Understanding Real Estate Market Cycles

understanding real estate market cycles

Fred E. Foldvary was a lecturer in economics who also did research at The Independent Institute. In 1997, Professor Foldvary noticed that the next major economic recession would occur around 18 years after the 1990 recession, barring any major unforeseen events such as a global war.

More recently, the Great Recession of 2008 significantly impacted the U.S. economy and real estate markets, as well as economies of other countries around the world.  As we’ve discussed in other parts of this site, we were pretty hard hit financially. That began our quest for understanding and expanding our financial education, particularly for any source of information that would lead to our financial freedom.

Although the last recession was a surprise to many people, it is possible to predict housing trends by observing real estate cycles. This knowledge can be used to estimate when the next real estate bubble might occur.

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What is a Real Estate Cycle?

what is a real estate cycle
What Is A Real Estate Cycle

Researchers have observed that real estate markets have a predictable 18-year cycle that they have been following since 1876. Up until 1925, the real estate cycle ran like clockwork through four main stages, according to a recent article on the legal intelligence website JD Supra:

  • Recovery with declining vacancy and no new construction.
  • Expansion with declining vacancy and new construction.
  • Hypersupply with increasing vacancy and new construction.
  • Recession where vacancy continues to increase as more completions are brought to market.

However, the 18-year real estate cycle was interrupted by government regulation beginning in 1925.

During the Great Depression from 1929-1939, as well as during World War II and more recently with the Federal Reserve’s yield curve control and quantitative easing programs, the real estate market has been impacted by skyrocketing government regulation and intervention.

Why The Real Estate Market Has Cycles

Why The Real Estate Market Has Cycles
Why The Real Estate Market Has Cycles

There are many factors that affect real estate market cycles, including some that are only evident after the fact. However, many experts agree that there are several main factors that influence cycles in the real estate market:

Overall Economy

Both the global and U.S. economy have a significant impact on real estate market cycles.

People tend to invest in real estate or upgrade their homes when the economy is prosperous and they have more money. People invest in real estate because it can provide them with income and the potential for profits through appreciation.

The demand for single-family rentals is at an all-time high, according to Roofstock. The online marketplace for investing in the single-family rental (SFR) sector has seen an increase in the value of the goods sold on its platform by 569% year-over-year (Q1 2021 vs. Q1 2020).

Interest Rates

Rates that are high can make it so that people are less likely to want to buy a house or invest in property. The higher the monthly mortgage payments are, the fewer people who will be able to afford to own a home.

Reducing interest rates will make homeownership more affordable, but it could also lead to an increase in property prices.

The BIS has looked at how changes in interest rates and house prices have affected the US economy and economies around the world. The working paper suggests that U.S. interest rates have a significant impact on house prices, both nationally and internationally.

The low interest rates and increased housing prices may be the reason why rents for single-family homes have increased. According to Nasdaq.com, home rent prices increased by 5.3% in April 2021 compared to April 2020, which is the largest year-over-year gain in nearly 15 years.

Demographics and Income

HUD states that changes in both population and real income levels can have an impact on the real estate market.

The homeownership rate in the U.S. increased significantly between 1940 and 1960, due to a combination of factors including a larger percentage of households being in the prime home buying age groups, higher incomes, and the development of large-scale housing subdivisions with affordable houses.

The homeownership rate has not increased since the 1960s because real family incomes have not increased.

Nowadays, single-family rental homes are increasingly becoming the homes that previous generations would have bought as starter homes.

According to the Single-Family Rental Investment Trends Report from Arbor Realty Trust, over 40% of Gen Zers (people born in the 1990s to early 2021s) want to rent a single-family home after graduating from university.

Government Intervention

Government policy and tax regulation can affect demand for real estate investment and, as a result, real estate cycles.

The low interest rates are causing the demand for housing to increase, which is then resulting in the demand for single-family rental homes to also increase. An increasing amount of institutional investors and home builders are looking to invest in properties that will be used as single-family rentals. It is estimated that 12% of new single-family constructions in 2021 will be bought by these groups.

Four Phases of The Real Estate Cycle

the four phases of the real estate cycle
The Four Phases Of The Real Estate Cycle

uA recent article from the Harvard Extension School, How to Use Real Estate Trends to Predict the Next Housing Bubble, describes the four phases of the real estate cycle:

Phase #1: Recovery

During the recovery phase, the economy may have characteristics of a recession. The unemployment rate is high and people are not spending as much money, so real estate prices are more affordable. Reduced vacancy rates are a result of decreased rent growth. New construction will begin to meet the future demand for real estate.

Phase #2: Expansion

As available property becomes harder to find, the price of housing will increase as more people compete for a limited number of homes. new inventory to the market, occupancy rates and rents continue to rise. Investors value property during the expansion phase based on anticipated rent growth, rather than current conditions in the recovering marketplace.

Phase #3: Hypersupply

Even though there are more people living in places than usual, rental prices are still going up. The increasing rental rates encourage new construction, with developers and investors building for a future market. During the hypersupply phase, investors should look for signs that the market is becoming saturated, such as an increase in unsold inventory or rising vacancy rates. This could be a sign that prices are about to peak and a recession is on the horizon.

Phase #4: Recession

Although there is a time lag between when people demand property and when new construction is completed, often more construction is finished just as a recession starts. As inventory levels increase and economic growth slows down, vacancies begin to rise.

During this stage of the real estate cycle, there may be a rise in the number of short sales, pre-foreclosure homes, and properties that have been repossessed by the bank. Real estate investors who are holding onto their capital rather than investing it right away often have the opportunity to buy good rental property at a lower price and hold onto it until the next stage of the real estate market starts.

Rules to Profit from the 18-Year Property Cycle

rules to profit from the 18 year property cycle
Rules To Profit From The 18 Year Property Cycle

Even though market conditions are always changing, the long-term strategy of “buying and holding onto stocks for 20 years” is still a valid option. Additionally, if you spend years waiting for prices to decrease, you are forgoing a lot of money.

There are, though, five very basic “rules” you should follow as an investor – and now you know about the cycle, it should be easier for you to do so:

  1. Don’t panic and sell a property just because prices are falling. Thanks to the cycle, you know that prices won’t go to zero and it won’t be that long (in the great scheme of things) until they’re back beyond where they were.
  2. Don’t put yourself in a position where you’re forced to sell at the wrong point in the cycle. This means not over-leveraging at the peak, and making sure your portfolio can withstand temporary falls in value.
  3. Don’t get carried away (like everyone else is) during the winner’s curse phase. This is the worst possible time to buy a property, because prices will soon fall and won’t recover to the level you bought at until relatively late in the next cycle. It’s an even worse time to remortgage and use the cash for fancy cars and holidays. You might think you’d never be so daft, but plenty of people were last time around.
  4. Don’t get mislead by the media. As we’ve already seen, the messages they pump out around the key turning points of the cycle are almost exactly the opposite of what professional investors are doing. Putting on the blinkers and shutting it all out is easier said than done, but it’s vital for making the right decision.
  5. Always keep adequate cash reserves to cover potential expenses.  While it may vary from investment to investment, for single family, turnkey rental property, a good starting point is to keep $5,000 in cash reserves at all times.

If you focus on the basics, you will already be doing much better than most nonprofessional investors. But if you want to push it even further, there are some more advanced options that knowledge of the cycle makes possible:

  • Be a seller when everyone else is buying. The winner’s curse phase is a terrible time to buy, but a great time to sell. You don’t have to sell everything, but it’s the perfect opportunity to offload any properties that haven’t performed as well as you’d hoped – and get someone to pay silly money to take it off your hands. Alternatively, you could sell everything. The idea is anathema to most small private investors, but it’s what the big institutional investors do: set an exit price at the point of purchase, sell once you’ve made the anticipated gains, and re-buy in a location that’s at a different point in the cycle (and therefore has greater growth potential).
  • Be a buyer when everyone else is selling. It doesn’t even have to be at rock bottom: people’s memories of a crash last longer than the economic reality, so the estate agents’ offices remain empty well after prices have stabilized and started to creep upwards again.
  • Stockpile your cash during the winner’s curse phase, so you’re prepared to swoop when everyone else is selling. Mortgage lending will immediately tighten when prices take a tumble, so even if you’re brave enough to buy you might not be able to access the funds. Instead, you can raise funds in advance by selling poorly performing properties or refinancing (to sensible levels) properties you’ve already got.

How Can We Profit from the Property Cycle?

How can we profit from the property cycle
How Can We Profit From The Property Cycle

The housing market is cyclical, meaning it goes through four stages during each cycle. How can we use this information to improve our investment skills?

Although it may seem unimportant, the implications of property being cyclical is actually very significant. Prices continually rising and falling back is something that should not cause alarm.

The media always give confusing messages about whether things are good or bad. It’s hard to know what to believe. Although it may seem like the stock market is random, it is actually driven by economic principles.

The implication is that if the cycle is predictable, you can see what is coming next. Despite not knowing when something will happen, the knowledge that it will happen makes a significant impact. For example, you’re less likely to panic and sell your investments during a market crash if you know that prices won’t fall forever – they will inevitably recover.

According to Fred Harrison, there is evidence going back hundreds of years that suggests the average duration of the cycle is 18 years, but I would rather not focus on the exact timing. The average age is 18 years old, but it could be a few years younger or older.

The duration of the cycle is not as important as other factors. Even if you don’t know how many years have passed, you can still see the stages of the cycle progressing.

You can predicted future events by looking at current events.

It seems as though there are more cranes around town recently and that prices have decreased after a few years of gradual increases. If you can guess that we are in the middle of the recovery phase, then you can also predict that the next phase will be much more exciting.

This sentence says that professional investors, or the “smart money”, act differently than amateur investors during different parts of the market cycle. As more and more people invest in the stock market, those who are aware of what is happening are selling their stock and putting their money into cash. This is because they know that a crash is coming and they want to be prepared for it. Most people do the opposite of what they should be doing when it comes to buying and selling.

Bonus Reading:

One of our best books for financial freedom is Ray Dalio’s book, Principles For Dealing With The Changing World Order. This book covers macro economic cycles, particularly from the standpoint of countries that have the privilage of being the world’s reserve currency.  It fits in nicely with the topic of real estate marketing cycles.