The main focus of investing in real estate is to compound the money and generate high profits. But the real strategy to get a lump sum of cash through real investment is purchasing a property at the bottom stage of the real estate cycle and selling it when it reaches the peak of the cycle.
The 1031 exchange can be utilized by the real investor to transform their gains from one market to another and thus can keep on compounding the money, unmolested by taxes. Six stages of real estate cycle help one to know when to buy and sell an income property to gain appreciated value out it.
- Early Down turn
At this point, the market is in its peak position and the forces that make it to reach peak start to falter. High occupancy persists still begin to decrease. Turn down rent growth, declined net operating Income, Upward cap rates, decline in prices can be witnessed on this stage. Tighten up credit flow, which might be free flowing earlier. New inventory will reach the market as construction projects will be finished off. Tenants are offered with concessions by the lessors facilitating signing up of new leases.
- Full Downturn
Corrections on pricing, Renegotiation of concessions by lessors to make the tenants stay back, rapid increase in vacancy, decreased sales, fall in selling price of properties, upward cap rates, unattractive terms included hard credit availability, and increased foreclosures can be witnessed during this real estate stage. Developers sell their finished property at fire selling price, or file bankruptcy to raise additional capital.
At the bottom stage of the real estate cycle, one can find lowest rental prices as never seen before, higher cap rates, points, excess inflow of inventory, and number of empty commercial spaces. Still, lessors continue to offer more concessions to tenants, not as much as earlier. All these metrics will start to level off and asset prices are comparatively well below the replacement cost. Its right stage for investors to buy assets aggressively.
- Early Recovery
Buying process start to pick up and still prices persist to be below the replacement cost. Stabilized rent prices, Low occupancy with gradual improved demand and decrease in vacancy. Downward ticking cap rates, NOI is increasing with the increase in price. Market participants acknowledge the bottom stage passed, even though there persist tentative investment with uncertainty about healthy recovery. Lessors offer fewer concessions if needed. Investors should pursue buying assets.
- Early Stable
During this stage, demand for gathering recovery stimulated. Increase in rent prices, decreased vacancy, growing NOI, downward ticking cap rates, increase in price exceeding the replacement costs can be seen in this stage. Capital and credits are more available. More investors invade with tough competition for deals. Absorption of completed construction projects at this stage. Lessors stop offering concessions due to high demand. The real estate market comes to equilibrium at this stage.
- Late Stable
It is the peak stage of the real estate cycle where prices begin to exceed the book value or reasonable property value. A peak increase of rent prices, new lows reaching cap rates, new highs reaching price bidding value, highest level of NOI increase and begins to turn down. Intense competitions for deals, readily available credit, freely available capital, prevalence of speculative buying are seen in this stage. If you are not a generational real estate owner, it’s time to sell assets.
Distinct markets experience distinct real estate stages
This six real estate stages is the independent occurrence in each market throughout the country. Also, within a market, distinct asset classes undergo through distinct stages in a distinct order. For an instance, if the single family falls on Late Stable stage and on its way of approaching peak, multifamily assets experience bottom stage of cycle in real estate market. Generally, single family and multifamily have a reciprocal relationship as tenants relocate from their apartments with the increase in home purchase.
There is no general thumb of rule for real estate cycle as it depends market scenario and asset class. So, by understanding the real estate cycle and related metrics in your local and other markets around the country, you can purchase assets at low and sells at peak prices. Warren Buffett calls the same as “business rates of return” with low risk. Begin building your wealth through compounding your equity.