I’ve never known anyone who can regularly predict when the real estate market will peak, but that doesn’t mean we shouldn’t try to gauge where we are in the real estate cycle.
Real estate regularly goes through multi-year cycles of boom and bust periods. These cycles can be broken into four periods: recovery, expansion, hyper-supply, and recession. The following is a mental model I use to understand how property ties into the greater real estate market.
What is the Real Estate Cycle?
The real estate cycle is a pattern of economic activity within housing markets. This pattern is predictable and consists of four distinct phases (recovery, expansion, hyper-supply, and recession). The housing market, wherever it is, will always be at one of the four stages, and real estate experts can make forecasts about what will happen to the market next based on where it currently is in the cycle.
What Affects the Real Estate Cycle?
Broadly speaking, the economy. Real estate markets are intimately linked to larger economic processes, both global and local. All sorts of factors play into the health of the economy, from global events to local unemployment and inflation rates, salary growth, and interest rates. Demographics also affect the economy and the real estate cycle. A population with many retired homeowners will affect the real estate cycle differently from that with a majority of younger people who are – or want to be – first-time homeowners.
How Long is the Average Real Estate Cycle?
It’s difficult to accurately predict how long a real estate cycle is because unexpected economic events can always skew the cycle. However, there is a theory, developed by the British economist Fred Harrison, that real estate markets move in 18-year cycles. Harrison developed his theory in the early 1950s, and there is some indication that he was right. So, it is useful to think in terms of a couple of decades as a typical real estate cycle.
Note that right now, it’s difficult to predict exactly how the real estate market will behave next because the Covid-19 pandemic disrupted the real estate marketand many of the economic indicators that usually allow experts to make accurate predictions.
The Importance of the Real Estate Cycle
Why is the real estate cycle an important concept? Above everything else, it allows homeowners and investors to plan accordingly. If you’re hesitating to decide if now is the right time to buy, sell, or invest, understanding where you are in the real estate cycle can help you make a smarter decision. If you are investing, you can also better predict how much income a property will generate and how much it will appreciate, depending on where you were in the cycle when you bought it.
What Are the Four Phases of the Real Estate Cycle?
Phase 1: Recovery
The characteristics in the recovery phase include declining vacancy and no new construction. More tenants are looking to sign leases. There may also be a glut of foreclosures on the market.
Unfortunately, securing financing during this phase can be difficult, and overall sentiment is still negative. This marks the contrarian phase, in my estimation, where value investors jump in by buying at low prices.
Many investors were burned by the 2008 recession and are unwilling or unable to buy in this phase. The majority of the real estate markets have emerged from this phase and find themselves in the expansion phase.
Phase 2: Expansion
Many markets find themselves entrenched in the expansion phase, a time of declining vacancy and new construction. It takes a few years for new inventory to come online, and during this long-term period, rents and occupancy both expand. In 2015, rent growth was a robust 5.6%, and occupancy stood at 96.1%—both highs.
During a peak, everyone wants to buy real estate. The fear of missing out leads to panic buying. Home equity loans become all the rage, and banks begin loosening their lending requirements. Real estate prices reach record highs, and appreciation begins to decelerate. Properties start taking a little bit longer than usual to sell. Housing becomes unaffordable in normal markets
Housing prices start to rise. Home builders return to the market, and we see a surge in the construction of new homes. Unemployment decreases. Real estate becomes popular again. Inflation increases, and the federal reserve begins raising interest rates. Think when the CAR affordability index was 36% in 2013 and 30.75% in 2014.
Real estate cycles can last decades or more. Sometimes they send us false signals that the market is going to continue expanding or doom is right around the corner. Unfortunately, it only becomes clear years later. So if we can’t predict where we are in the cycle, why should we care about it?
We should care so we can anchor ourselves to some semblance of sanity when the market becomes overly optimistic or pessimistic. If we think in probabilities of the likelihood of where we are in the cycle, it can inform us.
Phase 3: Hyper-supply
Trouble is brewing on the horizon in this phase. Vacancy begins to increase and new construction is still ramping up. This is a period when builders need to recognize that oversupply is occurring and should put the brakes on new construction… but often, they don’t.
The panic selling begins. You begin to see rapid price reductions for homes. Unemployment increases. Houses are taking even longer to sell, and housing affordability begins to increase. New home construction freezes. The federal reserve starts lowering interest rates.
Phase 4: Recession
Housing prices begin to stabilize during the recession phase. We’re heading toward equilibrium—but there are some rough patches ahead. Few people are willing to invest in real estate. Investors with experience, capital, and track records can raise funds for investing. Think when the CAR affordability index was 52.75% in 2011 and 51% in 2012.
For example, the occupancy rate was decreasing, and new completions were being delivered to the market in 2008. The new construction came to a halt, but it was too late. There was a double whammy – fewer renters plus the addition of new inventory. Rental rates, as well as occupancy, continued to plummet, and this accelerated the downturn in real estate values.
What’s most important is knowing what your financial goals are no matter what cycle the market is in.