Commercial real estate is a cyclical market. The real estate cycle is divided into four phases: recovery, expansion, hyper-supply, and recession. One of the unique aspects of real estate is that people can make successful investments through the four phases of the cycle but understanding if a cycle is approaching the top of the market or embarking on the slippery slope to a low market can often mean the difference between a successful investment and a meaningful loss. In this chapter, we describe the four phases of the housing market and provide strategies for successful investments at every step.
Like the rest of the economy, commercial real estate is a cyclical marketplace. The building cycle is divided into several phases. The four phases move according to a continuous waveform scheme which looks like this:
As described above is a one-time round. The end of the recession phase is related to the start of the recovery phase to form the continuous wave. One of the unique aspects of commercial real estate is that investors can make successful investments throughout the four phases of the cycle. However, understanding if a cycle is approaching a market peak or entering a slippery slope to a market through may impact a variety of factors, including:
· Linking the investment strategy to the phase.
· Periods of detention and exit policies.
· Return expectations
· Performance as it relates to income and the appreciation
· Timing of capital improvements
This chapter describes each of the four phases and highlights some investment strategies that are appropriate for each phase.
Stage One: Recovery
The recuperation phase is the bottom of the hollow. Housing is probably at or near its lowest point, with space demand and minimum rental speed. There is usually no new construction going on and lease rate growth is either always negative to stable or, later in the phase, perhaps occurs, but at levels that are lower than the inflation rate. It is difficult to identify the beginning of the recovery phase because the market always feels like a recession.
If you move at an early stage, there are still opportunities to purchase deadweight properties in various states of distress and start repositioning these assets as the recovery phase takes shape. Wait times are usually two to four years with a business plan which envisages removing the acquisition in question from its present state of distress and liquidating it during the expansion phase once the asset reaches a more value-added base profile.
Value-added strategies during a recovery period require careful consideration and patience. For example, although pricing can offer an excellent foundation for a value-added asset at the beginning or middle of the recovery phase, the business plan should include implementation contingencies, given that a strong lease may not take place before the first part of the expansion phase.
Investing in basic real property during recovery can be a very cost-effective strategy especially if the subject asset is subject to a significant lease carry forward for the next two to four years. A standard strategy for a base asset in a recovery stage will be to acquire a trophy asset in a "principal and principal" location and then capitalize on the strong rental growth of the next cycle by a combination of lease renewals and residual vacation leases from the preceding phase of recession. In this case, the asset is mainly positioned to be refinanced or sold during the expansion phase.
Stage Two: Expansion
During the expansion stage, the market is booming in terms of increasing demand for space. From a macroeconomic standpoint, GDP growth has returned to normal levels and quarterly employment growth is strong. Occupancy rates have improved, and rents have increased.
Rents are now approaching levels that can justify new construction, and in some very tight markets, they are rising at a dizzying rate. Development activity starts to come back through the expansion phase. There is also a culmination during the growth phase – the peak of the wave – where there is a balance between supply and demand.
It's the perfect time to develop or refurbish properties because the current demand for space and rentals helps properties stabilize faster on delivery at rental rates that can set new heights in the market.
Investors seeking lower levels of risk can purchase Core-Plus properties knowing they will benefit from high tenant retention rates with continued rental growth.
The expansion phase is a peak listening period for value-added investments. Savvy investors may acquire properties that currently lack substantial rebates to stabilize values by investing in capital spending and repositioning assets quickly through the high uptake inherent in the expansion phases of the cycle. Once repositioned, the asset can now order a fully stabilized value, which can lead to a refinance or sale.
Although most opportunities for opportunism disappeared during the expansion phase, it may still be possible to find the exceptional situation in which a private asset remains in a state of distress. In this case, an opportunist strategy during an expansion phase can be very beneficial but should be accompanied by a short holding period, unless the business plan involves refinancing and holding after stabilization.
Stage Three: Hyper-supply
The balance between supply and demand during the boom often ends up being excessive. Excess space supply may be caused by excessive construction or a decrease in demand caused by a change in the economy. Hyper offers are rarely characterized by an increase in offers. Rental growth could continue to be positive but at decreasing levels.
Some investors may choose to sell assets before they notice an imminent decline. In the value of homes and the more difficult leasing market. At the same time, other investors may agree on the macroeconomic outlook, but instead of liquidity look for opportunities to hedge against the coming storm. A basic property with a high occupancy rate and full rent rollover from credit tenants with average remaining rental conditions. The example of essential ownership is over five years, which will work well throughout the downturn, with lease rollovers that will be optimal in the next phase of expansion.
In this phase cycle, an opportunistic strategy may be more of a pricing strategy that can be applied to any asset class as opposed to a typical distressed asset scenario. For example, once the hyper-procurement phase has come into effect, homeowners who are poorly equipped to operate during the impending recession, can press the panic button and liquidate assets at prices that Eventually move towards toward recession price levels. In this scenario, the purchaser takes advantage of its capital superiority position to acquire a strong asset. It is confident that he will perform well in the next cycle as the deal has already included a recession phase.
Stage four: Recession
Supply outweighs demand, resulting in more vacant positions. Rent growth in recessionary periods is negative or below the rate of inflation. In addition, operators often offer more leases and rent discounts to attract and retain tenants.
This is a great time to purchase assets in trouble at abrupt reductions at replacement cost.
It is during the recession period that buyers will also be most likely to acquire assets in stress scenarios, such as special services and foreclosures by lenders, commonly known as real property holdings or "SROs". This strategy is based on a patient and well-capitalized business plan that, when the recuperation phase emerges and the sun starts to shine again, the acquirer will then begin reclamation of the asset with the expectation of disposal at the end of the recovery or early expansion phase.
Once you understand the cycle's four phases, it is important to start capturing the deviations from the four phases.
First, phases do not necessarily happen at equal times. The recovery phase can be short and the rapid transition toward the expansion phase or that could go on for years. In addition, it is difficult to predict the duration of expansion phases. Furthermore, the total length of the cycles may vary just because everybody agreed that the previous cycle was nine years doesn't mean that the next cycle is going to have about the same total duration.
Second, cycles are different for different regions and asset classes. Some markets, such as gateways, may lead to the transition between the recession and recovery phases of the next round, and secondary and tertiary markets will follow. In addition, different asset classes are recovering, expanding, overflowing, and shrinking at different rates, with some of the spread attributable to the commercial real estate markets being cyclical. Asset class and some of the variance are due to location at the subway level and in subways. For example, even though the overall asset class of office buildings is growing in each market, the suburban office buildings may still be recovering, while the urban office buildings may be about to be oversupplied. So, when you apply the concept of the four phases of the property cycle to a particular asset, you also must overlay the geographic location and the asset class to get an idea of what that asset represents through the cyclical wave.
The differences between market synchronization and yield at different stages of the real estate cycle, it's important to create a diversified real estate investment portfolio to balance the highs and lows in performance.
In previous post: " Why do you need to Invest in Office?"