The economic cycle is a topic of interest to everyone. Business owners, homeowners, employees and of course real estate investors are all impacted by the growth and decline of the economy. When we talk about cycles in the economy it is important to understand that there are several different cycles that economists have labeled which play a role on our investments and daily lives. In this article, we will focus on the most well know and impactful economic cycle which is the business cycle. In next week’s article we will continue our discussion with the two other common cycles.
The business cycle is the basic economic cycle which most Americans think about when asked about this subject. It takes around a decade for a full cycle and it has the most impact on our daily lives. The business cycle is driven my many factors including job growth, wage growth, supply and demand of housing, interest rates and inflation. The four phases of the business cycle are the expansion phase, peak phase, recession phase and the recovery phase.
In the expansion phase, the general confidence in the economy is high leading to an increase in the price of real estate. Much of this confidence is derived from increasing wages and job numbers. This results in low vacancy and encourages investors to pay top dollar for deals which are difficult to find.
The expansion will eventually lead to a peak point in the cycles. During this brief time investors will mistakenly overpay for properties believing that the market is still expanding. It’s important to note that the transition from the expansion phase to the peak phase is not easily identifiable except in retrospect. During the peak phase interest rates will increase leading to inflation as the demand in the market begins to weaken and eventually reaches a point of oversupply. It is at this point that the downward trend begins which is the recession phase.
During the recession phase the demand for housing is decreasing which is exacerbated by several factors including unemployment, lower wages and a tightening or even freeze on lending. Due to these issues, landlords will often need to lower rents during this time and sellers cannot expect to receive the premiums for their properties that they saw during the expansion and peak phases.
During the beginning of the recovery phase, interest rates will often be lower again as the Fed tries to encourage transactions. Gradually, buyers will begin to pay more for real estate as supply starts to decrease. At this point those who are well positioned finally can receive lending for properties and begin to find investments that will be considered a bargain later in the phase.
What does all this mean for the real estate investor and more specifically multifamily investor? The key point is that by understanding the place you are currently at in the cycle, you can make wise investment decisions that will prepare you for the next phase. It is important is to allow margin in your deals to account for future shifts in the economic cycle. For example, when analyzing multifamily deals, we assume that although we are currently in a strong sellers’ market (likely later part of the expansion or even peak phase) that we could be selling in one of the other two phases. This means interest rates will likely be higher and we must therefore assume we will be selling at a higher cap rate. This does not mean that we sit on the sidelines to wait for a change in the market as every part of the cycle has its challenges. A savvy real estate investor is always looking for deals, however they contextualize what a good deal is by the current state of the market.
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