The real estate market operates in cycles, featuring four distinct phases, each influencing differing investment opportunities. Understanding the market cycle empowers investors to discern between investments to maximize returns. The two most popular strategies are the gains approach and the cash flow strategy. This article explains both strategies and in what phases they are most commonly used.
Gains Strategy vs. Cash Flow Strategy
The two most common and widely discussed, investment strategies are the gains and cash flow strategies.
A gains-focused investment strategy revolves around acquiring properties at a low cost and selling them at a higher market value, generating a profit (gain) between the two transactions. In multifamily real estate syndication, the business plan often outlines acquiring undervalued properties, implementing light renovations, and selling at a significantly higher market price. This strategy may not always result in a quick turnaround and the cash flow may be relatively light.
Conversely, the cash flow strategy involves a buy-and-hold approach, where the buyer retains the property for an extended period, anticipating consistent monthly distributions. This strategy is exemplified by rental properties with established, reliable tenants, particularly in large apartment complexes. While there may be some natural appreciation, the business plan’s key highlight lies in the predictable, ongoing returns.
The Gains Strategy
To define it simply, the focus is to create profit. The project creates backend equity for investors. A very typical example of a gains investment is a new development. While a property is under construction there is no cash flow to be distributed. The business plan for this investment typically has the sponsor/builder finishing the property in 2-3 years and then selling to an operator. This ensures profit at the time of sale. Often development opportunities are most successful during the expansion phase of the real estate cycle. This is the second phase of the cycle and a time in the economy when the general public starts to regain confidence in the economy. Thus, renters begin creating higher demand once again.
Another example of the gains investment strategy would be a distressed property or foreclosure. This is an asset being sold under market value requiring some TLC and would generate very little or no cash flow. Once renovations are complete, it would be worth significantly more and produce a profit upon sale. Distressed properties will be most prevalent in the recession phase or recovery phase. Both phases require patience while the economy rebounds to allow the desired gains from the anticipated sale.
The Cash Flow Strategy
Investing for cash flow refers to an investment that consistently receives monthly or quarterly distributions throughout its lifespan. Unlike the gains strategy, this approach does not rely on market timing to maximize returns through strategic property purchases and sales. Ideally, a cash-flowing investment generates sufficient income to cover essential expenses such as the mortgage, insurance, maintenance, and potential renovations while still producing excess cash flow and profits.
How It Works
This strategy is a buy-and-hold strategy. The typical timeline for this strategy is 3-5 years. The investment concludes with a capital event such as a refinance or sale of the property. Generally, in a Viking Capital investment, at the time of a refinance, when excess proceeds are dispersed from the bank, many investors receive a return on capital. In some cases, an investment class such as Class A, (who does not receive backend equity) would be made whole with a return of capital and taken out of the deal. In this situation, all other investors would continue to receive their distributions until the sale of the property in year five.
Though this strategy is not dependent on the market timing, the most optimal phase of the real estate cycle to find these opportunities is the hyper-supply phase. This is the third phase of the real estate cycle and refers to the oversupply and under-demand for housing following the expansion phase. As an investor, resilience is key during such periods. Property owners may resort to liquidating their inventory due to concerns about potential vacancies or unsold properties. This presents a unique opportunity to adopt an opportunistic approach. Investors should identify properties with confidence in their performance in the upcoming real estate cycle. Embracing the buy-and-hold strategy during this phase ensures a portfolio of promising properties, poised for optimal selling opportunities when the market conditions become favorable once again.
Impact of Market Conditions
In real estate investment, numerous factors come into play, ranging from cap rates and interest rates to geographic location and sponsor credibility. However, one of the most important considerations is the economic market conditions. Assessing the real estate market cycle enables investors to make strategic decisions for their investments. These cyclical and evolving conditions can be forecasted to provide a general understanding of future trends.
Understanding the impact of the economy is paramount. It not only prepares investors for potential downturns but also establishes timelines for current and future investments. Most importantly, it allows them to capitalize on the opportunistic characteristics of phases 1 (recovery) and 4 (recession). Although these phases can create adversity, they can also create opportunities for investors who use this knowledge to their advantage.
Key Takeaways
No matter which investment strategy you prefer, it’s important to utilize the economic forecasts from professional economists. Understanding the nuances and characteristics of each phase allows investors to make calculated risks aligned with the nature of the real estate cycle.
The primary distinction between the gains and cash flow strategies lies in the timing of realizing the return on investment. The gains strategy focuses on backend equity, while the cash flow strategy involves receiving regular distributions, gradually contributing to the total estimated return.
In conclusion, both strategies play integral roles in an investment portfolio. Having both provides diversification and minimizes risk throughout the real estate cycle.
