The property cycle 2
The next stage of the property cycle that is very unpleasant for some people is the depression or the slump. It comes after the burst of the boom. In this period of time the interest to the properties declines and the supply continues to rise. There is mismatch between increasing supply and diminishing demand. The prices start to decline rapidly. The fear dominates the market. If you ask yourself why the supply continues to increase you must consider that the real estate production is long process that requires many months and even years. It is possible that you have started a project in one phase of the market and must sell your ready project during another phase of the cycle. And believe me during a boom many new projects are started.
The investors, who had the idea to make a quick fix&flip are often caught by surprise by the downturn of the market. All potential buyers are gone and this could be a problem if you can't keep the assets long enough. One reason could be that your investment is generating negative cash flow that it eating you alive. A situation like this one could easily put the short-term investor under pressure and force him/her to sell the asset. This comes at a very high costs, because the market in a depression phase becomes very illiquid. There are simply very few buyers and they are pushing very hard the price down.
Where is hidden the danger actually? Some fix & flip investors finance their deals with relatively short-term loans. They prefer not to pay monthly principal repayments, because they would repay the whole loan when they sell the property. In order to get a deal like this (with 100% bullet payment at the end) they often agree to pay higher interest rate. Hence their monthly payment to the bank consist only of the interest payment. However, they don't have any income from the property until the sale, so even this payment is a negative cash flow for them.
In a situation like this you should think of a workout of this deal. My experience so far shows that the sale is not always the smartest thing to do. It's much better to renegotiate your loan with the bank and structure it for a much longer period and rent the property. You will gain some time this way.
The depression is the time when all your mistakes as investor will become unfortunately visible. If you have chosen the wrong location or selected the wrong property, you will notice it very quickly in this stage of the market. You will see how the downturn in some areas is not so dramatic and in others is much fiercer.
This is one of the reasons why I basically don't like the short-term deals for myself. I have done some of them, but in general I try to avoid them.
One of the consequences of the depression is the lack of financing for your investments. The banks become much more restrictive in this stage of the market. The fear rules the day at all levels. If they were willing to give you up to 90% of your property's market value during the boom, now they will reluctantly offer you 60% of its liquidation value and add many restrictive covenants in the loan agreement. On top they will offer you an interest rate that is much higher than the interest rate in the boom phase. They will ask you to provide them with additional collateral etc. Of course, in each country the praxis is different. Please check diligently what is the experience of your fellow investors in the country where you want to invest.
Having said that you already know that you must find your financing or refinance during the boom and not during the slump. The banks are fighting for your business during the boom and this is the right time to ask them for their services. In the slump phase they will be happy if you prepay your mortgage.
These are natural cycles of the market and you will witness at least several full cycles during your lifetime. The whole cycle is about 18 years. In general, it is 14 years up and 4 years down. Remember when was the last boom – 2005-2008, right?
Let us now go to the third phase of the cycle, namely the recovery. The recovery start at the very bottom of the market. Everything is "frozen" at a very low level and the real estate market seem to be forgotten from everybody. It seems as if this will never change. Many people believe that the glory of the real estate is over once and forever. Because of this many leave the market and transfer their capital to more promising markets. Remember that the sellers are again the short-term investors. They are the ones disturbed by the prices of the real estate. The long-term investors are happy to receive in their bank accounts their recurring income each and every month and don't bother what is the market value of the property right now.
When the last recovery occurred on your market? The world crisis in 2008 launched the slump and in many markets, it lasted until 2012-2013. Then slowly the market began to recover. So, the depression lasted around 4-5 years.
Actually, the long-term investors are waiting for this stage of the market, because they can easily find everywhere very valuable gems on the market. The yields are at their highest point and the prices are at their lowest point. This situation provides marvelous opportunities for investing. The tragedy for ones is a feast for others as everywhere in the nature. In order not to be on the losing site always invest in a way, so that you have positive cash flow. That means the time should not run against you. Keep in mind that there will always be inpatient investors, who are chasing the quick buck and will buy properties for a quick profit. They are taking the bigger risk because their strategy depends on the market value of the property at the time, when they are ready to sell. Be patient and wait for the right time. It will come. For sure.
Let go back to the initial stage of recovery of the market. This is also a long period in the cycle. Everything is moving very slowly. The construction companies are coming gradually back to the market. The building permissions rise slowly. New buildings start to emerge, but there is no enthusiasm on the market yet. The buyers execute no pressure on the sellers. Not yet. The market is still in the hands of the buyers. They have the bargaining power to negotiate good deals. The sellers accept the conditions of the buyers, because there is no depth of the market and buyers are not so many.
In this stage the banks start to grant loans more easily and to ease the conditions for the mortgage loans. The financing percentage rises again and in certain cases the banks are willing to finance 90% of the market value again. With a delay of 10-12 months the easing of the financing and the reduction of the interest rates causes increased demand for real estate. This is very slow process and you could observe it and take the respective decisions and adapt your behavior. Notice something very, very important! The interest rate on the mortgage loans is a pre-indicator for the rise of the real estate prices. Take a deep breath and read the last sentence once again. This is so crucial. On the real estate market not only, everything moves like in slow motion film, but you have warning 10-12 months in advance for the direction of the market. How cool is that?
I hope you will keep several very important insights from this article. This is one of them. I will repeat it again. The interest rate on the mortgage loans is a pre-indicator for the real estate prices. When the interest rate on the mortgage loan start to decline, expect with a delay in the time of 10-12 months rising real estate prices. And vice versa. If the central banks start to rise the interest rates and the respective interest rates for mortgage loans rise, you might assume declining property prices.
The easy access to fresh financing leads to a higher interest for properties and it is more difficult for the buyers to push the prices low. The profitability of the deals starts to decrease, because the prices of the properties are increasing. It is increasingly hard for the buyers to push through their conditions in the negotiations with the sellers. The property prices start to increase slowly, but steadily.
This part of the cycle last also several years and the described tendency remains with a bit higher acceleration each year. The people get used again to hear more positive news about the real estate market. The fearful predictions are gradually forgotten.
As mentioned as a whole the full duration of a property cycle is about 18 years. Nothing repeats itself absolutely exactly with the same pattern.
It is not difficult to ride the property cycle, but nevertheless it is speculative to rely to sell your property exactly at the top of the boom and to buy at the lowest point of the decline. If you miss the boom to sell your property you will need to wait many years until you will have a second chance. That's why it is better to receive a positive cash flow during this long period expecting the next boom.