Small: Nearing the end of the cycle?
Since real estate investing is typically a long-term endeavor, it’s always important to keep an eye on where the market is in its cycle. Real estate is a cyclical industry rising and falling with the economy, inflation and interest rates. A real estate cycle is generally defined as the timeframe from a market bottom — when there are more sellers than buyers, prices are generally depressed and properties for sale are in abundance — to a market peak, where buyers outnumber sellers, inventory is scarce and prices are high, and then back to a bottom. Over the past 100 years, a typical real estate cycle has lasted, on average, about seven years.
Overlaying these seven-year cycles are more generational cycles that happen every 25 to 30 years. The generational cycles tend to be more extreme, and the correction can be pretty traumatic. Good examples of generational cycles in the residential market include the housing collapse when the Fed fund rate hit 20 percent in 1980 and the recent subprime mortgage crisis of 2008 to 2009. The commercial real estate market went through a generational cycle back in the early ’90s when a combination of overbuilding due to easy credit and a recession led to more than 1,000 bank and savings-and-loan failures, leading to takeovers by the federal government and the formation of the Resolution Trust Corp. to sell off billions in underperforming assets.
Most real estate economists believe that the last real estate correction bottomed around 2008 to 2009 with the end of the Great Recession. At this point, the real estate market would be about six years into its recovery. With a roughly seven-year market cycle, the question is whether we’re nearing the end of another market cycle. This is always a difficult question to answer, and it is always difficult to predict exactly when the current cycle may come to an end. However, there are currently some market indicators and patterns that are typically seen near a market peak. These are the current trend in pricing and capitalization rates on investment properties. The capitalization rate is a measure of the basic return on an investment property, similar to an interest rate on a debt instrument, and is determined by dividing the net property income by the sale price. As capitalization rates trend lower, sales prices trend higher.
In 2003, after the recession following the 9/11 disaster, the average capitalization rates for commercial investment properties in the United States were between 8.5 and 9.0 percent. Between 2003 and 2008, the period just before the onset of the Great Recession, average capitalization rates had declined to about 7.2 percent. As the Great Recession took hold, the average capitalization rates on commercial investment properties rose to about 9 percent across the country, and many investment properties lost 30 to 50 percent of their value. Since peaking in 2009, capitalization rates have again declined steadily to their current level of about 7 percent as more real estate investors have driven up the value of properties. In the major gateway cities, such as New York, Washington, Los Angeles and San Francisco, the commercial real estate markets are currently described as “priced to perfection,” meaning that in order for a property to appreciate in value, all aspects of the market from rental rates to property management have to fall into place perfectly.
In the Aspen market, similar patterns may be developing. Both the residential and commercial markets in Aspen bottomed in 2009. The market is about six years into its recovery phase. The residential market pattern of increasing sales volume and declining inventory is trending in the direction of the pattern that existed in 2006 and 2007, just before the last market correction. The most recent commercial real estate sales in Aspen are at values and capitalization rates not seen since just before the last market recession. If you’re a seller, this could be a great time to sell. If you’re a buyer, it’s possible that the market could be just 12 to 24 months away from the next market peak and correction. As Warren Buffett likes to say, “Be fearful when others are greedy, and be greedy when others are fearful.”
William Small is managing director of Zenith Realty Advisors LLC, a firm specializing in advising investors and owners of investment real estate. If you are interested in receiving his reports on real estate investing and trends, you can reach him at 970-925-3866 or firstname.lastname@example.org.
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