Understanding Linear and Cyclical Markets | PREI 006
What’s the difference between a linear real estate market and a cyclical market? Is one better than the other? Today we explore the different market types and what they mean to you as a real estate investor.
We also take a quick look at a turnkey property available in one of our linear markets with great cash-flow and high rates of return.
We also take a look at a real world example available today from www.NoradaRealEstate.com.
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Understanding Linear and Cyclical Markets
Welcome back to another episode of Passive Real Estate Investing. I’m your host, Marco Santarelli. This is the show where busy people like you learn how to build substantial passive income while creating wealth for the long term. Thanks for joining us. If this is your first time here, welcome. If not, we’re glad to have you back.
Today’s show is about something that I talk about on a very regular basis. Something that most people understand conceptually but a lot of people still don’t completely understand. This is really important if you’re a real estate investor, especially when you’re in the early stages of selecting what markets to invest in. This is the concept of linear and cyclical real estate markets.
Cyclical markets are real estate markets that tend to have larger price moves up and down over the years. Property values will move up and down like a roller coaster and they have noticeable peaks and troughs. They are essentially the shooting stars of the housing market. These are the markets that have the booms and busts. The length of the cycle can vary from market to market because, as you know, all real estate is local. That’s the saying in real estate. These cycles can last from seven to ten years from end to end. Many of these cyclical markets are found along the east and west coast of the United States where the household incomes are higher and land for new construction is in short supply.
Good examples would be coastal markets along the coast of California, New York, New Jersey, as well as many parts of Florida, from Miami on up north. When conditions are ripe and the annual housing price gains in these areas go up, you can see 20 to as much as 30% or more in property values in a single year. These are crazy rates of appreciation and they are absolutely not sustainable.
You may remember back in 2005, 2006, we’ve seen appreciation rates in southwest Florida, in the areas like Lee County go up 32 to 40% in a single year. There were two years back to back where they had large double digit returns. We all know what happened. Years later, that market became one of the ground zeros of the foreclosure crisis. Las Vegas, Phoenix, Riverside, California, southwest Florida, these were areas that had some of the largest number of foreclosures.
We saw property values increase dramatically and then come crashing down. These local booms burn themselves out by pushing prices to unaffordable levels. When those prices get to those unaffordable levels, very few, if any, people can afford to buy the median priced home. At that point, what happens is buyers dry up, there’s an excess amount of supply and that equilibrium no longer exists. The pendulum swings from one end to the other and property values come crashing down since there’s no one to buy these properties because of the lack of demand. You get a galette of inventory.
I often refer to these markets as bubble markets because they appreciate in value so dramatically in a relatively short period of time but they come crashing down as the economy changes and brings property values back down as quickly as it went up. Often, at double digit rates.
We try to avoid these cyclical markets. In fact, we’re not in any cyclical market at this time. We don’t advice our clients and investors to speculate and chase appreciation in these high stress, high appreciating markets. Although it’s great when you have appreciation, we consider that icing on the cake. The most important thing is the cash flow and potentially the equity in the property. You want to invest in property, in a market that makes sense the day you buy it with positive cash flow.
Appreciation will happen over time, equity will grow over time. You shouldn’t be investing in a market primarily for the reason of appreciation. That’s chasing after gains that don’t exist, they’re phantom gains on paper. They’re never realized until you actually sell the property. That’s when you could literally realize a gain and place those gains in your pocket in the form of cash.
As quickly as property values can go up, they can also come down. It’s very difficult in real estate to time the market. Granted, real estate is a slow moving asset class and that’s one of the great benefits of real estate. However, if you notice that a market that you’re in has changed or flattened out or is declining, you can get out of that market and do a tax deferred exchange, a 1031 exchange out of that market into another market by simply selling that property under that exchange, taking the equity out of that property, moving that equity tax free into another market where you can pick up more properties or step up into a larger numbers of properties or larger types of properties such as multi unit properties. Keep that equity, increase your cash flow and get into a market that may see or have better price appreciation potential than the market that you’re coming out of.
Let’s talk about linear markets. A linear market is a real estate market with more of a flat growth curve over time. If you looked at a graph with an X and Y axes, you would see that that trend line would start in the bottom left and over time fluctuate mildly to the top right. You would see average annual increases in appreciation. You wouldn’t see crazy spikes up and valleys down.
In other words, this graph would have a more visually smooth and steady growth with no major spikes or declines. Linear markets are where booms and bust virtually never occur. We’ve seen this in states like Texas back in the housing boom and bust in the mid 2000s up to about 2008. There were many markets throughout the mid west all the way down through to Texas where we saw mild appreciation rates and then when the housing markets around the US crashed or deflated, we saw these markets in the mid west and in Texas come down. They were single digit changes. They weren’t erratic or crazy changes.
Some people refer to these markets as boring markets because they are relatively lower in terms of annual appreciation rates. But they happen to be the markets that provide some of the best capitalization rates and some of the best cash on cash returns. Many of the linear markets around the US are in the interior middle American heartland, what we know as the mid west, as well as some of the southern, in other words, Texas, and southeastern states of the United States like Georgia and Tennessee.
Interestingly or coincidentally, these are the markets that we tend to focus on. For example, Memphis, Atlanta, San Antonio, Houston, Dallas, on occasion, Oklahoma City on up to Indianapolis, Kansas City. These are markets that we have been in for many years, they’re what are essentially perineal markets for us. There’s always great cash flow opportunities, they’re predictable markets, they don’t have any surprises, we have very good, average annual appreciation rates.
The most important thing is, everything in these markets for us where we are focused on makes sense the day an investor gets involved in these particular properties. Focus on these linear markets because over time, some studies have shown that these linear markets actually perform just as well, if not better than these cyclical markets with higher rates of appreciation.
Of course, when I make a statement like that and you look at these studies, it actually averages out the peaks and valley into the entire equation. It’s not a very small set of data. In other words, we’re not looking at a three year period of time. We’re looking at a ten, fifteen, twenty year period of time.
In between these cyclical and linear markets, we have another market type and what we may call a hybrid market. A hybrid market are markets and areas that have linear slow growth characteristics for a short period of time followed by periods of more moderate cyclical style appreciation. These markets never boom quite like in the Florida, in California markets. These markets never need to correct like the more volatile markets.
Markets like Phoenix, Las Vegas, Chicago, Seattle, Minneapolis, St. Paul and Detroit are actually in this category. They’ve seen periods of slow steady growth. Sprinkled in to that timeline from time to time, they would see peaks and valleys in terms of price of appreciation. These are hybrid markets, something to keep an eye on.
How do you compare these different market types? Although each market has a different characteristic, one is not necessarily better than the other. Each market offers the real estate investor different levels of appreciation and different levels of cash on cash returns. Some investors may not sleep well at night investing in a cyclical market and they prefer the pace of a linear market. While other investors may find a linear market too slow and prefer to see these greater appreciation gains that are found in some of these coastal markets and cyclical markets. However, over the long term, appreciation rates in both market types end up being about similar, as I’ve said a minute ago.
The idea of chasing after appreciation, or what I call speculating, should be avoided. The best strategy in selecting a market is to focus your investing in good markets, then good neighborhoods an then on good properties within those neighborhoods, followed by great property management and you will be very very successful. This is a tried and true formula. It works all the time. This is how many people create wealth and build substantial passive income.
If you have any questions about this, please go to our website, PassiveRealEstateInvesting.com and submit a question or you could leave a voicemail. We’ll read some of those questions on the next episode and address any ambiguity or clarification that you want on these types of markets.
Speaking of linear markets, let’s take a look at one of our linear markets, Birmingham, Alabama as our deal of the day. We have a new all brick property on 18th Avenue North in Bessemer, which is a suburb of Birmingham. This three bedroom, one bath home is $51,800. It rents for $750 a month. That’s a whopping 1.4% rent to value ratio.
This property will generate a net operating income, gross $580 a month. It has a cap rate of 13.5%. It’s in a very good neighborhood, what we’ll call a B to B+. It was freshly renovated. It’s completely turnkey. It’s gone through an extensive renovation. New HVAC unit, a new hot water tank, a great condition roof, all the plumbing and electric has been checked and repaired as needed, they’re a new light fixtures, plumbing fixtures installed. It is a beautiful like new property. This property’s available but may not be for long. It’s one of the many properties available on NoradaRealEstate.com, something you can check out.
In closing, please remember to download a copy of our free report, the Ultimate Guide to Passive Real Estate Investing. You can find that at both of our websites, NoradaRealEstate.com or PassiveRealEstateInvesting.com. While you’re there, you can submit any question or topic suggestion you have, just fill out the form or click the button on the right that says, “Send us a voicemail.”
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