The ability to accurately predict the peak of the real estate market remains an elusive skill. However, that shouldn’t discourage us from attempting to assess our position within the real estate cycle.
Real estate experiences recurring cycles of booms and busts that span several years. These cycles can be divided into four distinct phases: recovery, expansion, hyper-supply, and recession. To gain a better understanding of my property’s relationship with the broader real estate market and determine whether to adopt a more aggressive or conservative approach, I utilize the following mental model.
Defining the Real Estate Cycle
The real estate cycle refers to a pattern of economic activity observed within housing markets. This pattern is predictable and consists of four distinct phases: recovery, expansion, hyper-supply, and recession. Regardless of its location, the housing market is always positioned within one of these four stages, enabling real estate experts to make informed forecasts about its future trajectory.
Factors Influencing the Real Estate Cycle
Broadly speaking, the real estate cycle is closely tied to the economy. Real estate markets are intricately linked to various economic processes, both at a global and local scale. Numerous factors contribute to the overall health of the economy, including global events, local unemployment rates, inflation levels, salary growth, and interest rates. Additionally, demographic factors play a significant role in shaping the real estate cycle. For instance, a population composed primarily of retired homeowners will impact the cycle differently than one dominated by younger individuals aspiring to become first-time homeowners.
Duration of the Average Real Estate Cycle
Accurately determining the duration of a real estate cycle is challenging due to the potential influence of unexpected economic events. However, a theory proposed by British economist Fred Harrison in the early 1950s suggests that real estate markets follow an 18-year cycle. While there is some evidence supporting this theory, it is still useful to consider a couple of decades as a typical duration for a real estate cycle.
It’s important to note that the ongoing disruption caused by the Covid-19 pandemic has made it particularly challenging to predict the behavior of the real estate market and rely on the usual economic indicators for accurate forecasts.
The Significance of the Real Estate Cycle
Why is the real estate cycle a crucial concept to grasp? Above all, understanding the cycle allows homeowners and investors to plan their actions accordingly. If you’re unsure whether it’s the right time to buy, sell, or invest in real estate, determining your position within the cycle can help you make more informed decisions. Furthermore, it enables better predictions regarding the potential rental income and appreciation of a property, depending on when it was acquired within the cycle.
Exploring the Four Phases of the Real Estate Cycle
Phase 1: Recovery
During the recovery phase, several characteristics become apparent, including a decline in vacancy rates and a lack of new construction. More tenants express interest in signing leases, and there may be an excess of foreclosed properties available for sale. Savvy investors recognize this as an opportune time to acquire new assets.
Securing financing can prove challenging during this phase, and overall sentiment remains negative. This phase is often considered the contrarian phase, wherein value investors seize the opportunity to purchase properties at lower prices.
Many investors, still bearing the scars of the 2008 recession, are hesitant or unable to engage in the market during this phase. As a result, the majority of real estate markets have transitioned into the expansion phase.
Recommended Strategies during the Recovery Phase: Flipping, Wholesaling, Buy-and-Hold, Multifamily, Private Lending, Hard Money Lending
Phase 2: Expansion
The expansion phase is characterized by declining vacancy rates and an increase in new construction. It takes several years for new inventory to enter the market, resulting in both rising rents and occupancy rates. In 2015, rent growth reached a robust 5.6%, accompanied by a 96.1% occupancy rate, both representing record highs.
During this peak phase, there is a surge in demand for real estate, driven by the fear of missing out. Home equity loans become popular, and lending requirements loosen. Real estate prices soar to record levels, and the pace of appreciation starts to decelerate. Properties take longer to sell than usual, and housing affordability becomes a concern in normal markets..
Housing prices begin to rise, and home builders reenter the market, leading to a surge in new home construction. Unemployment rates decline, and real estate once again becomes an attractive investment option. Inflation increases, prompting the Federal Reserve to raise interest rates. This phase can be exemplified by the affordability index, which stood at 36% in 2013 and 30.75% in 2014.
Real estate cycles can span decades or even longer, occasionally presenting false signals of continued expansion or impending doom. Unfortunately, clarity regarding the phase only emerges years later. However, recognizing the prevailing market conditions allows us to anchor ourselves to a semblance of sanity amid excessive optimism or pessimism. By assessing the probabilities associated with each phase, we can determine the appropriate level of aggression or defensiveness when pricing our deals. Moreover, we must be aware of the influence the collective wisdom of the market can exert, even on the most sophisticated investors. Recognizing the market’s dynamics is the key to reducing its hold on our decision-making process.
Recommended Strategies during the Expansion Phase: Buy-and-Hold, Multifamily
Phase 3: Hyper-supply
The hyper-supply phase signals impending trouble. Vacancy rates begin to rise while new construction continues unabated. This period calls for builders to acknowledge the occurrence of oversupply and exercise caution by slowing down new construction. Unfortunately, builders often fail to respond appropriately.
Panic selling ensues, resulting in rapid price reductions for homes. Unemployment rates rise, prolonging the time it takes for properties to sell, and housing affordability starts to improve. New home construction comes to a halt, and the Federal Reserve responds by lowering interest rates.
Recommended Strategies during the Hyper-supply Phase: Buy-and-Hold, Multifamily
Phase 4: Recession
During the recession phase, housing prices stabilize as the market moves toward equilibrium. Nevertheless, challenges lie ahead. Few individuals are willing to invest in real estate during this period, but experienced investors with sufficient capital and a proven track record can secure funding for their ventures. This phase can be exemplified by the affordability index, which reached 52.75% in 2011 and 51% in 2012.
For example, in 2008, the occupancy rate was decreasing, while new completions flooded the market. Although new construction eventually ceased, the damage had already been done. A double whammy ensued, with fewer renters available due to economic conditions and an influx of new inventory. Rental rates and occupancy levels plummeted, further accelerating the decline in real estate values.
Recommended Strategies during the Recession Phase: Private Lending, Hard Money Lending
Investing in Property Based on the Real Estate Cycle
To make informed investment decisions based on the real estate cycle, follow these steps:
Select a market to invest in and conduct thorough research on that particular market.
Pay close attention to job growth, aiming for an average of at least 2% growth over two consecutive years. Utilize online resources or the Bureau of Labor Statistics to gather employment data for the chosen city. Familiarize yourself with companies relocating to the market and become acquainted with the employers in that area.
Target markets experiencing household and population growth, as household growth is a strong indicator of potential clients.
Analyze the demographics of the market, particularly focusing on the percentage of millennials and baby boomers. The middle-aged demographic, often composed of families, tends to have a higher propensity for homeownership.
Should You Invest in Real Estate Based on the Cycle?
While understanding the macroeconomic forces and the real estate cycle is important, it should not be the sole determinant of your investment decisions. Instead, your investment choices should be driven by the specific property and its alignment with your financial goals. Avoid the temptation to withdraw funds from your own home simply because interest rates are low. Likewise, don’t dismiss a financially viable investment opportunity solely because interest rates are high.
While macroeconomic indicators may spark interesting discussions, they are not the sole determinant of success in real estate. To achieve success, clarify your financial goals and evaluate potential deals based on their alignment with those goals. Pay attention to the neighborhood and local market conditions, and make offers that consider both the potential risks and rewards associated with the real estate market.