Investors are beginning to wonder

I often get asked these days, “Is this the right time to invest in real estate?”  It’s a legitimate question.  As capitalization rates have steadily declined and property values have rapidly increased this question becomes ever more important to answer.  Other insightful questions being asked are, “When will the real estate market turn?” Or another way of saying it, “Has the market peaked?”  All good questions.

Before we can answer these questions, we need to determine where we are on the real estate market cycle.  As you are probably aware, the real estate market cycle is cyclical with four distinct phases: Recovery, Expansion, Hyper-supply and Recession.  The chart below shows these four phases and how each phase impacts new construction and vacancy rates.

The Real Estate Market Cycle

Before I talk about the four phases of the real estate market cycle, let’s discuss the basics of the chart.  The X axis (horizontal line) represents time and the Y axis (vertical line) represents the occupancy rate.  The horizontal dotted line represents the long-term average occupancy for the market.  The vertical dotted line represents when supply and demand are perfectly in balance.  The black solid line that travels through all four quadrants represents the change in the occupancy rate over time.  Now that we’ve discussed the basics, let’s discuss the four quadrants.

Phase I – Recovery

This quadrant of the real estate market cycle, shown in the lower left hand corner of the chart, is characterized by high vacancy and no new construction.  Though it’s not shown on this graph, generally rents are flat or declining.  Rent concessions are common to avoid the occupancy rate from further declining.

The mood of investors in this quadrant begins with panic, “Oh my, am I going to survive?” (think 2009). Slowly investor attitude turns to one of relief, “Whew, I made it through the worst of the market” as the occupancy rate improves to the market’s long-term average occupancy rate.

Phase II – Expansion

This quadrant, shown in the upper left hand corner of the chart, is characterized by declining vacancy and the start of new construction.  As occupancy improves, concessions are eliminated and rent growth begins.

The mood of investors turns from relief, “I dodged a bullet” to giddiness as vacancy rates decline and rents increase dramatically.  Life is very, very good at this point in the real estate cycle for investors.

Phase III – Hyper-Supply

This quadrant, shown in the upper right hand corner of the chart, is characterized by more new construction and for the first time in a long time vacancy rates begin to rise.  Rent growth, though still positive, is growing at a slower pace.  And some neighborhoods are beginning to experience rent concessions as new product that has recently come on line is becoming increasingly more difficult to lease up.

The investor mood turns from giddiness to one of caution and then denial that there is a problem brewing.  The “glass half full” type of investors are still confident everything is going to work out just fine.  They rationalize the slow rent up as only a bump in the road which will self-correct itself as long as they don’t panic.

Phase IV – Recession

This quadrant, shown in the lower right hand corner of the chart, is characterized by more and more product being completed resulting in a substantial decline in occupancy rates.  Newly completed product are sitting there unoccupied so developers begin running blue light specials to get them rented up.  Concessions are abundant and established properties to avoid wholesale move outs are forced to offer concessions too.

Investor mood goes from denial, early on in this phase, to one of outright panic.  Developers begin to wonder, “Am I going to make it?” and some will not.  Also some investors who recently bought properties at premium prices and then loaded them with lots of debt realize their mistake as well.  Because they are leveraged to the hilt, a small drop in vacancy results in properties that no longer cash flow.

Those are the four phases of the real estate market cycle.  Understanding where the real estate market is on the cycle is critical to successful investing.  Is the market climbing closer to a market peak or is it starting down the slippery slope to recession?  How we answer this question will in large part determine the difference between a successful investment or an albatross hanging around our necks.

So where are we today?  The 3 indicators

I believe the evidence suggests that we are at the beginning of Phase III, the Hyper-Supply Phase.  Why?

  1. After double digit rent increases the past couple of years, rents are beginning to level off. Rents are still going up but much more modestly.
  2. Construction in the Portland market is at an all time high. The Oregonian in a front page article a couple of weeks ago indicated there was $2.5 billion worth of new development under construction.  This was the single largest amount of construction in the Portland area ever, easily eclipsing the previous high of $1.9 billion set the year before.
  3. For the first time in a long time, concessions are being offered on new product.

These three are factors all classic indicators that the market is in Phase III, the Hyper-Supply Phase.  So for the moment, let’s assume that the real estate market is in fact in this quadrant of the real estate market cycle.  Does this mean that investors should stop buying real estate right now?  Heck no and here’s why.

Be cautious, but continue investing

If you have inside information about a property that is for sale that the seller is not privy to, or you have a vision for how to turn a property from a “loser” to a “winner” it makes little difference what phase of the market cycle we are currently in.  Even so, it’s still important to understand that some phases of the real estate cycle are more difficult for profitable investing than others.  If we truly are in the beginning of the downward real estate market cycle then proceed with caution.  Don’t be one of the Pollyanna investors who throws caution to the wind.  Be prudent.  Be alert for sudden changes to the market.  If you do, you’ll increase your chances for success.

So what phase do you believe the real estate market is in?  I’d like to hear from you.  Please give me your thoughts.

Sources: Real Estate Cycles, Glenn R. Mueller, Ph.D., Professor Daniels College of Business, University of Denver; 21 cranes, 15 hotels, 10,000 jobs: Inside Oregon’s development spree, Jeff Manning and Anna Marum, The Oregonian, July 17, 20017.