How to Play Market Cycles

If you are ever going to make it in the real estate investment world, you need to understand:

(1) How Market Cycles work, and

(2) How to operate within each phase

How Market Cycles Work 

There are four phases to the real estate cycle:

- Phase 1: Recovery

- Phase 2: Expansion

- Phase 3: Hyper Supply

- Phase 4: Recession

The Market Cycle applies to all real estate forms (multifamily, industrial, SFH, etc). Each phase has defining characteristics evaluated by what is happening in the market. We define “Market” many ways, but real estate is ultimately a localized asset class - so consider your use of market for a specific MSA (though I reference each phase in respect to the total market).

Recovery Phase: Identifying Early Opportunities

Real Estate Economist call this the "Perfect Investment Period"

Why?

- Values are down

- Interest rates are declining

- lack of competition

The early recovery stage experiences low demand and leasing activity, stagnant rental rates, and a lack of new construction. It's a period that feels close to a recession, making it hard to recognize but ripe for strategic investment.

Strategies

Opportunistic: Target distressed properties at low prices for renovation and resale. The goal is to improve these assets and sell them during the upcoming expansion phase, usually within a 2-5-year timeframe.

Value-add: This requires a cautious approach. While acquiring assets at a good price point is possible, investors need to plan for a gradual improvement in market conditions, with significant gains not realized until the expansion phase.

Core: Focus on acquiring high-quality assets in prime locations that are likely to see rental growth as the market recovers. These assets should have the potential for high occupancy and rental rate increases over the next few years.

Expansion Phase: Maximizing Growth

Marked by increasing demand and rents, this phase benefits from economic growth and job creation. New construction starts to pick up, especially in tight markets where rents can surge.

Strategies

Development: The robust demand makes this an ideal time for developing or redeveloping properties, which are likely to stabilize quickly at high rental rates.

Core-Plus: Lower-risk investments in properties with high tenant retention become attractive, as continued rent growth is expected.

Value-add: Investors can rapidly reposition properties to take advantage of the strong market absorption, aiming for a quick transition to stabilized value.

Opportunistic: Although rarer, finding distressed assets that can be quickly turned around is still possible, with a focus on short-term gains.

Hypersupply Phase: Preparing for a Shift

An imbalance occurs as the supply begins to outpace demand, leading to rising vacancies and decelerating rent growth. This phase usually overlaps with macroeconomy inflation - not just real estate. When your dentist starts giving you investment advice, start to look around…

Strategies

Core: Investors may choose to sell to avoid potential declines in value or seek stable, high-occupancy assets that can endure the downturn, banking on their long-term leases with credit tenants.

Opportunistic: With owners potentially looking to offload assets at reduced prices, investors can acquire solid properties at a discount, anticipating a recovery in the next cycle.

Some groups will switch from equity placements to lending/preferred equity as it presents greater downside protection.

Recession Phase: Capturing Distressed Opportunities

The market sees higher vacancies and minimal or negative rent growth. It's a challenging time with increased leasing incentives and tenant-related challenges (job loss). Credit tightens making transactions difficult. Equity is less available.

Strategies

Opportunistic: It's an optimal period for buying distressed assets at deep discounts. Strategies focus on long-term improvement and positioning for sale when the market enters the recovery phase, capitalizing on lower competition for acquisitions.

A word to the wise: It is of the utmost importance for you to focus on business plan execution and basis at any point of the cycle. But everything starts to become more challenging in the latter 2 stages. The value-add renovation plans do not achieve the same premiums. Equity is harder to raise. Debt can be more expensive. There will be challenges with your residents, especially in B and C-class properties. You could very well be purchasing into a falling-knife situation.

You must be LAZER-FOCUSSED on buying the right price and have cash set aside for downside risk. Right now, that means using sales comps from 5-10 years ago, not 2022. Do not fool yourself from behind the desk.

Being able to identify what phase the market cycle will define your opportunities, risks, appropriate returns, and strategies to execute.

Here is a look at Mueller’s 1Q24 Market Cycle Report:

This is lagged data (which is why the chart is a forecast). I am seeing the market live. We talked last time about where we were:

- Values down from peak

- Vacancies rising

- Deals harder to get done (equity tough to raise)

- Supply is just starting to take effect. Wait 12 months.

- Cap rates remain tight (~5%) due to high competition

Fundamentally, it’s clear we are somewhere in the valley of recession (minus the continued capital demand). Where? I’m not entirely sure but my eyes are glued to employment numbers. Remember, we cut rates and 6 months later Bear-Stearns collapsed. It’s all lagged.

There is still liquidity in the system. The biggest factor is the amount of competition and capital readily available for deals. Dollars were raised and now need to be deployed (which is holding valuations up).

Looking back, it will all look obvious...

But it is a confusing time.

Would love to hear from you and how you plan on attacking the market.

Blessings,

M.F.Man