I bought my first investment property at 21 years old, before I really understood the potential impact of real estate market cycles. Of course, I knew the adage to “buy low and sell high.” But it took time and experience to figure out the particular moments in a real estate market cycle that are better for different types of investing.
While tracking market cycles is widely accepted in the stock market, it has been strangely ignored in real estate investing. Perhaps this is based upon the fact that real estate will, given an infinite amount of time, always appreciate in value. Unfortunately, we as investors are mere mortals and don’t have infinite time on this earth. Therefore, in this article we will explore common real estate market cycles and the indicators you can look for to better understand which market stage your area is in.
Understanding Real Estate Market Cycles
It’s important to say that, despite the fact that national and global events can have a great effect on housing markets and cycles, real estate markets are primarily local. Even during the Great Recession that began in 2007, there were local markets that saw steady appreciation throughout those larger economic events.
This is because local factors were still favorable even though the rest of the nation was suffering from the recession. There are several factors that can impact a real estate market. However, the number one reason a market will change is employment.
A strong job market will attract people from other areas. The increase in population alone will support the rental market, and the rental market in turn supports housing prices. The reverse of this is also true. High cost of living or increasing unemployment in an area will cause people to move to areas where they may have a better quality of life. The push and pull of affordability is ultimately what causes housing markets to cycle in and out like the tide of the ocean.
8 Stages of Real Estate Market Cycles
Real estate markets are cyclical. Housing prices rise and fall as factors such as local economies, national events, and interest rates change. Most real estate experts believe a full real estate market cycle is approximately 12 to 14 years. Six to seven years are up and the other six to seven years are flat or down markets.
While I generally agree with this, I break market cycles down into eight stages to make them easier to follow. These stages are not equal, and they are never constant. A real estate market can shift from one stage to the next and even go backward. One stage can last for a few months or a few years. Some areas may not recover in our lifetimes.
In any given moment, we can look to certain indicators to suggest what market stage an area may be in:
- Active housing inventory
- Housing values
- Rental rates
- Real estate sales by unit
- Preforeclosure and bank-owned properties, or REO
Stage 1: The Turn
At stage 1, supply or inventory is still low and prices are still rising. This is because the market is still experiencing a feeding frenzy from buyers and investors looking to cash in on the appreciation from the previous cycle.
However, the reality is that the market is already shifting. Appreciation has started to slow due to local incomes not being able to keep up with the rising housing costs. High costs in the area begin to push away blue-collar employees and even businesses that seek areas with a lower cost of living. This causes the migration pattern to shift to more affordable areas.
The main indicator you’re looking for in this stage is a decrease in rental rates. Rents begin to soften because most qualified renters have made the decision to purchase during the last stages of the previous housing cycle. Other renters are moving out of the area seeking a better balance between income and rent.
Investing now requires a lot of expertise because you are buying at the top of the market. Novice investors see an increasing market and they want to jump on the bandwagon with everyone else. What they don’t comprehend is that they’re likely buying from savvy investors who are selling off properties so that they can get off the previous market cycle and prepare to buy near the bottom of the next.
Stage 2: Softening Market
This stage is easy to identify because real estate market appreciation in the area has all but stopped. The insane demand and multiple offers are now a thing of the past. However, housing prices are not falling … yet!
Distressed sales will create a downward force on sales prices, especially for sellers who are forced to move. This is because when the seller down the street falls behind on payments and has to sell at below market price in order to avoid foreclosure, it affects the asking price for everyone else’s property on the block.
Foreclosure filings begin to increase as financially distressed homeowners no longer have the option to refinance and access their equity, and the tighter market gives them few options to sell or downsize. So they hold out and try to find ways to keep their homes. Often, they wait too long and lose their home in the process.
Further out, suburban areas begin to lose value as homebuilders continue to overbuild because new construction timelines are longer. Builders experience an increase in failed sales due to move-up purchasers not being able to sell their existing homes. This will further increase inventory.
Rents are still stable now but they are likely to drop in the next few stages. So, if you are already invested in the market, this is a good time to evaluate your investment properties to determine if they will continue to produce positive income for the foreseeable future.
This is typically a bad time to re-invest in more properties. Even though you may have to pay some capital gains taxes if you cash out of the market, it could be a wash. Your taxes may very well be less than the loss in value or income associated with holding a poorly performing property through a recessionary market.
On the other hand, you may be able to identify another real estate market somewhere else that is in a better stage for investing.
Stage 3: Rising Inventory
Active housing inventory is rising rapidly as sales numbers begin to slump. Homebuilders are still sitting on inventory that they started in the late stages of the last cycle, offering outrageous incentives to get buyers to purchase what remains in their pipeline.
Appreciation has completely stopped and prices are beginning to fall. Preforeclosure and short sales are more common. Even a few bank-owned homes are starting to show up in the MLS. These are early-stage distressed homeowners, because it typically takes nine months to a year for a bank to foreclose on a home, clean the title, and place it back on the market. This timeline may be longer if you’re in a judicial foreclosure state, where such sales are required to go through the court system.
Despite many people moving away from the area, rents remain stable due to the new demand from previous homeowners who are unable to repurchase after a foreclosure or bankruptcy, thus forcing them to become renters.
To the novice investor, it looks like opportunities are everywhere. But the experienced investor knows that the real estate market cycle is likely to continue to recede as more shadow inventory comes onto market. Shadow inventory refers to the homes that are in preforeclosure, foreclosed and getting ready to come to market, and bank-owned or REO properties.
Wholesale and fix-and-flip investing is possible during this stage if you adjust your acquisition price for the continued devaluation of properties.
Stage 4: Free Fall
Distressed sales and preforeclosures are continuing to put downward pressure on prices. Buyers and sellers are beginning to feel there is no hope for the real estate market cycle.
Even though homebuilders have retracted all plans for future projects, inventory is oversupplied. Bank-owned homes seem to be everywhere. The market has officially shifted from a balanced market to a buyer’s market.
Despite this, lack of appreciation and uncertainty in the market prevent many potential buyers from taking the leap into homeownership. This makes the demand for rental housing outpace the demand for ownership, causing rental rates to rise again.
If you are a cash-flow investor, you may start considering taking advantage of the increased inventory and strong rental market by buying long-term rental properties. If you are feeling this way, be patient. There is no need to rush into the market. The biggest opportunity is yet to come!
It is important to note that not all real estate markets recover quickly from stage 4, and some won’t recover in your lifetime. In order for a market to recover, it must see increased population growth.
Stage 5: Recovery
This stage is similar to the previous moment in the real estate market cycle. Foreclosures and bank-owned homes are still commonplace. Most investors and buyers are still hesitant to purchase, since many homeowners have not seen any substantial appreciation for three to five years.
However, this is exactly what Warren Buffet is talking about when he says to be “fearful when others are greedy, and greedy when others are fearful.”
The main difference between the two stages is the shift in population growth. Due to falling prices, the area has become affordable again. Affordability, along with new industry and jobs, has made the area an attractive place to live. When the news gets out, people from outside the area begin to migrate in. The combination of good employment and a large pool of quality housing will increase population and stabilize the rental market.
This stage is the best chance to succeed in all forms of real estate investing. The real estate market should provide a stable rental population to withstand the ups and downs of being a landlord, as well as a solid pool of qualified buyers to whom you can sell your fix and flips.
Stage 6: The Honeymoon
Rents are increasing and values are steadily rising again: It’s true love! There’s a steady flow of shadow inventory from the previous recessionary stages creating a consistent pool of undervalued properties.
A strong supply of jobs and migration are causing a steady pressure on rent. This unique occurrence makes it more affordable to purchase a home than to rent. While this may make sense to some, most renters are still hesitant to buy due to the recent headwinds from earlier stages.
Builders are ramping up again, and low land costs allow them to price new homes competitively against the aging existing-home inventory.
Even though there may be a large supply of quality, rentable homes on the market due to the lag time in the foreclosure process, you should still continue to purchase wisely. This is because it isn’t feasible to make all your investment purchases at the exact same time, and the market can quickly shift if local or national events change.
Stage 7: The Rise
Decreasing inventory and high demand is causing housing prices to rise rapidly at 10% or more per year. Increasing rents, a fast-paced market, and year-over-year appreciation are overwhelmingly convincing renters to get off the fence and buy before they are priced out. This will become a self-fulfilling cycle.
Due to the strong and appreciating market, distressed sellers have many options other than foreclosure and most of the bank-owned inventory has been absorbed. New homes are abundant and more homebuilders are popping up every day.
Wholesaling and fix and flips are abundant. Speculation investing, for the sole purpose of capturing appreciation, is beginning to get out of hand. However, if you still want to find good cash-flow investments, your best bet is to look for new-home communities. Renters love new: Think babies and puppies.
Stage 8: The Spike
If stage 5 is the safest opportunity for investors to take a chance on a real estate market cycle, then stage 8 is the opposite. If you are going to invest in this stage, you must proceed with caution.
Remember what happened to Icarus: In his overconfidence, he flew too close to the sun, his wings melted, and he fell to his death.
Now sales and home values are increasing at a breathtaking pace—in some areas greater than 30% per year. This is because active housing inventory is scarce, prices are high, and offers are even more unreal.
Even though people are still moving into the area, rental rates are not keeping pace with home prices. Due to this, it makes little sense to buy cash-flow investments now. This is also the final stage of purely speculative investing. Move forward with caution.
If you still have a speculation itch that needs scratching, do not close unless you have checked and double-checked current prices and days on market. This is where greed kills. You must sell speculative properties before the real estate market cycle ends, or you may be left with a cash drain for the next five to seven years or more.
If you are planning on holding your real estate investments for more than 10 years, knowing real estate market cycles may not be too important to you. However, if you are involved in short-term deals or long to make a couple of strategic real estate investments, then there may be no more important information than knowing what market stage your area is in or entering.