Most real estate investing strategies are focused on forced appreciation to generate lump sums of cash (fix and flips, short sales, foreclosures), others focus on cash flow (mobile homes, low-end rentals, Class C apartment buildings).

While building cash reserves and having cash flow are important, they will not lead to you building any significant wealth over time. Real wealth is only created through strategies that harness the power of compounding.

Banks know this. But for real estate investors, the only strategy that can really put compounding to work is buying income property at the bottom of the real estate cycle, when it’s available below replacement cost, and selling at or near the peak of the cycle, while trading far above replacement cost.

The real estate investors’ perk, the 1031 exchange, then allows your gains to be transferred from one market to another for the compounding to continue, unmolested by taxes.

This is why real estate is so great! The key, though, is being familiar with the real estate market cycle.

There are six stages of the cycle:

1. Early Downturn

This is the point at which the market has reached its peak. The forces that have been driving the market to this point begin to falter.

Occupancy is still very high but starting to turn down. Rent growth has flattened out, Net Operating Income is beginning to decline, Cap rates are ticking upwards, and prices are starting to fall. Credit, which may have been free flowing with good terms to this point, is tightening up and harder to come by.

Construction projects are being completed, bringing new inventory onto the market. Lessors are starting to offer concessions to tenants in order to sign new leases.

2. Full Downturn

In this stage, the “correction” of all pricing is now under way. The bottom has dropped out of demand, rents are falling, and lessors are renegotiating leases and making what concessions are necessary to get tenants to stay.

Vacancy is rapidly increasing. Sales volume is decreasing. The prices of properties that do sell are falling, and Cap rates are going up. Credit has all but dried up, and what is available is expensive with unattractive terms.

Foreclosures are increasing. Developers with completed projects are selling at fire sale prices, or filing bankruptcy if unable to raise more capital. Operators are in survival mode, trying to keep NOI high enough to cover their payments.

3. Bottom

At the bottom of the real estate cycle vacancy has reached its highest point. Rents are at their lowest, prices are as low as they’ve ever been, and Cap rates have reached their highest point since the Downturn began.

Market participants know the bottom has been reached only after looking back three to six months and seeing no news of new lows in price, rents, and Cap rates. All of these metrics begin to level off. Asset prices are well below replacement cost.

The signs of excess inventory are everywhere, with “for sale” signs, a lot of empty commercial space lining streets, even whole subdivisions of new houses boarded up. Lessors still offer concessions to attract tenants, though not as desperately as earlier.

This is the time for investors to aggressively pursue asset purchases.

4. Early Recovery

In this stage, prices are still below replacement cost and buying activity begins to pick up. Rents are no longer falling, but have stabilized and leveled off. Occupancy is low, but demand is starting to improve, and vacancy starts to decrease.

Cap rates start ticking downward from their highs. NOI is growing and prices are increasing. There is a general acknowledgement among market participants that the bottom has passed, though investment is still tentative with remaining uncertainty about how “robust” the recovery really is. Lessors are making fewer concessions, though they are still made where necessary.

Investors should continue purchasing assets.

5. Early Stable

In this stage, the gathering recovery stimulates demand. Rents are increasing, vacancy decreases as occupancy approaches long term average levels. NOI continues to grow. Cap rates start moving downward, and prices increase as they start to equal and exceed replacement costs.

Credit is increasingly available. Capital becomes more available. More investors enter the market, and competition for deals increases. Construction projects completed at this stage get absorbed straight into the market. Lessors have all but stopped making concessions as demand makes them unnecessary.

This is as close as the real estate market comes to the state of equilibrium.

6. Late Stable

In this stage, the real estate cycle is building up to its peak and prices start exceeding the Net Asset Value (book value) or any reasonable valuation of properties.

Rents increase to peak levels. Occupancy is 100% and vacancy close to zero. Lessors no longer offer concessions to tenants. Prices are being bid up to new highs, and Cap rates reach new lows. NOI has increased to its highest level and starts to flatten out. Price now far exceeds replacement cost.

Stories about “real estate riches” start appearing in the newspaper, many first-time investors enter the market. Competition for deals is intense. Credit is readily available on attractive terms. Capital is freely available to investors. Mezzanine financing is now available and used on most deals. Speculative buying is prevalent.

Unless you are a generational owner of real estate, this is the time to sell your assets.

Different Real Estate Markets Are At Different Stages of the Cycle

It’s important to note the six steps of the real estate cycle occur in each market independently throughout the country. Different markets are at different stages of the cycle at any one point in time.

Also, within any one market, different asset classes move through the stages of the cycle in a different order. For example, when Single Family is in the Late Stable stage and approaching its peak, Multifamily will be in the Bottom stage.

There’s a reciprocal relationship between Single Family and Multifamily because tenants move out of their apartments as home buying increases.

There is no way to generalize about the stages of the real estate cycle. It depends on the market you’re in and the asset class within that market.

This is what creates the opportunity.

By familiarizing yourself with the real estate cycle and the associated metrics in your local market and in other markets around the country, you can very intentionally buy low and sell high. And you can grow your equity at what Warren Buffett calls “business rates of return” with minimal risk. Let compounding build your wealth.