Like any business, real estate is subject to certain market forces that affect values. The life-blood of commercial real estate is affordable financing for the acquisition, development, redevelopment and refinancing of improved properties. The availability of financing is determined by the overall economy, overbuilding, interest rates, market perception (right or wrong), unemployment and, of course, local product supply and demand. Real estate prices can fluctuate wildly as these factors exert their influence.
Historically, real estate cycles typically have an average duration of six to nine years. There are four distinct phases to a commercial real estate cycle including: Recession, Recovery, Expansion and Contraction.
The Recession Phase follows a market contraction, when the availability of financing has dried up and property values fall precipitously. Properties experience vacancies and owners cannot sell because financing has become unavailable to prospective buyers. Prices fall far below the cost to construct the same facility new, resulting in many good buying opportunities for those with the liquidity to take advantage of market weakness. Foreclosures increase and property owners become even more motivated to sell as investors sit on the sidelines. The longer the Recession Phase drags on, the lower prices usually go. This is the time to buy.
In this phase, excesses have been wrung from the market and prices begin to recover, although most investors are still afraid to make a move. New tenants enter the market and property owners refinance as affordable institutional money becomes available. Prices begin to move up. This is the time for owners to improve their property, maximize rental rates and wait for the next phase.
The real estate market is humming along and equity investors are plentiful. Institutional financing is readily available and the price of improved real estate moves up well over the cost to construct the same facility new. Vacancies are at their lowest, prices are at their peak and there is a general feeling of wellbeing, prosperity and abundance. This is the time to sell.
It is in the Contraction Phase that reality sets in. The market has become overbuilt and vacancies begin to rise. Financing and equity investment withdraw from the marketplace as delinquency rates rise. Prices begin to fall from the peaks of the expansion phase. Investors rush to exit the market, causing prices to fall with increasing speed.
The phases of a real estate cycle are always in the same order. The only differences being the duration of a phase and longevity of a cycle. By determining our current phase we can logically anticipate where we’re heading, taking a great deal of the guesswork out of the equation. Recognizing and timing market trends need not be as formidable as it may seem at first glance since we know that the typical investment cycle timeline is six to nine years.
When to buy and when to sell
To the real estate investor the most important question is, "When do I buy and when do I sell?" This is the point where we find out if we are contrarian investors or just one of the herd. When the market is still in the Recession Phase, the stage is set to reap the biggest profits later on, at or near the top of the Expansion Phase.
To make money, the old saw, "Buy Low and Sell High" universally applies. The best time to buy is when the cycle is in the Recession Phase, when the best deals become available due to pervasive investor fear. In this phase the best prices and terms can be negotiated, well below the replacement cost to build the property new. The time to sell is during the peak of the Expansion Phase, when buyers can easily obtain financing and the market is on a high note. Another old saw applies here: "Buy when everyone is selling and sell when everyone is buying." This is contrarian investing at its best.
The problem with contrarian investing, even though logic may dictate otherwise, is that it goes against our survival instinct and plays into our herd instinct, both paths being governed by emotions. Illogically, most investors decide to enter or leave the market at the wrong time by following their emotions. Contrarians tell us to do the opposite of the herd but the fact is, when logic and emotion are in conflict, emotion will usually rule the day. This is the point where confidence and nerves of steel are useful.
One thing is certain, cycles will repeat-that’s why they’re called cycles. Those with the discipline to understand cycles and invest contrarian will reap the big rewards.