In 1998, ten years before the dramatic crash of the U.S. housing market and the Great Recession that resulted, economics lecturer Fred Foldvary wrote “The U.S. economy as well as much of the global economy will very likely fall into a depression in 2008.” The basis of his claim? Utilizing a model of property market cycles, Foldvary’s prediction – as unrepeatable as it may be – points to the wisdom of paying attention to business cycles and evaluating how they might affect investment decisions. Whether you’re considering a personal home purchase or investing in commercial property through a real estate marketplace like the company I work with, history has shown us that property cycles do exist – and certain key data points can be useful in one’s proces of deciding how or when to invest.
Early Views of Property Cycles
Foldvary’s work was based on embellishing a theory of Homer Hoy, a University of Chicago real estate economist, who in the 1930s observed that real estate prices seemed to flow up and down in a predictable 18-year cycle. For the date that Hoy had reviewed (Chicago real estate prices during the 100 years leading up to his publication), his model really did seem to work with some accuracy, and it seemed that investors might be able to “time the market” by buying when prices were cheap, and selling at peaks, during those 18-yr cycles.
Of course, it’s never that easy, and Hoy’s theory soon ran into difficulties when the Great Depression and World War II played havoc with the idea of a consistent cycle in property markets. Almost a half-century later, Foldvary added a qualification to Hoy’s theory by asserting that cataclysmic events can set the property cycle off its “normal” pattern.
Although Foldvary’s 2008 prediction seemed prescient, there are still plenty of economic observes who disagree entirely with the idea that property cycles show any degree of predictable consistency. Just as with business cycles generally, though, property cycles themselves are very real. What makes them tick?
The 4 Stages of the Real Estate Cycle
Understanding the mechanics of what pushes prices up and down on a macroeconomic level can certainly help provide a deeper understanding of the larger economic cycles that might affect an investment. Moreover, because of lengthy build times, real estate supply tends to lag behind demand – adding another nuance to the property cycle.
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Although precise market timing remains elusive, many observers identify four stages of the property cycle: recovery (from a recession), growth, hyper-supply, and then crisis (heading into another recession).
Stage 1: Recovery. Coming off a recession, prices are generally at their lowest point in a cycle. The Federal Reserve often tries to aid a recover by dispersing cheap credit and other monetary expansion measuresmonetary expansion by the government encourages borrowing as businesses recuperate. Outlooks begin to brighten, vacant spaces begin to find tenants again and prices stabilize.
Stage 2: Growth. Employees are hired in greater numbers and property values begin to climb. For existing commercial real estate operators this can be a profitable period, since new construction may have commenced but likely won’t yet have been completed. Until that new competition arrives in force, as long as fundamentals continue to improve then rents rise and profits begin to increase. The viability of renovation and construction projects has now become apparent, and developers continue to break ground for new projects.
Stage 3: Hyper-supply. New construction continues to come on line, and the new inventory begins to satisfy demand increases. The time lag involved with new developments means, however, that more recently started construction projects are becoming increasingly risky, since they may prove to be a too-late response to the supply and demand needs that they were targeting. The bubble has yet to burst, but cap rates are increasingly low, underwriting is optimistic, and supply begins to outstrip demand. A key milestone occurs when rental growth begins to slow, foreshadowing a market correction.
Step IV: Crisis. Rent revenue finally begins to drop as an overheated market has supply exceeding demand. While generally no new construction is started during this period (often because financing is unavailable), a surplus of inventory from late-finishing projects is still coming online, eroding profits and occupancy rates of the property market overall. Asset values go into decline.
Then Why Aren’t Predictions Easy?
The above analysis of property cycles generally holds true, but real estate typically remains “local,” meaning that local markets are sometimes more important than broader macroeconomic trends. Growth in some regions may coincide with downturns in others. For example, no one is writing off Texas just yet, but the marked pullback in oil prices has definitely affected that state’s property market. At the same time, San Francisco’s boom in internet-related companies has resulted in record rental rates and abundant new construction coming online.
No one said that investment analysis was easy. Research and “due diligence” go a long way toward enabling better investment decisions, but there is no certainty in this business. A close analysis of real estate cycles, however, is a key component of such decision analysis.
The author does not make investment recommendations or provide investment advice, and this article should not be construed as such.