How to Capitalize on Real Estate Cycles
How to Capitalize on Real Estate Cycles
Understanding how to capitalize on real estate cycles will help you reap the rewards of real estate investing and avoid risk. Learning about the components of a real estate cycle is fundamental to successfully investing in real estate. The real estate cycle is usually a long term phenomenon. While it’s difficult to predict precisely in the short term, it’s important to remember that it is a cycle with definite phases. You can be a strategic, and ultimately successful, real estate investor if you are aware of these phases and adjust your real estate investment strategies accordingly.
Currently in Canada, particularly in very active or “frothy” markets like Metro Vancouver and Metro Toronto, recent actions taken by government (municipal, provincial and national) are impacting real estate markets and causing phase changes within the related real estate cycles. Unfortunately, these actions also impact normal or slower real estate markets across Canada, resulting in a mosaic of markets that are in different phases of their individual real estate cycle. This means that it’s even more critical to understand the markets in which you have real estate investment properties and plan accordingly in keeping with the phase of the local real estate cycle. Don’t assume that there’s one consistent pan-Canadian real estate market. The reality is that some markets are in positive phases of the real estate cycle and others are in more negative phases. I’ll talk more about the specific phases of the real estate cycle, but first I want to talk about the potential short term and/or long term impact of the various actions recently taken by different levels of government.
Impact of government action
In BC, the provincial government has implemented a Foreign Buyers Tax. This is an additional property transfer tax that applies to foreign nationals or corporations purchasing residential properties within the Greater Vancouver Regional District/Metro Vancouver . This additional tax has contributed to a slowing of sales in this large regional market, not only amongst foreign buyers but also local buyers – as people wait to see “what impact” the tax has on availability and affordability. However, the number of Single Family Dwelling (SFD) sales in Metro Vancouver had already started to slow before the tax came into effect this past August. Further slowing of this market is expected, especially in the City of Vancouver as buyers of all types continue to “wait and see” what happens next. This, in turn, means that less money is being invested in the Metro Vancouver market and that will start to have its own impact. The BC government’s income may also experience unintended consequences as there may be lower property tax revenues because of the slowdown in the sales and price reductions of SFDs in the markets affected by the Foreign Buyers Tax. The tax may also influence markets outside of Metro Vancouver that are not subject to the Foreign Buyers Tax, in that there could be an increase in sales for those markets close to Metro Vancouver, or places like Victoria on Vancouver Island that have experienced a significant increase in demand.
The mayor of Vancouver recently announced the initiation of an empty home tax and new regulations for Airbnb type short term rentals. These measures will also have short and possibly long term impacts on the demand, supply and vacancy rate of the overall housing market in Vancouver. These measures could also affect the status of the Vancouver real estate cycle.
The Canadian government’s recent changes to national mortgage rules will impact first-time and other buyers that require some form of insured mortgages regardless of where they are in the country. It’s expected that this will limit what such buyers can afford to purchase and that will likely affect demand, especially for entry-level properties. The good thing for real estate investors is that rental demand could increase from these recent changes.
Now that we have an overview of the current situation in Canada, let’s take a closer look at the real cycle itself and then discuss how you can adjust your real estate investment strategies for any given market.
Real estate cycle
Each real estate market follows a long-term cycle consisting of four phases that follow a predictable pattern.
What isn’t so predictable is the duration of each phase within the cycle, and therein lies the challenge of understanding the cycle and appreciating that when you understand what phase a particular real estate market is in, you can utilize the most appropriate investment tactics for that phase.
The four physical phases are:
There is also a corresponding emotional cycle with the real estate cycle. As a real estate market moves from a recovery stage through the expansion phase, the emotions move in sync i.e., from hope to relief to optimism, excitement and so on through all the corresponding phases.
Let’s look at each phase of the real estate cycle and the corresponding emotions.
Recovery: This phase represents a real estate market’s recovery from a contraction or recession. This means that the market is recovering from factors such as higher unemployment, higher vacancy, decreased consumption, decreased investment/development, oversupply of housing and lower real estate prices. As the recovery proceeds, there are increased employment opportunities, and the population start growing and improving. Typically, increased growth in Gross Domestic Product (GDP) will have already begun and vacancy rates will start to decrease as the growing number of people and businesses in the market begin renting available stock. Decreased vacancies in industrial and commercial (office and retail) space is another good indicator of a turnaround in the economy and real estate market. Typically single family construction continues to be active through all phases of the cycle, but suffice it to say that there is less construction during the latter parts of the contraction phase and the earlier part of the recovery phase.
During the recovery phase of the real estate market cycle, a strategic investor holding for the long term should be seriously investigating the opportunities in the market and identifying investment properties that may be ripe for acquisition. However, one really should look at the areas within the market that are going to have the highest potential for growth. What major announcements have be made recently? Is there new infrastructure or transportation going in? If so, where and when? Is there gentrification going on in specific areas?
It is not always a seller’s market at the early stages of this phase, but as it gains momentum it can shift to a seller’s market. A key way to really know whether it is a seller’s, neutral or buyer’s market is to understand the trends indicated by amount of housing inventory supply, days on market, pricing trends and sales-to-listing ratios, etc.
The emotions associated with the recovery phase are cautious optimism and a sense of potential and hope.
Expansion: The transition from recovery to the expansion phase occurs when the existing stock is increasingly being bought up and/or rented. Factors such as GDP, jobs availability and population continue to grow; vacancy rates continue to decline and landlords start to raise rents as the demand begins to exceed supply. During the early part of this phase, typically, there is little new construction and usually no new multi-family dwelling (MFD) projects being built, because the property values are usually below replacement cost during this phase. Once developers see that there is a realistic opportunity to make a profit, they usually start investing in building projects in anticipation of launching successful projects. Single family dwelling construction typically increases in this phase and housing starts grow. However, there is a lag within the expansion phase, as it takes time to put new development and investment projects together, get them built and then sell, or rent them out. Large multi-family dwelling projects like townhouses and condos can take two to five years from conception to finish.
As the expansion phase continues, the real estate market becomes very active as everyone looks to take advantage of the recovery.
During this phase of the real estate market cycle, a strategic investor holding for the long term should be investing in good property opportunities that have positive cash flow or if they are in the early stages of expansion to have a high probability for positive cash flow within this phase. Property values may be below replacement cost which allows for appreciation. This is also the phase that enables maximum return with the least amount of risk. Bear in mind the further this phase of the cycle advances, the more competition you will encounter and the market will become more of a seller’s market. Therefore, buy for cash flow so that you are not relying entirely on appreciation.
As the values increase, there will be more supply being built. This is when it becomes riskier due to the probability of over development. If you were going to sell for whatever reason, this is the best phase in which to sell, as there is still a trend upwards. During the expansion phase, an investor should be also building up a capital reserve (rainy day contingency fund) for the inevitable next phases of hyper-supply and contraction/recession. This would also be the phase in which the strategic investor should be stress testing their real estate portfolio for increased interest rates to ensure that you can hold through the eventual downturn.
During the expansion phase, the associated emotional phase is characterized by optimism, anticipation and positive possibilities.
Hyper-supply: As expansion transitions into the hyper-supply phase, a tipping point is reached and available stock starts to exceed the demand. The market changes from a seller’s market to a buyer’s market as more properties are available for sale, and vacancy rate increase. Due to the inherent lag in large developments/construction projects stock will continue to come onto the market even though demand is decreasing. Investors continue to put new deals together and the speculation continues. The super-active real estate market continues, but this is the danger zone.
Initially, landlords can continue to charge top rental rates, but as vacancy rates increase, landlords get nervous and the first thing they usually do is lower rental rates to try and fill their units. During the latter part of the expansion phase and definitely during this hyper-supply phase GDP, jobs and population will have already typically levelled out even began decreasing.
Hyper-supply (an increase in rental vacancies and in unsold stock) is the first sign that the real estate cycle is changing and heading into a downward trend. The question now is, how low will the market go and how long will the next phase last.
During this phase of the real estate market cycle, the strategic investor holding for the long term should be seriously considering “battening down the real estate hatches” and investing in tenant retention, whether that is physical or systems improvements, or lowering costs wherever possible.
On the emotional front, people still experience thrill and euphoria until the phase begins its transition to contraction/recession as the economy changes and money becomes tight and then the emotions tent to shift to anxiety and denial.
Contraction/Recession: With the transition from hyper-supply to recession, vacancy rates can increase to above the long-term average. Surplus SFDs and large MFD developments continue to come onto the market as projects started during the expansion and hyper-supply phases come to completion. This leads to even more surplus supply which results in higher vacancy rates and lower rents, and lower purchase prices for real estate. GDP continues to fall as the economy moves further into its recessionary phase, jobs decrease and the market’s population decreases.
The next factor in this phase of the real estate cycle can include potential increases in interest rates, which further slows the real estate market and the economy. However, once the real estate cycle is firmly in the recession phase, this can also be the beginning of the opportunity for bargains for the strategic real estate investor. And so, the cycle continues back towards the recovery phase.
During the contraction/recession phase of the real estate market cycle, the strategic investor holding for the long term should be maintaining the highest possible occupancy rate and continuing to work with their tenants to ensure as much positive cash flow as possible. In the case of negative cash flow, using the cash reserves you have accumulated will help you weather the downturn. Remember that if you experience a net loss during this period you have the tax benefits to offset some of the losses. This is why stress testing your portfolio is so very important during the expansion phase. Also, this is why I suggest that you do not put all your real estate eggs in one market basket. Geographic diversification can greatly reduce the risk of net losses throughout your real estate portfolio
The emotions associated with this phase, are fear, pessimism, depression, and even panic especially if the investor is either a novice or overextended.
Length of real estate cycle
There isn’t a specific predictable length of time for a real estate cycle, but historically full real estate cycles typically take from 7 to 20 years to move through all four phases depending on what factors affect and influence a specific market. As these factors vary from region to region, there is an aggregate of real estate cycles occurring that form individual provincial real estate cycles and a collective national real estate cycle. This provides opportunity for the savvy real estate investor as usually there is always a market that will be in the upward phases (recovery and expansion) of the real estate cycle.
Affecters (sometimes referred to as drivers) are those key market factors that directly impact real estate supply and demand within a market, including: economic, financial, demographic and housing factors. Affecters tend to have longer-term effects on the real estate cycle.
Examples: The Evergreen Line Light Rapid Transit line impacts the areas adjacent to its stations; demographic impacts due to Millennials, Gen X-ers and/or Baby Boomers; or game changers like the Site C development or the building of a new hospital complex or university campus.
Influencers are those factors that impact the impression or understanding of an impending change in the real estate cycle. Influencers typically have a temporary impact on the market, so it’s wise to be aware of them, but they don’t usually have a long-term impact.
Examples: The Foreign Buyers Tax, while this tax is having an initial impact, with time the market and people will adjust and the fact that certain buyers must also pay an additional property transfer tax will be accommodated and the impact will be smaller than when originally implemented.
What to look for and how to take strategic advantage
Knowing there is a real estate cycle, and understanding the phases of the cycle, is fundamental to knowing what to look for to make strategic real estate investment decisions. When considering real estate markets in which to invest, gather the facts in order to identify where that market is in its particular real estate cycle. Look at what’s happening with the GDP in the area. This type of information can be easily located in bank reports and various government sources.
Check the Canadian Housing and Mortgage Corporation information on the market and with city/regional planning for the area. Ask questions about the job market, population and economic outlook; ideally there should be growth in all these areas. Find out what’s happening with the market’s vacancy rates and new construction/projects under development, but don’t forget about the lag in these factors in the recovery, expansion and especially the hyper-supply phases.
Understanding the real estate cycle and its phases, enables you make strategic decisions about your real estate investing. We have all heard the adage of location, location, location as the key to real estate, but I suggest that timing, timing, timing is key or most critical, where “timing” means knowing what is the current phase of the real estate cycle for the market in which you are interested. Location, location, location is secondary once you understand where the market is on that cycle.
They say buy low and sell high but that is easier said than done. You can never pin point the exact top or bottom of a real estate cycle, which is why understanding what direction the cycle is trending based upon the key factors we have discussed is important.
I tend to buy into markets that are in the beginning of the expansion phase as “the trend is my friend”. Bear in mind I am older and I invest for the long term, while I look to minimize my risk given my age. For a younger investor who is more of a risk taker, buying between the contraction and the recovery phase can have its rewards. Flipping properties can be quite lucrative in the latter stages of the expansion phase, but it is the part of phase that can carry the highest risk. Conducting solid research and being aware of the affecters and influencers in the market in which you are interested, as well as the characteristics of the upward phases of the real estate cycle, will enable you to make informed, effective decisions about your real estate investing.