No study of real estate investing would be complete without a comprehensive understanding of markets and how those markets are affected by economic conditions. Only through an understanding of this critical topic can the Investor properly understand their risk exposure and implement strategic investment planning and effective risk mitigation techniques.
The following section will provide an overview of the four major phases of a real estate market cycle. Although each of these phases have specific characteristics that make them stand apart from one another, unfortunately, the initial transitions in and out of each phase may not be plainly obvious. The four market phases are listed below:
- Sellers Market I (Expansion)
- Sellers Market II (Equilibrium)
- Buyers Market I (Decline)
- Buyers Market II (Absorption)
Each phase of this cycle can present the Investor with both challenges to overcome as well as opportunities to benefit from. The well informed and action oriented Investor will know what strategies to utilize during each of the phases. The following section will provide an overview on each of the market cycles.
Sellers Market I (Expansion)
During a Seller's Market phase I (also referred to as the Expansion Phase), many of the key economic indicators are telling a compelling story that includes the following:
Due to the strong economic conditions, builders and developers regain their confidence that new construction now makes sense; significant increased activity is seen in the building permit application process. As construction levels begin to increase, it will also stimulate the need for primary and secondary workers.
The general population feels that times are good and discretionary spending increases; this in turn will help to stimulate the economy.
Market sales price and market rents are at the highest levels due to the high demand for housing; this increase in demand absorbs the available inventory and creates sometimes fierce competition among home buyers who are bidding against each other for the same property. This bidding frenzy can result in multiple offers being presented to the sellers and in some cases, bidding up the list price.
The Investors who have been holding properties coming into this phase will be benefiting from significant appreciation of their real estate holdings; this market cycle could be a great time to leverage your equity by selling at the top of the market and re-invest the proceeds in other perhaps larger properties. In order to maximize your available re-investment capital, an IRC 1031 Tax Deferrered Exchange should be considered.
Warning! It is strongly recommended that you seek advice from your Accountant prior to implementing any tax reduction strategies.
In a market with high demand, you should expect to pay strong sales prices; the higher demand may also set the stage for sellers to be less motivated in agreeing to creative deals like seller financing, assignments, or Lease Options.
In this market, you will also see Investors who are purchasing properties just for the appreciation and are not concerned with the cash flow. For Investors who are considering this approach, it will be critical that they have adequate cash reserves available to them in the event there is an interruption of rental income resulting from vacancies. In addition, not having cash flow could make it difficult to maintain the property effectively in the event repairs or replacement is required.
During the Sellers Market Phase I, there will be numerous opportunities to take advantage of the aggressive buying activity that can exist. Outstanding profits can be realized from business models like flipping and wholesaling. This market phase will allow the Investor to get the property turned over without the concerns of a dropping market price. The fact that the property is appreciating will help create a cushion for the Investor in the event the exit strategy does not happen in accordance with the schedule and cost goals established for the project. In fact, if delays do occur, it may be possible that it could relate to more profits in the Investors pockets! At the tail end of this phase, the growth rate will start to cool down.
During the Sellers Market Phase I, Lenders will tend to be more lenient with their underwriting and approval ratio due to their confidence in the strength of the market. This can be a double-edge sword, as we have seen leading up to 2006, Lenders were approving loans for people who weren't really qualified and as a result, when the market started to nose dive, it took many homeowners with it.
Sellers Market II (Equilibrium)
In a Seller's Market II (also referred to as the Equilibrium Phase), many of the economic indicators are no longer exhibiting explosive growth and are heading towards national averages with regards to new construction starts, migration movement, sales price, and appreciation. Most people now recognize that the market has peaked and those who didn't sell in the prior phase will now consider putting their property up for sale. Towards the end of this cycle, added inventory along with diminished economic incentives will reduce the demand and therefore, owners who are strongly motivated to sell will need to consider aggressive pricing strategies and open to creative deal making.
Due to the difficulties with owners selling their property, many may have to consider putting the property in rental service; this increase in available supply will drive fair market rents down.
Without proper consideration of the current declining market, business models like Flipping and Wholesaling can be risky; missed cost and schedule goals can have catastrophic results. For those Investors who are working on tight margins, it will be challenging to make the profits they are accustomed to.
If purchasing with a Hold to Rent strategy, strong walk-in equity and cash flow is vital. The equity will allow you have a good cushion in the event there is another reset to the market. Equity stripping techniques are strongly discouraged during this cycle because if you pull out all of your available equity out before a reset, you may actually end up upside down on your equity and make it difficult for you to sell the property unless you are willing and able to reach into your pockets at closing.
Buyers Market I (Decline)
In the Buyers Market I (also referred to as the Decline Phase), inventory levels and days on the market are at the highest point. Due to the continuing degradation of economic conditions which includes declining employment and little new construction, the rate of foreclosures, Short Sales, and Deed in Lieu of foreclosure will continue to increase significantly and contribute to further reductions in property values that have potentially hit the bottom.
The demand side of rental units could actually be strong during this time due to the following factors:
A higher percentage of homeowners are being displaced and may need to rent a home.
Home buyers who are able to purchase a home may hold back in fear of not knowing when the market will bottom out.
In order for a market to recover from this phase, national and/or local economic stimulus programs must be implemented to help stop the bleeding and to help to restore the confidence in the market.
When purchasing in this cycle, it will be vital to ensure strong cash flow and organic appreciation since there is no way of knowing how low the market may go. You should plan for longer hold times in order to ride out the market until it gets out of the decline phase.
Wholesaling and Flipping are difficult business models due to the fears of many buyers who are not sure when it is time to pull the trigger and make a purchase; this could result in Sellers getting stuck with inventory that is not moving.
During this cycle, it is a great opportunity for Investors to add to their investment portfolio; a strong buyer especially with all cash offers will reign supreme in this market and get the pick of the litter. This is also a great time to implement creative buying strategies and capitalize on the many Sellers who are strongly motivated to sell and will consider deals that may include Options, Seller Financing and other creative avenues.
During this phase, traditional Lenders are extremely cautious due to the uncertainty of the market. New loan applicants will be scrutinized and on higher risk loan programs like commercial lending (5 or more units), Lenders will be cherry-picking for the best applicants on the cleanest deals. Underwriting guidelines may be adjusted increased down payment, Debt Service coverage and occupancy percentages.
Buyers Market II (Absorption)
In the early stages of a Buyer's Market II (also referred to as the Absorption Phase), the economic conditions are starting to improve. Local stimulus initiatives are underway and some results can be seen. As this phase progresses, confidence starts to be restored. Although at this point there is still only little new construction, builders and developers will eventually be convinced it now makes sense to start to build again. With the economic indicators making a turn for the better, the groundwork for an Emerging Market has been established. As employers see the need for expansion, unemployment rates will start to drop for both the primary and secondary workforce. With the improved economic conditions starting to be seen on many fronts, the oversupply of properties will start to get absorbed. As the demand side of housing increases so will the property values.
In the beginning of the Buyers Market Phase II and prior to the rise in property values, the well informed Investor should accumulate as much in their portfolio as possible. Hold to rent strategies will allow you to reap the benefits of strong cash flow while riding comfortably through a market that will soon be in an upswing.
Challenges in Reading the Market Phases
Despite the fact that there are some very specific characteristics associated with each market phase, as each phase progresses in time, there is not a specific event that will give obvious notice that we are at the end of the current phase and moving into the next one. In most cases, the transition of phase to phase will be based upon a number of different key economic indicators changing.
It is also important to note that although there are four distinct market phases, each phase can have its own rate of change, amount of change and total duration. Therefore, unlike the mathematical Sine Wave that may have predictable expectations, Real Estate Investors are not so fortunate in trying to anticipate future market trends.
It is not just about employment opportunities
Migration trends although significantly affected by the promise of employment are also affected by other factors as well and are highlighted below:
Demographic studies validate that people will continue to migrate to warmer weather. The southern states will see an influx of new residents coming from cooler areas.
Quality of education is a driving force that will affect migration patterns. Those towns and cities that can demonstrate high quality educational opportunities for adults as well as children will set the stage for a higher than national average population growth.
Another factor that will affect migration patterns is the lifestyle the area can offer. Many people are seeking areas filled with cultural, entertainment, and leisure activities in order to help balance the high stress society we live in.
In an ideal market expansion model, the economic growth that is occurring is coming from a number of different significant industries that are not reliate on the others. When there are larger employers in a community, smaller sub-contractors will also be established and the large employer may be the only or significant portion of sales to the smaller firms. When the larger company struggles, the smaller ones follow suit. Although there can be extraordinary economic growth when a major industry makes their home in a given geographic area, if changes occur within that industry such as the need for outsourcing or demand decline, it can cause catastrophic damage to the local community; this is very evident in areas like Detroit where the auto industry has virtually crippled the local economy. Another example is the struggle Youngstown Ohio experienced as they worked through a key industry shutting down. Youngstown's economic foundation was built upon the significant employment from the steel industry; in fact, Youngstown was referred to as "Steel Town". When the town factory closed in the 1970's, it created devastating economic conditions.
In order for a town to recover from the effects of an economic downturn, local government, community leaders, and the private business sectors must diligently work hand in hand to create a vision for future economic rebirth.
The Side Effects of Unemployment
When unemployment reaches dangerous economic proportions, there is always collateral damage that will be seen and includes the following:
o People will start to leave for the hope of employment elsewhere; in many cases people are forced to abandon their homes and the structural carcasses of the poor economic conditions are clearly evident as you look around the community.
o Tax rolls collected will be significantly reduced due to the exodus out of the area. In addition, there is a larger volume of unemployed people who have stayed behind who will not be able to pay their taxes. When tax collections are reduced, critical services and programs may also be cut or reduced.
o Crime and drug use will significantly increase.
Proactive Economic Recovery
Most local governments have established a department or agency whose primary charter is to develop programs with the objective of stimulating the economic growth of the community.
Examples of initiatives that will help stimulate the economy can include the following:
- Improvements and expansion of roadways and railways making commuting and transportation more efficient
- Tax incentives to builders, developers and employers to stay or come in to the area
- Loans with better than market terms
- Crime reduction programs
- Homebuyers assistance programs
- Revitalization initiatives of trouble areas
Many of these initiatives have been documented in the communities "Master Plan"; it will be critical as a successful emerging market Investor to interpret the "writing on the wall" from these plans. Community Master Plans are usually available to the general public. Contact the local economic development organization or agency for further information on how to receive this valuable data
Types of economic growth
The effects of economic stimulation and growth can geographically be seen a few different ways as follows:
With sporadic growth there is random geographic visual evidence that new development is occurring; new construction and rehabilitation is seen in various locations of a town. This type of growth makes it difficult to "read" the local sub-market trend because of the lack of concentrated improvement in a given area.
Centered around a target area, hub or anchor
Growth concentrated around a hub or anchor is the typical economic growth model and is the catalyst of new construction and rehabilitation. Examples of hubs and anchors are as follows:
1. Large universities
3. Industrial complexes
4. Malls and large national retail stores
5. Planned communities
6. Housing projects
In many cases you will see a "Growth Radius" surrounding a hub or anchor. As the properties located around these "centers" are developed, the radius will continue to expand outward. Investing in these areas not yet started in the transformation process can yield outstanding financial benefits.
Along a "path of progress"
The third type of growth that can be seen is called the path of progress. This type of growth is typically associated with "Straight Line" development going in specific directions. Perhaps the most vivid example of this type of development can be seen "on the strip" in Las Vegas. Here developers understand the importance of positioning hotels and casinos to provide the best exposure to both car and foot traffic.
Another example could be the development of retail and service stores along the path of a main road or highway, development of such stores "off the path" will be minimal.
On a national level, all major real estate markets are not created equal, some can be experiencing explosive growth while others are seeing a decline. The same holds true when you narrow the market region down to a local level; in any given city you may have areas that are expanding while other areas are not. These smaller markets contained within regional markets are referred to as Sub-Markets. These sub-markets can be below the radar screen of the national agencies and research companies; therefore, having local knowledge can be very helpful in identifying these growth opportunities.
Keep in mind that even in the worst of economic times, there may be markets or sub-markets that are or soon to be hot!
Fundamentals of an Emerging Market
All experienced Investors know the benefits and peace of mind of owning a property with strong equity and cash flow; these characteristics will help set the stage for long term financial security. When you add market appreciation on top of the equity and cash flow benefits, it will supercharge your wealth building engine. This relationship can be illustrated by the following formula:
Strong Cash Flow + Organic Equity + Market Appreciation = Wealth Success
One sure fire way to utilize the advantage of the wealth success formula shown above is to invest in Emerging Markets. Simply defined, an Emerging Market represents an area that has started or will start to see growth resulting from both private industry development and local government initiatives to attract business and industry. As primary jobs are created from these initiatives, it will cause a change in local demographic trends; people will now start to move there or may stop leaving. With the increase in primary jobs, the secondary job workforce will also be increasing. The secondary workforce will consist of service related businesses to support the primary workforce; examples of these services include the following:
- Food service
- Retail stores
- Health care
The secondary industries and workforce is vital in order for an area to be perceived as "family oriented". This is important to younger families who are trying to establish roots in the community. For each primary job created, it is estimated that it will generate a need for 2-3 secondary jobs!
With the increase of employees from both the primary and secondary work force, the need for quality housing will also increase. Explosive profits will be realized by those Investors who "saw it coming."
What makes investing in Emerging Markets challenging for the typical Investor is that unfortunately you will not necessarily see an ad in national newspapers or bill boards stating "Emerging Market coming here soon!" The successful Emerging Market Investor will need to implement comprehensive marketing and research strategies in order to identify and react to the next Emerging Market opportunity they would like to invest in.
The following is an overview of the most common strategies you may want to consider in locating a hot or Emerging Market:
Purchasing Demographic and Migration data from List Brokers. List Brokers are companies that provide lists based upon search criteria you provide them. The cost of these lists will depend on how many "hits" you want to purchase. Typically, you can expect to pay a few hundred dollars for a small list and up to a few thousand for an extensive list. These lists can include a targeted market that will help you determine the viability of an investment area. Some of these targeted market examples are as follows:
- Search by age group
- Income levels
- Educational levels
- People in foreclosure
- Out of area property owners
- Long-term property owners
Reviewing the data provided by government and private businesses that create market research data. Reviewing national hard print or electronic newspapers like the Wall Street Journal or New York Times. For a listing of national and local newspapers, look at http://www.newslink.org
- National Commercial Real Estate Brokers do have a good handle on market trends and can be a vital source of information to the Investors searching for hot markets; it is strongly recommended to have some of these Brokers on your Professional Team.
Family and friends can be a great source of information for things that are happening in their backyard that have not hit the national level of news coverage and below the radar screen of most outside Investors.
- Having a connection to various real estate investment organizations and clubs.
- Property Management companies are a great source to get a pulse of the local investment trends. Visit http://www.irem.org for a listing of certified Property Management companies in your targeted investment area.
- Paying Birddog fees for leads to emerging or hot markets and properties.
The Early Stages of an Emerging Market does give away some clues
During the early stages of an Emerging Market that is about to unfold is the ideal "Strike Time" for Investors to buy into the market. At this point in time, the market may be filled with excessive inventory and motivated sellers looking to do a deal. By focusing on some clues, you will be able to "See into the Future". Some of the clues are as follows:
- Having visibility in the local permitting activities. Remember, the permitting process can take years for major construction projects like highway development, office buildings and factories.
- Environmental impact studies underway
Review of the areas "Master Plan" which will provide an insight on the future vision.
- Publicized initiatives from Economic Development agencies trying to encourage industry and job growth.
- Advertised Government grants or tax credits.