to pull their equity out tax-free and move it into other markets where they preserve that equity, but build up a larger portfolio and/or increase their cashflow and their cash-on-cash return or their overall rate of return. Think about that if you have a lot of equities sitting in the cyclical markets.

In these hot markets, property values can increase by as much as 20% to 30% at the peak of the boom. I’ve seen this happen in many markets in California, in southwest Florida. I remember Cape Coral, Florida one year appreciated 32% year-over-year. It was unbelievable. We’re seeing that happen again in some markets. Of course, the boom fizzles out eventually when prices reach unaffordable levels. That’s when the bust occurs, dropping prices dramatically.

Now, you have a basic understanding and background of market cycles. What I suggest is look at the portfolio you have, consider what you own and where it is and what phase you might be in, in terms of what you own. If you’re looking to invest, consider the markets that you’re looking at and consider where those markets may be going and where they’re at today so you know what might be the best market for you to invest in as a real estate investor.

I hope this has been helpful. By all means, if you have any questions, contact one of our investment counselors. If you have a question you like me to cover on the show, just click the Ask Marco button on the PassiveRealEstateInvesting.com website. I’ll be happy to reply to your email.

Thanks to everyone for all the great reviews recently. If you enjoy the content of this show and you find value in it, please share it with your friends. By all means, leave us a rating or review iTunes. That’s the best way for us to share it with more people.

Thank you for listening. We will see you on our next episode.