Investment And The Four Cycles

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December 2, 2012 by Jeff Lowen

Let me share something with you. Currently, there are over 2,400 “distressed” properties either with a pending offer or fully available for purchase in the Northern Virginia area! These properties are short sales and bank owned/REO/foreclosures. Now, with a large part of the region (Over 10% of the total available properties) falling into this category, what many are doing is somewhat of a revitalization of the community. These properties offer some excellent opportunities to obtain rentals – income producing rentals. However, it’s important to know where we are and in what cycle the market is in. Real estate is and has traditionally gone through cycles. Four of them to be precise. Two represent appreciating markets and two represent declining markets. The two appreciating market cycles are called Recovery
and Expansion. The two declining market cycles are called Hypersupply and Recession. The main characteristics driving market cycles are vacancy rates, new construction, employment growth and rental rate growth. Let’s take a closer look at all 4 market cycles and how each of these areas changes with the market cycle.

Recovery: The Recovery market cycle starts at the point that most people call the “bottoming of the market.” It’s the moment when the market stops declining and slowly starts to level off or grow slightly again. During a recovery you will see vacancy rates stabilize and actually start to decrease a little. One of the main reasons for the drop in vacancy rates is due to very low or virtually no new construction. During most recoveries there is very little new supply coming on the market and current property
occupancy rates start to stabilize. There is usually low employment growth, but the decrease in jobs has ended. During a recovery you will see very low rental rate growth and it may even go down a little. The good thing about this market is that it signals the end of a declining market. This is a great time to buy properties for cash flow. If they cash flow now, when the market really improves you can see major jumps in rental rates, occupancy, and value. We feel most of the US is in this market phase right now.

Expansion: The next market cycle is called Expansion. Expansion is a very exciting market cycle because it’s where the economy starts to get rolling again. During expansion you will start to see vacancy rates decreasing. You’ll start to see a little new construction at first and a great deal more toward the end of the cycle. Absorption rates pick up as more people go back to work or upgrade jobs. Job growth picks up as well as income. This leads to moderate to high growth rates in rents. Property values start increasing until the end of the cycle where they hit the peak. You want to buy at the beginning or middle of this cycle and look to sell toward the end before the market starts declining again. Property values hit their peak at the end of this cycle and then will start to decline again. The US experienced a lot of this in 2006 and 2007 when property values hit their peak. Those who sold during those years made a killing while those who bought at the peak and overpaid will take years for their properties to get back to the value they bought them at.

Hypersupply: The market cycle following Expansion is called Hypersupply. Hypersupply happens when the market gets oversupplied during expansion and job growth slows down. Due to the amount of new construction, the supply now outweighs demand. You start to see vacancy rates increase again. There is still new construction happening, but absorption of new homes and apartment units starts to really slow down. Employment also starts to slow down as companies have already done their major expansions. Rental rates may still be growing, but they are definitely starting to grow at much lower rates or stop all together. You don’t want to buy during Hypersupply unless you buy for major cash flow that can withstand prices going down and weathering the storm that follows next. You need to be very cautious and sell marginal properties before the market starts to decline more rapidly.

Recession: Recession is the last stage of the market cycle. Most of the US and the world has experienced recession over the last 4-5 years. During a recession, vacancy rates increase as jobs decline, as well as income. New construction slows to a halt. Fewer apartments or houses are absorbed. You’ll also see low to negative growth in employment as salaries level off or companies
even have layoffs. The economy slows down and you’ll start to see many more specials offered, or rental rates will actually go down, as there are fewer people willing to pay as much for units. During a recession you want to focus on buying quality properties that provide strong cash flow. While your value will probably not increase anytime soon, you can still find properties that will provide a strong cash flow again.

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