Is It The Right Time For You To Buy Real Estate? - The Real Estate Cycle Explained

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Is it possible to know what the real estate market is going to do?

While nobody can predict the future, there are indicators we can analyze from the past that drive the real  estate market to forecast the future.

What is the Real Estate Market?

The Real Estate Market reminds me of a complex, constantly-moving machine shaped by supply and demand. On the surface we’re describing the overall economic condition, however the details explain things much deeper.

  • Are we talking about the market in a specific location? Real estate markets are hyper-local, which means that real estate prices and demand can differ wildly from one area to the next.
  • Are we talking about the market within a specific niche, like single family homes, condos, or office buildings? It may be a great time to buy a single family home, but it might be impossible to find a great deal on a multi-family property.
  • Are we talking about the market for a certain type of user? The market may feel different for someone who is looking to rent versus someone looking to buy. A Seller may think it’s a great market, while a Buyer may think it’s terrible.

Therefore, the next time someone asks “how’s the real estate market?”, ask yourself “what are they actually asking about?” It would be mindless to say “the market is good” without any specifics.

  • Where is it good?
  • For who is it good?

Something important to understand is in most markets you can think of (aside from real estate), prices are kept roughly in balance by the forces of supply and demand. However, real estate is unique because the amount of land in existence is fixed. When demand rises, it isn’t possible to just create more land like you can with another product. As a result, when the economy is growing and there’s demand for new properties, the extra demand pushes values up. Now because there isn’t a supply instrument to pull prices back down, land prices increase faster than wages and the price of goods. These patterns form the real estate cycle.

The Real Estate Cycle in Four Phases

Similar to the seasons changing, real estate follows a pattern that can be researched and predicted. However the cycle moves at its own pace, which is the difficult thing to predict.

The real estate market typically cycles through four phases before recurring again. These phases can be described as:

  • Phase 1: Recovery
  • Phase 2: Expansion
  • Phase 3: Hyper supply
  • Phase 4: Recession

This graph demonstrates these four phases:

 

Phase 1: Recovery

During Phase 1 of the cycle (which doesn’t have an actual beginning; we’re just picking a subjective starting point), the market is recovering from the last downturn. The market is no longer falling and begins to trend back upward. This, in theory, is “The Bottom”.

**Keep in mind that “the bottom” is not the “be all and end all” of securing a good deal. Value always exists if you know how to identify it. I remember my rule of thumb by putting a spin on one of my favorite Warren Buffett quotes; It is far better to buy a wonderful property at a fair price, than to buy a fair property at a wonderful price.

This phase of the cycle is represented by high unemployment, a high number of home foreclosures, and elevated levels of fear in the general population (consumer confidence). This is the time when most people say “real estate is a bad investment”.

Prices have fallen far enough to tempt the savviest investors back into the market, looking for high yields.

Soon following, large real estate investment funds begin buying properties in large quantity to expand their portfolios, typically a signal of the recovery solidifying. Prime properties will always be the most attractive, so early growth tends to begin in the most dominant major metro areas, then expanding outward from there.

Who Benefits?

  • Now is the best time for ANYONE to buy, since prices are most attractive (think of this as a sale).
  • Investors looking to build equity.
  • Sellers that may be in unfavorable situations in which they must sell quickly (for example a Seller who may have lost their job, needs to short sale their home to avoid foreclosure & relocate to another area for new employment etc.) can benefit by securing a purchase contract quickly due to an abundance of cash Buyers in the market during this period.

Phase 2: Expansion

During the expansion phase, businesses are hiring and confidence in real estate is growing. Lenders begin to overcome the initial trauma and loosen lending criteria. This in turn creates confidence and capital for development to begin once again.

Property values begin to rise, caused by a low supply but increasing demand, as more people decide that buying real estate might be more fruitful than renting or living with family. As businesses expand, desire for commercial property follows. Developers now begin to build new properties to accommodate the growing demand.

During this phase of the cycle, it is still a great time to invest in real estate. Rents and values are both increasing and the general population begins to express optimism for the future. Attractive deals can still be found as there are still foreclosure issues leftover from Phase 1, however these deals aren’t just lying around; investors must work harder to identify them.

This period of growth is a good market to be a part of, however an important shift also slowly begins: speculators enter the playing field. Speculators are buyers and investors who deeply depend on future growth of the market to produce profits and base their numbers upon this need. This is a point where Buyers decide to upgrade into larger homes and “new” investors look to enter the market. Given this, they begin to pay more for properties than they should.

Who Benefits?

  • First Time Homebuyers who can finally qualify for a mortgage.
  • Investors who are able to secure some of the good deals still remaining from Phase 1.
  • Sellers that have been underwater that can finally sell and pay off their existing mortgage.
  • “Boomerang Buyers” who may have gone through a foreclosure back in Phase 1, have been renting since then, and can finally qualify for a mortgage once again now that their credit has recovered.

Phase 3: Hyper Supply

Phase 3 is the strongest upsurge of the cycle. Looking back on American real estate in the mid 2000s, you’ll remember this period defined by large building projects, high prices and many people looking to buy real estate.

Builders begin to pay more for land and construction than they should, based on the thought that rents will continue to increase. Rehab investors do the same, as they overpay for property because they know another Buyer will pay them even more for the full renovation.

Demand during this time begins to wane as the supply created during Phase 2 reaches a balance. Ideally the market should stabilize here because everyone is happy. However, developing real estate can take years, and the construction that began during the expansion phase is persisting. Eventually supply overtakes demand, and vacancies increase.

During this phase in the market, stories of real estate wealth are told because many people are making money before this growth begins to slow. It’s important to recognize when you are in this kind of market and not get lured by stories of prosperity. Abide by your numbers and find a real estate niche that works for now or be patient and wait for the next phase.

Who Benefits?

  • Any Seller, since prices are at their highs.
  • Buyers looking to purchase a home they can grow into and stay for a number of years (well into the next cycle) enjoy an abundance of inventory to choose from.

Phase 4: Recession

Since property values increase faster than wages do, real estate eventually becomes unaffordable for the majority of the population. This creates a chain of events:

  • property values begin to fall
  • lenders begin to tighten lending criteria to reduce risk
  • development activity slows
  • businesses shut down

These factors then begin to have a trickle-down effect for the stock market and employment volume.

The building projects that seemed promising just a few years earlier are unable to sell, driving prices down quickly. Foreclosures increase as more and more owners find themselves underwater and more and more investors find themselves unable to pay the mortgage with the decreasing rents and increased vacancy. Compare this phase with the economic recession like we saw in 2008, and you’ll see millions of homeowners out of work and unable to pay the mortgage on their homes.

This can be an opportune time for real estate investors, but one that must be carefully examined. While most of the world is in panic, savvy buyers and investors are looking for “the bottom”. Once the market hits bottom, this is the best time for a real estate investor to jump in and get some wonderful deals which helps save the falling economy.

From here, the market begins to rise once again. Confidence begins to restore itself in real estate and in a cycle that repeats over and over, the market re-enters Phase 1: Recovery.

Who Benefits?

  • Buyers and Investors looking for better deals than they’ve been able to find during Phases 2 and 3.
  • Sellers that may be in unfavorable situations in which they must sell quickly (similar to the Recovery Phase) can benefit by securing a purchase contract quickly due to an abundance of cash Buyers during this period.

Where Are We Now?

The real estate market is dependable, but never certain. However with proper research, trends can be identified that act as key indicators for the state of each market. Real Estate operates on a boom and bust cycle, fed by supply and demand, though it’s timing can never be predicted with absolute certainty. Various outside influences such as interest rates, who’s making the calls in the white house, and even wars (for example WWII created a huge cycle interval) can make a difference as to when the market will peak and when it will hit bottom.

The most fascinating aspect of the cycle is not it’s inevitability but rather it’s regularity. Many people agree with the “18-Year Real Estate Cycle” theory, originally summarized by Homer Hoyt, an economist in the 1930s. The 18-Year Real Estate Cycle explores the previous 100 years in American housing prices and has found that the market has usually functioned on an average of an 18-year cycle from cap to cap.

Our last market cap was in 2007, and we can’t say for sure if exactly 18 years from then (2025) will be the next cap. The more important thing to understand about the 18 year cycle is why it has worked, not the exact time period. Important indicators show when change in each phase is about to occur, and it’s important to look to those indicators to guide you in the real estate world. There comes a point when eagerness drives prices greater than the math does. There also comes a point when fear drives prices down.

I will conclude with 1 important takeaway; no one can predict the real estate market with 100% accuracy. However you can prosper through any phase of the market if you just focus on the basics; do your research, make smart choices and enjoy the ride.

For questions or for any of your real estate needs, contact me at 561-948-3599 or dominick@realtystandard.com.