Real Estate Market Cycles: Where Are We Now?

Like so many other things in life, the real estate market is also known to run through cycles of up and down, “boom and bust”, over time. Much of the real estate market cycle timing was initially studied and proposed back in the 1930’s by real estate economist Homer Hoyt. His initial determination of an approximate 18 year real estate cycle was based on studies he had done in Chicago, but this was also later studied and identified in other cities as well. His conclusion was that real estate markets tend to peak and subsequently decline in 18 year intervals. His data over a couple hundred years (in graph below) illustrates the extent to which history has shown this. The couple of exceptions to this were theorized to be due to the effect of World War II which affected the interval at which a peak would have otherwise occurred in the 1940’s and the shorter cycle in the late 70’s due to an abrupt tightening of the money supply contributing to a recession that cut the interval shorter.

Analysis of Hoyt’s work was later expanded by Fred Foldvary, an economics teacher and researcher, who warned about a downturn in the economy and real estate markets in an article called “The Depression of 2008”. Although Foldvary has many thoughts and theories on the making of a recession, to me one of the most significant points he repeats is the long term impact of cheap credit and low interest rates causing non-sustainable financial distortions. On one level that seems pretty obvious, but on the other hand it doesn’t ever seem to be so obvious as to have the same historical outcome again and again. For that reason, it is always worth a reminder.

Most illustrations of the real estate market cycle show 4 phases:

- Decreasing vacancy
- No new construction
- Result: best time to buy as you buy at lower prices and less risk; the trick is recognizing this position

- Vacancy still decreasing
- New construction starts again
- Rising sales numbers and prices
- Affordability still good

- Vacancy begins to level off and then increase
- New construction continues
- Weakened affordability
- Some “smart” money starts being pulled off the table

- Increasing vacancy
- More construction completions but new starts stall
- Early in a downturn capital is still being deployed by some, but much of the smart money has already moved into more low-risk hedges to be protected

So what determines the inflection point when we start to transition from Phase III to Phase IV? Again, it seems fairly obvious when spelled out, but it is basically nothing more than the higher costs of investment, namely interest payments and land (property) prices in this case, leading to a decrease in the rate of investment growth. As the change in the rate of growth decelerates and turns negative, the market turns toward recession.

So where does that leave us now? Well, if nothing else in real estate is certain, we can at least be sure that even within the larger real estate market, regional variations in markets are certainly present. Therefore, what might be happening in your market might vary from the global trends in the space. However, in my opinion I would say we are probably in Phase III (Oversupply) at this point. Certainly, new construction seems to be booming everywhere I have seen based on all the new development and cranes in the air I have witnessed. Unfortunately, much of that new development has been directed at the moderately high to high-end markets and little of it serves the vast need for affordable housing, thus checking the box on weakened affordability. For the same reason, vacancy is variable depending on which class of housing you are referring to but no doubt lower in the high-end housing compared to the “affordable housing” sector. As to where the smart money is going, we will probably not be able to say for sure until we look in the rear view mirror and determine who made the best choices. However, I think the “smart money” is always that which is being directed with great consideration to all of the market forces with a historical perspective in mind and not just that which follows the herd expecting all great things to continue. For me right now, this means bearing in mind the projected duration of each investment, incorporating stress testing for various market conditions affecting rent and CAP rates, and factoring in interest rate risk into the equation.

Since it’s not a matter of if we will have another market peak and recession and only a matter of when, the best we can do is stay educated, keep our eyes open, and make decisions based on our own investing goals and risk tolerance and not just follow the crowd in good times.

How about you? Where do you think we are and how are your investing pursuits tailored around that?

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