Life can only be understood backward; but it must be lived forwards.
All markets move cyclically, including commercial real estate markets. While the crash of 2008 (fueled in large part by a bloated real estate market) is the beginning of recorded history in the minds of some investors, the crash, recession, and ensuing recovery constitute only the most recent real estate cycle playing out. Though the gory details of the financial market collapse of 2008 were unique, the lead-up to the crash followed a cyclic pattern that has repeated several times in history.
This article takes a look at the real estate cycle: what they are, their ramifications, and how real estate investors should assess them.
These are the basic 4 phases of a real estate cycle:
- Recovery – Rock-bottom, when the economy at large is characterized by pessimism and austerity. In both residential and non-residential commercial real estate, occupancy tends to be low, with average rents either declining or stagnant. With little demand for new space, there is little construction activity. Think mid-2009 in the latest cycle.
- Expansion – this phase corresponds with the definition of economic expansion in the business cycle: GDP and job growth are positive, and demand emerges again for built space across sectors. In commercial real estate markets, occupancy and average rents grow, and new construction resumes. This phase is synonymous with “economic recovery”.
- Hyper Supply – At some point, supply will outrun demand generated during a recovery, as overbuilding and/or contractions in demand occur. In this phase of the real estate cycle, vacancies rise and rent growth slows or stops altogether.
- Recession – With a dampening of demand in the economy and a glut of supply (with mid-recovery construction hitting the market upon completion) vacancies rise, and rents often decline as landlords struggle to attract tenants.
These phases of economic boom and bust certainly dictate how much opportunity real estate developers and investors have. However, CRE investors are not powerless; shrewd investors incorporate the real estate cycle into their portfolio strategy, and are prepared as the market moves from one phase to the next.
Here is how experienced institutional investors tend to think about strategy relative to phases of the real estate cycle:
Strategies for Investing, by Phase of the Real Estate Cycle
Successful real estate investing during the recovery phase hinges on identifying opportunistic projects close to the trough of the cycle. These opportunities do not occur uniformly across markets and subasset classes: different markets will be impacted to varying degrees by sectoral forces in the economy and will recover at varying times and pace. Successful real estate investors will be able to identify pockets of opportunity as the recovery begins, and have the knowhow and capital to see through opportunistic investments that may take four years or longer to realize.
During this phase, it’s broadly understood that demand for built space is on the rise, and that there is opportunity for new construction. Development investments become much more feasible, provided that the time horizon for completion and sale and/or lease-up aligns with the expected duration of economic expansion. This is very difficult to predict, of course, but identifying development deals in more economically and demographically durable markets can help mitigate risk.
Value-add investment is often a strong play during this phase, as savvy investors can acquire properties at substantial discounts to replacement value, add value through capital improvements, better management and marketing, and raise rents considerably while capitalizing on increased rental demand.
Sophisticated investors may seek shelter from the coming storm at this phase. Core assets in gateway markets can provide a hedge against a likely recession, particularly if many tenants are locked into long-term leases. Multifamily assets in high-demand urban cores may provide safe harbor, as a diverse mix of tenants from a crowded tenant pool can help weather a short recession.
Certain alternative assets may also provide a solid hedge against an economic downturn. Self-storage tends to perform well, as tenants downsizing to smaller apartments or offices require space to house possessions. Student housing often thrives relative to core real estate asset classes, as student matriculation is unscathed – or in some cases even grows – during mild recessions. Certain multifamily assets also tend to provide relative downside protection. Mobile homes (or “manufactured housing communities” in modern parlance) can provide affordability relief for working families in lean times, as can well-situated workforce multifamily properties in suburbs and exurbs.
By any broad measure, real estate investment opportunities will be fewer during a recession. A prolonged downturn will provide an opportunity to acquire distressed assets at steep discounts to replacement value. As a passive investor in commercial real estate, perhaps the most important thing to look for during this phase is time-tested well-capitalized real estate firms to co-invest with; those who have survived and thrived during past recessions will likely do so again.
So what are the key takeaways for passive real estate investors? It’s important to note that, again, these phases do not play out uniformly across asset classes and markets. All else aside, your real estate portfolio will be better positioned to weather real estate cycles if it is diversified across markets, subasset classes, and term lengths. EQUITYMULTIPLE allows you to do so with relatively low minimums and a wide array of offerings.
Access to experienced sponsors to co-invest with is also key. Those who operate with a sensitivity to the real estate cycle will perform better over time. Through platforms like EQUITYMULTIPLE, you can evaluate the track records of sponsors, and access those who have operated through past cycles.
The bottom line: all real estate investments carry some degree of exogenous risk; a well-diversified portfolio is your best defense against the shifting tide of market cycles.