After viewing the graph above, ask yourself these questions: "When the market is down (Recession Phase) what is the only direction it can go?" and "When the market is up (Expansion Phase) what is the only direction it can go?”Some commercial real estate investors are able to consistently earn big profits due to the fluctuations common to the industry. Who are they and how do they do it? They are contrarian investors, who know when to buy and when to sell by identifying and understanding the phases of real estate market cycles. It also helps to have nerves of steel.
Like any business, real estate is subject to certain market forces that affect values. The life-blood of commercial real estate is affordable financing for the acquisition, development, redevelopment and refinancing of improved properties. The availability of financing is determined by the overall economy, overbuilding, interest rates, market perception (right or wrong), unemployment and, of course, local product supply and demand. Real estate prices can fluctuate wildly as these factors exert their influence. Historically, real estate cycles typically have an average duration of six to nine years. There are four distinct phases to a commercial real estate cycle including Recession, Recovery, Expansion and Contraction.
Recession. The Recession Phase follows a market contraction, when the availability of financing has dried up and property values have fallen. Properties experience vacancies and owners cannot sell or refinance as financing has become unavailable. Prices fall far below the cost to construct the same facility new (the cycle’s benchmark), resulting in many good buying opportunities for those with the liquidity to take advantage of market weakness. Foreclosures increase and property owners become even more motivated to sell as investors sit on the sidelines. The longer the Recession Phase drags on, the lower prices usually go. This is the time to buy.
Expansion. The real estate market is humming along and equity investors are plentiful.
Institutional financing is readily available and the price of improved real estate moves up well over the cost to construct the same facility new. Vacancies are at their lowest, prices are at their peak, and there is a general feeling of well-being, prosperity and abundance. This is the time to sell.
Contraction. It is during the Contraction Phase that reality sets in. The market has become overbuilt and vacancies are on the rise. Financing and equity investment withdraw from the marketplace as delinquency rates rise. Prices begin to fall from the peaks of the expansion phase. Investors rush to exit the market, causing prices to fall with increasing speed.
Recovery. In this phase, excesses have been wrung from the market and prices begin to recover, although most investors are still afraid to make a move. New tenants enter the market and property owners refinance as affordable institutional money becomes available. Prices begin to move up. This is the time for owners to improve their property, maximize rental rates and wait for the next phase.
The phases of a real estate cycle, as seen in the graph, are always in the same order, the only differences being the duration of a phase and longevity of a cycle. By determining the current phase and locating it on the graph we can logically anticipate where we're headed, taking a great deal of the guesswork out of the equation.
To the real estate investor the most important question is, "When do I buy and when do I sell?" This is the point where we find out if we are contrarian investors or just one of the herd. While the market is still in the Recession Phase the stage is set to reap the biggest profits later on, at or near the top of the Expansion Phase. Recognizing market trends will give us the confidence to move forward at a time when others in the marketplace are frozen with fear.
1 comment:
I loved this article. It really helped me understand the current market conditions and made me feel comfortable staying in the real estate market.
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