How the Real Estate Cycle Provides Reliable Information about Possible Investment Returns

Understanding when to buy and sell a home can be a nervous time for a lot of people and unfortunately it is often done based on what people hear from the media or the uninformed opinions of people who either do not invest themselves or do so poorly.  The first stop to making the right investment decision is to understand what phase a particular market is in the real estate cycle.

There have been many studies on real estate cycles done and as early 1870, Henry George discovered that real estate cycles move in predictable patterns.  The below chart by economist Edward R. Dewey shows the pattern from 1795.  Understanding this cycle is one way successful investors buy at the bottom and sell at the top of a cycle.

Dr. Glen Mueller defines four phases of the real estate cycle which provide a basis for decisions on whether it is time to invest and what type of investment to make. 

Phase 1 – Recovery

During the recovery phase we start to see initial growth happen after a recession.  This is the Springtime of real estate investment, the initial signs of growth are there, but it is too early for the beach attire as temperatures are beginning to rise. GDP increases, interest rates may start to increase, population will increase and consumer confidence begins to return.  As a result of increased economic activity, vacancy rates start to decline and prices start to slowly recover although an oversupply still exists until later in the cycle.  This is the point when successful investors identify specific areas of opportunity as the cycle times vary in different locations.  It is also a good time to purchase value add properties to be sold during the expansion period.  The end of this phase is when the local market reaches its long-term occupancy average and rental growth is equal to inflation. 

Phase 2 – Expansion

Summer has arrived!  As demand continues to increase and subsequently vacancy continues to decrease, new construction begins and demand for rental is high during this period of low unemployment rates and a strong economy.  In the initial part of the phase it is difficult to find space, and rents increase rapidly until rental prices increase to a point where new construction is feasible.  This can be a long period as it takes time to deliver new properties to the market.  The peak of this cycle is when demand and supply grow at the same rate known as equilibrium. 

During the upcycle of the first two phases demand grows faster than supply as we move to the down cycle the supply growth exceeds growth in demand.  The upcycle is when it is best to buy lower class properties for higher returns.

Phase 3 – Hyper Supply

As the naming suggests, this period is marked by the time where the supply of housing exceeds the demand, the down cycle.  It is a very difficult cycle to predict as the initial as vacancy rates are still much lower than their long term average.  Investors will start to see signs of this phase as properties will take longer to sell due to buyers having many options with the increased inventory. There will be indications that the economy is overheating with increased interest rates and inflation.  Eventually new construction stops and rental growth slows.  Investors look to balance their portfolios with long term lease properties before heading into a recession it is the fall time of the cycle and you know winter is coming. 

Phase 4 – Recession

A recession is defined by two successive quarters of negative GDP growth.  Unemployment increases, consumer spending lowers, and landlords compete for tenants with lower rents to move inventory. This cycle begins when the local market moves below its long-term occupancy average with high supply, and demand growth is either very low or negative created either by excess construction or decreased demand from a recession.  Although winter can seem dark and bleak, this phase would be the time to buy higher class assets that will appreciate the most in the upcycle.

It is impossible to predict the length of a phase in the real estate market and do not listen to anyone who tries to tell you otherwise.  It is best to do your own research and understand the market you are looking to invest in with great detail or team up with someone who is credible and does this research for you. 

Next week we will show you our analysis on the real estate cycle and where we choose to invest.

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