The end of the beginning – deciphering the stages of the downturn

Welcome to this issue of the Memo.?

We are going to stay on the topic of market cycles in this issue as it is arguably the timeliest investment fundamental currently in play.? Specifically, what stage of the downturn are we currently in?? To answer this question requires a bit of background – so let us start with a refresher of the main phases of the cycle.

Broadly speaking, we can break the real estate and business cycle down into three phases.? Peak, trough and expansion.? ??

Even though both the real estate and business cycles mimic the above illustration they do not usually occur at the same time.? The real estate cycle typically precedes the business cycle.? This makes perfect sense if you think about it – a slump in construction leads to a reduction in durable good sales (carpet, refrigerators, building materials, etc.) and finally employment.

This happened during the last downturn as the real estate industry entered a slump in late 2006 through 2007 prior to the broader economy tanking into the GFC of 2008.

Now that we have the bird’s eye view on the phases of the cycle, let us discuss the stages within the phases.? Each phase (peak, trough, and expansion) has distinct stages, a beginning, middle and end.? In real estate, research has indicated these phases and stages play out roughly over an 18-year period.

The 18-year real estate cycle is a concept that suggests the real estate market follows a predictable pattern of boom and bust approximately every 18 years.? This cycle, first popularized by economist Fred Harrison, has been researched all the way back to the origination of private real estate ownership in the U.S in 1800.

This cycle has been observed in various economies over centuries, with notable examples in the U.S. real estate market. While the specific timing and impact of each phase can vary due to external factors like government policy or unexpected economic events, the general pattern tends to repeat itself, making it a valuable tool for investors aiming to understand long-term real estate market dynamics.

If you asked me to summarize how this cycle works in a numerical equation, I would show you:

7 + 7 + 4 = 18.? The illustration below neatly encapsulates a visual representation of the 18 – year cycle.

To summarize the 18-year cycle, you just need to understand the following:

1. This is the average number of years for each full real estate cycle in the U.S. and other Western countries.?
2. The cycle consists of two expansionary halves of 7-years each, with a short mid-cycle slowdown in the middle, followed by a 4-year recession period.

How does this fit into today’s market?? Almost perfectly.? If we use transaction volume to pinpoint the low of the last downturn, it began in 2009.? Adding the 14-years of expansionary phases we end up in? the year 2023 – just around the recent peak in the market.? This indicator tells us we have entered the recession phase – but remember, there are stages within each phase, a beginning, middle and end.

Let us do a little deeper dive on the beginning stage of the recessionary phase in our Expert Insights section below.

Expert Insights:?Characteristics of the beginning stage of downturn

The downturn is a difficult phase of the property cycle but can also offer the greatest opportunity.? Most investors misunderstand this phase and believe prices crash instantly as the market enters it.? The beginning of this phase is much more subdued than many anticipate before the slump inevitable bites.?

During the beginning stage, affordability becomes an issue as a result of the former expansionary (boom) phase.? The boom phase pushes pricing to levels that cannot support required investment returns.? As a result, buyers begin to pull back on acquisitions.

In addition, lenders begin to pull back on their loan-to-value (LTV) ratios.? Whereas, previously they would have supplied a 75%-80% LTV loan, they now will only supply a 50%-60% LTV mortgage.

This pullback begins to manifest itself through diminished transaction volume.

Typically, there is also an oversupply as deliveries begin to come online that were started at the end of the expansionary phase.? Notably in this stage, there is a significant lead time before all the new supply is delivered, with demand (vacancies) continuing to soften before inventory peaks.

Sentiment plays an integral role in the beginning stage, as fear begins to take hold as investors realize that the boom period in now just a memory.? This realization takes some time, as many inexperienced investors feel secure their investment position will remain sound, despite falling values and eroding ?fundamental drivers indicating the boom is over.

The beginning stage of the slump is also accompanied by media headlines as the experts begin to note the shift in the market as real estate loses favor as an investment vehicle.? Many inexperienced, and a few of the true experts (because of their vested interests), will still be marketing the praises of investing irrespective of fundamental value, reassuring investors the market will soon rebound with similar growth that has been experienced in the preceding few years.

During the beginning stage of the slump, astute and knowledgeable investors will start to position themselves to take advantage of opportunities to purchase repriced opportunities through forced sale situations.? These investors will still be reluctant buyers at this stage, as they know the next stage (the middle) will produce even better opportunities.

How do we tell that we are about to enter the middle stage of the downturn when the buying opportunities are at their best?? When forced property sales become commonplace.? We are just now starting to see the first trickles of foreclosures, while lenders are under increasing pressure to resolve a gigantic backlog of extended loans that are maturing.

This brings us full circle with our lead-in for this issue, the beginning of the end.? Based on previous cycles, it appears we are at the beginning of the end of the beginning stage.? Wow - that is a mouthful, but it does realistically portray where we are in the current downturn.

The most important takeaway in understanding the beginning stage of the downturn?? This is the stage where you prepare to take advantage of the buying opportunities that will emerge in the next stage – the middle.? Specifically,? by accumulating dry powder and putting in-place your investment platform so you can deploy capital at scale, targeting out-sized returns, in the middle stage of the downturn.

The most severe downturns are led by both overpricing and overbuilding.? The more overpriced and overbuilt the market becomes, the harsher the correction in values will be.? Corrections of the magnitude we are currently experiencing take time to play out – at first slowly, and then all of a sudden.

It is when the fear that has accumulated during the beginning stage of the downturn translates into panic, that the best opportunities present themselves in the middle and end stages of the downturn.? We will cover the characteristics of the middle and end stages of the downturn in the next two issues.

That is a wrap for this issue. ?We hope you have found it enlightening and invite you to contact us with any questions or thoughts.? We are always happy to help.

Finally, if you have not already, be sure to Subscribe for more insights gleaned from over four (4) decades of navigating market cycles.? We look forward to bringing you more of the information you need for successful multifamily investing.