Cycle-ology: Let’s Talk about Navigating the Market Cycles…
“Before you start trying to work out which direction the property market is headed, you should be aware that there are markets within markets.” - Paul Clitheroe, ipac
“How about this market?”
This seems to be a question everyone asks us. In fact, this seems to be the question we are asking ourselves… everyday!
Today, when it comes to market supply, we are finding that there is no shortage of opportunities. On the other side, however, we have discovered that market demand is off the charts (i.e. there is certainly no shortage of buyers).
There are a number of factors that are creating this unique environment we are seeing in current times, some of which we will discuss in a future discussion. For now, let’s focus on the market cycle.
So, let’s cover the basics first: “what is the market cycle?”
Four Stages of the Market Cycle
Phase 1: Recovery
“First Half of a Seller’s Market”
Common Characteristics:
Declining vacancy
Little or no new construction
To CF Capital, while there are great opportunities in every part of the market cycle, this is where we look to buy -- the contrarian’s realm (see post on contrarianism). Overall sentiment is weaker than normal, but that means there are opportunities for value investors like ourselves, to purchase a property at a more attractive price.
Less investors are in the market because they are still shaken up from the recession that recently occurred (Phase 4 of the looping cycle). Although a majority of the real estate markets emerge from this phase and move onto the expansion phase, some do not, which makes the market seem riskier to a number of parties tied into real estate.
With many of the signs for “happy hunting” to contrarian investors present, it is not all smooth sailing. It is common for property investors to have a harder time getting financing because the financial system is still adjusting from the last phase.
Phase 2: Expansion
“Second Half of a Seller’s Market”
Common Characteristics:
Declining vacancy
Some new construction
Inventory of new property slowly creeps in after a few years as real estate developers cater to the changing market forces. With a decreased supply and rising demand, we typically see prices, rents, and occupancy moving upwards as more (optimistic) people realize that property investments could be more attractive.
This phase can still be a great time to invest for us because good deals can still be found, and the market may have some lingering foreclosures from previous times. With that said, these deals still take quite a bit of work in order to be discovered.
Lastly, speculators start to appear - those who make a huge bet on future growth on individual real estate markets and use that as a foundation of their projections. This means they begin to pay less of a discount or even a premium for investment properties.
Phase 3: Hyper-Supply
“First Half of a Buyer’s Market”
Common Characteristics:
Increasing vacancy
New construction picking up
We like to think of this phase as the market “boom” as hyper-supply impacts the market and conditions for investors worsen. Currently, many markets are revealing signs that we are most likely in this phase.
It is not uncharacteristic to see skyrocketing prices, mass building projects, and everyone rushing to buy real estate. Builders should recognize what is occurring and should put the brakes on new construction and buyers should approach things with more caution.
The first part of Warren Buffett’s famous quote seems appropriate here: “Be fearful when others are greedy.”
Deals are harder to find, but we would still pursue them in select “pockets” in our target regions. We know that our usual emphasis on quantitative discipline and due diligence is important as ever. After all, it is all about the bottom line (speaking of, ask us about our new e-book on this topic).
Phase 4: Recession
“Second Half of a Buyer’s Market”
Common Characteristics:
Large increases in vacancy
New construction halted
Think 2008. Twice the trouble -- less renters on top of new property inventory. Rental rates and occupancy tanked, which, in turn, caused a large downturn in real estate property values. The building projects that initially seemed so promising are now unable to sell, causing the prices to shoot downwards. Another part of the domino effect is skyrocketing foreclosures -- more property owners are becoming underwater while investors find themselves unable to pay.
For contrarian CF Capital, this can be exciting. Although, everything must be carefully examined to avoid any value traps (i.e. “catching a falling knife”), especially for bad debt.
The second half of Warren Buffett’s quote aligns quite well with this phase of the market cycle: “Be greedy when others are fearful.”
Although we believe it is extremely hard to market time, we remain patient and wait for signs. Among many indicators, we like to look for the market supply to dip below the market demand. This is where the gems can be found.
When the market hits the bottom, which is not always easy to tell, this is the best time for real estate investors like us to capture some excellent property deals (while “elevating communities together”).
Important Considerations: A (Very) Brief Overview
As we go through our investment process, we like to focus on many metrics when navigating the market cycles. But we also favor a few criteria when investing in multifamily properties.
Cash-on-Cash (“COC”) Return: We expect to earn an absolute minimum of 7% COC return over the hold period of a property. We focus on acquiring multifamily assets that provide stable cash flow, capital appreciation, and a margin of safety.
It may be more difficult to find these deals in the current market, but we trust that our strict discipline will serve us right even if it means analyzing a lot more deals.Debt-to-Service-Coverage Ratio (“DSCR”): We shoot for something over a 1.25 DSCR (= Net Operating Income “NOI” / Annual Debt), which goes above and beyond what most lenders typically require. Put simply, a property with a 1.25 DSCR is generating 25% more income than the amount that is needed to pay the debt. For distressed opportunities, in the short term while repositioning we would like to see a minimum of 1.0 DSCR while capitalizing reserve accounts appropriately.
Cap Rates: As the market continues to appreciate across the nation, we continue to see further cap rate compression. That’s because of the inverse relationship between property values and cap rates; as property values increase, cap rates decrease. In our target markets, we aim for garden style, Class B, or Class C assets with a cap rate greater than 5%, generally, even though we are more cash-on-cash driven and less driven by cap rate (that said, cap rate is a great barometer on the appropriateness of value). If we can’t find the risk/reward ratio we are looking for, we will just move on unless there are exceptional value-add opportunities to increase the NOI significantly.
In one way or another, we would like to think that we have a leadership mindset. As such, we know that consistency and discipline in the investment process allows us to analyze deals faster and become better and better at our underwriting.
We take away the emotion from the process, and the numbers as well as the qualitative facts become our focal point. We don’t make the mistake of falling in love with a deal as that can lead to poor outcomes. Instead, we fall in love with what we know, including the numbers.
What Market Are We in Today? Closing Thoughts
At this point you are likely asking yourself, “Okay… so which phase of the cycle are we in today?”
Although each region and submarket differ, we believe that we are in the "oversupply phase" broadly across the nation in the multifamily asset class. It is certainly ironic to think about as we are in the midst of a unique economic situation brought down by the pandemic. New construction continues to increase and prices continue to rise.
It’s important to remember that the dependable real estate cycle is never certain. We can count on the boom and bust real estate cycle being fed by supply and demand. But, general trends and estimates can be made by looking at the facts from the past. Timing is always a source of uncertainty, as external forces (e.g. interest rates, politics, etc.), can make a huge difference on the roller coaster ride of the real estate market.
We understand this. We also understand when fear, rather than educated decisions, drives prices down, it is probably a good time to work harder to find opportunities when the crowd goes running for the hills.
CF Capital knows that investments can be made in any market if there is focus and an avoidance of getting caught up in the “hype.” We will remain diligent and focused on success for our investors in the long term, rather than making rash decisions on the short term nature of the market cycle.
So we would like to leave you with these questions:
What do you think? What market are we in? Where are we headed?
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