I don’t know of 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 phases. These cycles can be broken down into four periods: recovery, expansion, oversupply and recession. The following is a mental model I use to understand how my property is tied into the larger real estate market and when to become more greedy or more conservative in my real estate activities.
Prepare for a market shift
Learn to change your investment tactics – not just to survive an economic downturn, but to thrive! Accept any recession and never be intimidated by a market shift again.
What is the real estate market?
Before we get into the specifics of market analysis and forecasting, we should come to the same page we are talking about when we use the term “real estate market”.
“The real estate market” is a term used to describe the macroeconomic situation of real estate, which is based primarily on supply and demand.
However, the term “real estate market” is a little more complicated than you might think when you first hear it. While we’re referring to the general economic condition of real estate, the devil is in the details.
- Are we talking about the real estate market in a particular location? Because, as you probably know, real estate prices and demand can differ greatly in different areas. Just ask someone buying a home in Southern California versus Iowa.
- Are we talking about the real estate market within a certain niche, such as single family houses, apartments, office buildings or hotels? After all, it might be a good time to buy a single family home, but it can be impossible to find a lot on a condominium or to build a new commercial building.
- Are we talking about the real estate market for a specific type of real estate user? After all, the market for someone looking to rent a property can be very different than for someone looking to buy a property. A buyer might think it’s a great market while a seller might think it’s terrible.
Thus, when economists deal with the “real estate market” they could be referring to all of these factors at once, but they are likely to be focusing on one aspect or a summary of the whole. So the next time you hear the phrase “the strength of the property market” or something similar, ask yourself, “What are they really talking about?” It would be silly to say “The property market is strong” without additional qualifications. Consider:
- Where is it strong?
- Who is it strong for?
- What kind of real estate is it strong for?
However, as mentioned in the definition above, the real estate market is based on the supply and demand for real estate. So regardless of niche, location or user, there are patterns that we can analyze and hopefully predict that niche.
These patterns make up what you’ve probably heard before: the real estate market cycle.
Phase 1: recovery
The characteristics in the recovery phase include falling vacancies and no new construction. More and more tenants are looking for rental agreements. There can also be a spate of foreclosures in the market. This is when the savvy investor wants to buy new assets.
Unfortunately, it can be difficult to secure funding at this stage and the general sentiment is still negative. This, in my opinion, is the opposite phase where value investors step in by buying at low prices.
Many investors were burned by the 2008 recession and either do not want to or cannot buy at this stage. The majority of the real estate markets have emerged from this phase and are in the expansion phase.
Great strategies: Flipping, wholesale, buy-and-hold, apartment buildings, personal loans, hard cash loans
Phase 2: expansion
Many markets are in the expansion phase, at a time when vacancies and new buildings are falling. It takes a few years for new inventory to come online, and during that long period of time both rents and occupancy increase. In 2015 rental growth was a robust 5.6% and occupancy was 96.1% – both highs.
At peak times, everyone wants to buy real estate. Fear of missing out leads to panic buying. Everyone is talking about home loans and banks are starting to relax their lending requirements. Property prices are reaching record highs and appreciation is starting to slow. Selling real estate takes a little longer than usual. Housing is becoming unaffordable in normal markets (i.e. not in Silicon Valley or New York).
House prices are starting to rise. Home builders are returning to the market and we are seeing a surge in new home construction. Unemployment is falling. Real estate is becoming popular again. Inflation rises and the Federal Reserve begins to raise interest rates. Remember when the CAR Affordability Index was 36% in 2013 and 30.75% in 2014.
Real estate cycles can last for decades or longer. Sometimes they send us the wrong signals that the market will continue to expand or that doom is imminent. Unfortunately, it doesn’t become perfectly clear until years later. So if we cannot predict where we are in the cycle, why should we care?
We should see to it that we can anchor ourselves to some semblance of sanity when the market becomes too optimistic or pessimistic. Thinking in terms of probabilities the probability that we are in the cycle can show us how aggressive or defensive we should be when evaluating our businesses. In addition, the wisdom of the crowd can influence even the most discerning of investors. The only way to lessen your influence is by realizing what is happening in the market.
Great strategies: Buy-and-hold, apartment buildings
Phase 3: hyper-supply
In this phase problems pile up on the horizon. The vacancy rate begins to rise and the new building continues. This is a time when builders need to recognize that oversupply is occurring and new builds should put the brakes on … but often they don’t.
The panic sale begins. You are starting to see rapid house price drops. Unemployment is increasing. Home sales are taking even longer and housing affordability is starting to rise. New home construction freezes. The Federal Reserve is starting to cut rates.
Great strategies: Buy-and-hold, apartment building
Phase 4: recession
House prices are starting to stabilize during the recession. We are headed for equilibrium – but we have some difficult spots ahead of us. Few people are willing to invest in real estate. Investors with experience, capital and a track record can raise funds to invest. Remember when the CAR Affordability Index was 52.75% in 2011 and 51% in 2012.
For example, the occupancy rate fell and in 2008 new buildings were delivered to the market. The new building came to a standstill, but it was too late. There was a double hit – fewer renters and the addition of new inventory. Both rents and occupancy continued to fall, which accelerated the decline in property values.
Great strategies: Personal loans, hard money loans
Look beyond market cycles when making your investment decision
Decide which market to invest in and start researching that market. Focus on employment growth, which should average at least 2% for two consecutive years. To access data for jobs in a market, google the city name and “Employment Growth” or use the Bureau of Labor Statistics to collect employment data for a specific city. Look for companies announcing entry and familiarize yourself with employers in your market.
Target markets with household and population growth. Household growth is a stronger barometer because households are the ones who become customers.
Study the market demographics and look for a higher percentage of Millennials and Baby Boomers. The middle-aged population usually has families and is more likely to become homeowners.
The specific property you are looking at should drive your investment decision – not macroeconomic factors. You shouldn’t be pulling money out of your home to buy a property because interest rates are low. And when interest rates are high, you are not going to pass on a financially sound investment.
Macroeconomic indicators are great for cocktail parties and useless debates. However, if you want to be successful in real estate, you need to know your financial goals. What Makes a Potential Business Good for Your Financial Goals? What is happening in the neighborhood you are investing in? And how can you make an offer that takes into account the potential risk of an overly pessimistic or optimistic assessment of the real estate market?
Discover the real estate market cycle