Real Estate Cycles and Opportunities
Real estate experts and analysts explain that the industry has four distinct cycles that can be tracked and observed. Monitoring the long-term real estate cycles is vital for success as a real estate investor, either with personal investments or an asset that is a component of a diversified investment portfolio.
The four primary real estate cycles are recovery, expansion, hyper-supply, and recession. Each stage typically lasts about 10 to 20 years and is affected by several economic and demographic factors.
Recovery: The stage usually follows a recession. In this stage, demand for real estate rises due to an improving economy, though interest rates remain relatively low. Property prices are often low, enabling investors to buy properties at a discount. Investors often snap up properties that may be in financial or physical distress to improve and then sell these properties at a profit when the economy fully recovers.
Expansion: The stage features robust economic growth, which increases demand for real estate and boosts property values. Due to these favorable conditions, developers launch new projects due to the expanding demand. There are still attractive opportunities during this stage, but savvy investors must do their due diligence to scout out properties with the best value proposition. With the economy humming, investors may look to develop or redevelop properties to cater to prevailing market tastes and trends.
Hyper-supply: Dynamic, new construction during expansion can lead to a short-term glut of supply and, in turn, can lead to a drop in property prices. Typically, real estate investors try to offload their properties to take advantage of their accrued equity. Declining prices may discourage investors because properties may be on the market for a protracted period due to saturation. The best strategy in this stage may be to buy and hold buildings that will be more attractive to sell as the economy cools.
Recession: In this stage, purchases reach a trough due to a general slowdown in economic activity. This stage can be difficult for many property owners and an opportune time for savvy investors. Some investors who are underwater on their mortgages and losing tenants may have to unload properties at a loss. Unfortunately, property prices retreat, and many properties go into foreclosure. At this point, opportunistic investors can buy properties at low prices, but they must have a clear vision about how to turn around these investments.
Studying long-term real estate cycles or stages is essential for investors who want to assemble a profitable real estate portfolio. As a result, investors can make intelligent decisions about the right time to buy, hold, or sell their properties.
An example of investment savvy is adaptive reuse, for example, an investor who purchases a hotel with a plan to convert it into a multifamily complex. Similarly, an investor can buy an office building to convert it into mixed-use property while reducing the office footprint. Third is transformational renovations. For example, an investor can buy an older and tired class C multifamily project in a great location, gut it and turn it into a much higher quality product.
These are some of the best strategies when the real estate cycle enters a time of great stress where investors can buy assets below the cost of building them. During these periods, many property owners must sell assets because their loan terms are about to reset or other factors.
Current Market Conditions: Distress or Stress
As the real estate market declines in a difficult economy, investors differentiate between assets under stress versus distress. To define a property under stress, Jeremy B. Hill of JB Capital writes that a stressed asset may be experiencing financial hardship due to a temporary economic downturn, such as the COVID-19 pandemic, or the difficulty may be due to issues like liquidity or rising interest rates.
Distress typically refers to an asset with much more significant fundamental problems. For example, the property has passed the stress stage and now requires immediate assistance (usually within six months) before it becomes balance sheet insolvent, i.e., unable to pay its debts on time. Common signs of distress include prospective covenant breaches, high-interest payments, stagnated or diminishing cash flow, falling margins or extended creditor days.
According to MSCI, distress (including financially troubled assets and assets repossessed by lenders) outpaced workouts between property owners and lenders by about $8 billion during the second quarter of 2023. The $8 billion represents the most significant growth in distress in a quarter since the second quarter of 2020 at the onset of the pandemic. The real estate sector with the most distress was office, representing 80% of the distress added in the quarter, with $6.7 billion in net inflows.
By June 30, the office sector had the largest share of market-wide distress, according to MSCI, representing the first time since 2018 that retail or hotel sectors were not the largest contributors. Major office building owners have defaulted on a large amount of debt in 2023.
There have been a few recent well-publicized cases, such as in downtown San Francisco, where owners who were underwater because the properties were worth less than their debt just walked away from their properties. However, overall loan defaults and delinquencies remain relatively low for now.
Investors who want to purchase these assets from lenders may acquire them at favorable prices. That is because lenders want to recover the amount due on their mortgages, and the buyers may be able to negotiate a lower price than if they were bidding on the property on the open market.
The current economy continues to boom in many ways with high employment, but higher interest rates have negatively impacted several commercial real estate market sectors. The U.S. real estate has enjoyed a bull run for nearly a decade but now faces headwinds. For example, there has been a slowdown in the construction of new multifamily properties in recent months.
Construction statistics for multifamily units with five units or more declined 26.3% to a rate of 334,000 units in August, the lowest level since August 2020, according to U.S. Census Bureau data. Multifamily housing construction peaked in April 2022, when higher mortgage rates led numerous potential home buyers to rent apartments, according to U.S. Census Bureau data.
According to recent Goldman Sachs Global Investment Research, commercial real estate has “significant headwinds,” including tighter credit income pressure and elevated refinancing needs in the next two years. The company estimates that the refinancing needs are quite large—about $1.1 trillion worth of commercial mortgage rates are expected to mature before the end of 2024.
Unfortunately, many borrowers may have to refinance existing loans at higher interest rates (unless the Fed lowers interest rates next year). Goldman Sachs writes that the risks are most significant for owners of office properties, with a few prominent commercial real estate loan defaults hitting news headlines. However, other commercial real estate sectors may be more resilient in the remainder of 2023.
In fact, Cred iQ, a real estate data, analytics, and valuation company, reported in early October that the Special Servicing Rate has continued to rise year to date in 2023. The overall distressed rate (combining the two indicators of distress, the delinquency rate and special servicing rate) was 7.43% in September of commercial mortgage-backed securities (CMBS), a climb of 26 basis points from August.
Another barometer of real estate distress, a report from MSCI Real Assets, stated that the distress volume rose in 2023. The balance of distress in the U.S. commercial property market increased to $71.8 billion in the second quarter of 2023, the fourth consecutive quarter of growth.
A measure of real estate executives’ opinions on the market, The RCLCO Current Real Estate Market Sentiment Index, which measures sentiment on a 100-point scale, rose 10.7 points to 19.0 for the six months ended June 30. The index improved slightly from year-end 2022 but still reflects an opinion of challenging market conditions.
Looking forward to 2024, respondents expect improvement in the real estate market, but it will stay in the distress mode. However, niche sectors such as self-storage, seniors housing, grocery/necessity retail and hospitality should be more resilient than the overall market. Nearly 20% of respondents said the office property sector will have the largest weighted peak-to-trough, with 40% predicting that the decline would surpass 20%.
The real estate market is entering a more volatile and confusing period as borrowers with stressed or distressed properties whose values are underwater or close to it will face a difficult decision: Either sell the asset, possibly at a loss or give it back to the lender, which has happened several times this year. The other choice is to hold on to the property and try to negotiate with lenders to extend or restructure existing loans.
As a result, staying up to date about market conditions is crucial for making informed investment decisions. Regardless of market conditions, savvy investors can shift their investment strategies to respond to the prevailing economic climate and pinpoint the best opportunities. These investors can manage risk, capitalize on superior investments and hopefully optimize returns. For example, during an economic downturn, investors may pivot their portfolios towards more conservative, low-risk assets to protect their investments. In contrast, in a booming economy, it may be advantageous to focus a portion of the portfolio on riskier assets to capitalize on higher returns.
Now in a climate of relatively higher inflation (though inflation has dropped quite a bit from last year), different types of assets may be impacted in divergent ways, i.e., real assets such as real estate and commodities may outperform. The bottom line is that reassessing and adjusting investment portfolios as the economy rises or declines can help sustain an optimal asset allocation and generate strong returns. In turn, maintaining a diversified portfolio can create a hedge against inflation and minimize losses during economic downturns.
About CaliberCos Inc.
Caliber (NASDAQ: CWD) is an alternative asset management firm whose purpose is to build generational wealth for investors seeking to access opportunities in real estate. Caliber differentiates itself by creating, managing, and servicing proprietary products, including middle-market investment funds, private syndications, and direct investments, which are managed by our in-house asset services group. The Company leverages access to both the public and private markets to maximize value for its customers and funds. Our funds include investment vehicles focused primarily on real estate, private equity, and debt facilities. Additional information can be found at Caliberco.com and CaliberFunds.co.