Like many businesses, commercial real estate tends to be cyclical in nature, which means that the success or failure of a commercial real estate investment is tied to the cycles in which the property is bought and sold.
In this article, we are going to describe the four major phases of the real estate cycle, how they are measured, how long they last, and what phase we are currently in at the time of writing. By the end, readers will be able to identify the major phases of the real estate cycle and use this information as part of their pre-investment due diligence process.
At First National Realty Partners, we specialize in the purchase and management of grocery store anchored retail centers because we believe that grocery store anchored tenants are among the most stable options throughout all phases of the real estate cycle. To learn more about our current investment opportunities, click here.
What is the Real Estate Cycle?
The first, most critical point, to remember is that the commercial real estate markets are dynamic and constantly changing in response to prevailing market conditions. The second point is that commercial real estate tends to be a highly local business. This means that “market conditions” can vary widely from one market to the next. For example, the CRE market in Omaha, Nebraska is very different from the market in New York City. As a result, it is very possible that different markets can be in different stages of the real estate cycle at the same time.
With this in mind, the term “real estate cycle” refers to the four distinct phases of economic conditions that a commercial property may experience. CRE cycles are nuanced and can be impacted by a number of factors including: interest rates, demographic shifts, the broader economy, and regulatory policy. From an investment standpoint, it is important to be able to identify each phase of the cycle and to position properties and investment strategies in response.
The Four Phases of the Real Estate Cycle
There are four phases of the real estate cycle, each of which have their own distinct characteristics. It is important to note that it can be difficult to predict when each phase will occur and the transition from one phase to the next is sometimes only realized in hindsight. With that in mind, details on each phase are described below.
Phase #1: Recovery
Starting at the “bottom,” the recovery phase is the first in the beginning of a new cycle. They typically come on the heels of a correction or recession and may be sparked by government interventions such as lower interest rates.
The recovery phase is characterized by stagnant rental growth and little to no new construction (supply) coming online. For investors, this can be an excellent entry point because there are often deals to be found in all asset classes from property owners who are desperate to sell their property and raise cash. The activity generated by investors looking for deals and the capital that flows into them can spark positive growth, which leads to the next phase.
Phase #2: Expansion
The expansion phase is characterized by an improving economic outlook. For example, wage growth may begin to tick up and new job growth is positive. Because people tend to follow jobs, strong job growth may lead to an influx of new residents, which creates a virtuous cycle.
When new residents arrive, demand for housing increases. In response to new residents, new businesses like restaurants and grocery stores pop up to accommodate them, which leads to an increased demand for commercial space. With increasing demand for commercial property and limited supply, rents tend to rise and new construction begins to take shape. New construction means more jobs, which means even more people, and so on. The expansion phase, especially the start, can also be an excellent entry point for real estate investors because increasing rent growth, occupancy rates, and rising property prices are all good harbingers of a strong investment return.
Phase #3: Hyper Supply
Sometimes, the expansion phase gets out of control. When it does, there is a rush of new construction and new projects looking to take advantage of the growth. If these new projects outpace the rate of growth and there aren’t enough people and businesses to fill all of the new space, a condition known as hyper supply can result.
In hyper-supply, there is more space than demand. In such an environment, the most logical response is to lower prices to stimulate demand. For example, if a tenant is leasing space at $20 PSF, but they can move to a new space for $15 PSF, they have a strong incentive to make the move. This example highlights the major risk of the hyper supply phase.
If developers, investors, and lenders modeled rental rates of $20PSF in their proforma, but market conditions are $15 PSF, they may not be able to generate enough rental income and/or cash flow to meet their financial obligations. This could lead to a string of loan defaults/investment losses, which can drive prices down even further, leading to the next phase.
Phase #4: Recession
If there are enough defaults, and the losses pile up, real estate markets enter the recession phase, which is characterized by falling rental rates, declining property values, job losses, property foreclosures, and companies going out of business. In this phase, the oversupply of properties is far more than demand and the general economic climate is poor. Many of us are familiar with the Great Recession of the early 2000s that was triggered by a frenzy in residential real estate and the financial products designed to support it. An initial economic downturn triggered a wave of job losses, which triggered a rash of mortgage loan defaults, which triggered significant losses in the financial products backed by the same mortgages. Those losses spread to the broader economy.
Because recessions are often very painful for many, it is common to see governmental authorities step in and take actions designed to ensure that the downturn is as short as possible. In the wake of the crash described above, governments quickly recognized the systemic risk and took unprecedented, coordinated steps to limit the effects of the slowdown. Over time, these interventions helped to get the real estate market back on track and within a few short years, a new recovery phase took hold.
Economic Factors in the Real Estate Cycle
As described above, there are a number of factors that can impact the stages of the real estate cycle. They include:
- Interest Rates: Borrowing costs have a significant impact on the economic viability of a real estate project. When they are low, they can help spur new projects. But, when they rise, those same projects may no longer be profitable so they tend to slow down. Interest Rate policy is set by the Federal Reserve and it is one of the main tools they have to combat a recession.
- Demographic Shifts: Individuals are constantly moving to new property markets in response to favorable economic trends. Over the last 50 years, there is a general trend of the US population shifting away from crowded, cold, expensive northeast property markets like New York and Boston and to warmer, more comfortable markets in Florida and Texas. Thus, it is no coincidence that some of the highest growth real estate markets are in places like Miami, Orlando, Tampa, Houston, Austin, and Dallas. New real estate opportunities, for all property types – multifamily, retail, office space, etc – will pop up when there are major shifts of people to a particular market.
- Regulatory Policy: Governmental interventions can trigger demand or they can put the fire out. Consider two examples. In recent years, governments have designated certain areas to be “opportunity zones” and have given major tax incentives to invest in them. As a result, a significant amount of capital has flowed into these areas. At the other end of the spectrum, federal legislation has also placed a limit on the so-called “state and local” tax deductions that certain individuals can take in high tax areas. As a result, many individuals have left high tax markets in places like New Jersey and Connecticut and re-settled in more tax friendly jurisdictions like Florida and Texas.
- Broader Economy: If the broader economy is strong, like job creation is good, wages are rising, and GDP is growing, real estate is an attractive asset class in which to invest funds.
Many real estate investors use data points like the above to build an investment thesis as to why a particular strategy may or may not work. They may also be used in economic forecasts to try and predict the direction of real estate prices.
Current Phase (2021)
Again, it can be difficult to spot a phase in the real estate cycle while it is happening. But at the time of writing, it is highly likely that the United States is in the expansion phase of the real estate cycle. We know this because there is high demand, rising prices for commercial rental properties, and residential real estate values are strong in many US markets. However, there is some uncertainty as to how much longer this expansion phase can continue before it moves into the recessionary phase of the real estate market cycle. For this reason, we believe that it is best to take a long term view and to invest in asset classes that are viable in all phases of the cycle. For example, we believe that grocery store anchored retail centers are one such type of property.
Summary & Conclusion
The term real estate market cycle refers to the four distinct phases of economic conditions that a property may experience.
There are four phases of the real estate market cycle: recovery, expansion, hyper supply, and recession. The exact timing and boundaries between phases can be difficult to spot, but can have a major impact on the outcome of a commercial property investment.
Phases of the cycle are impacted by a variety of economic factors including: interest rates, demographic shifts, and governmental policy. At the time of writing, we are most likely in an expansion phase.
Because it can be difficult to spot phases or capitalize on the changes, we like to invest in assets that perform well in all phases of the cycle – like grocery store anchored retail centers.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or info@fnrealtypartners.com for more information.
