Seasons, stages, phases and cycles. In biology, astronomy, time and many other aspects of life, things repeat. Real estate is no exception. Market analysts have shown that real estate markets pass through recurring cycles.
In 1933, Homer Hoyt revealed how real estate passes through stages in his book “100 Years of Land Values in Chicago.” A person can still purchase used copies of the book at Amazon.com. In his research, Hoyt discovered that real estate goes through cycles of approximately 18-year intervals.
Examine the boom-bust cycles of non-residential construction in the following graph. Each peak is followed by a decline that coincides with an economic recession. During these same years of boom or bust in the real estate market, the stock market also saw similar ups and downs.
Graph Courtesy of NAREIT.com
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What does a typical real estate cycle look like? Let’s start at the bottom of the curve.
Recovery
Recovery takes place at the bottom of a market swing. Investing sentiment is pessimistic. Few think about investing in real estate. Rental occupancy is low. Construction of new houses, apartments and commercial real estate is at a virtual standstill. A contrarian’s delight, right?
In recovery, you can see evidence that the economy and the real estate market are getting better. The monthly job numbers are improving, rental income starts rising and real estate valuations begin to increase. Lending institutions start loaning out more money, and construction begins on formerly vacant land. When the recovery phase has matured, previous losses have been regained.
Slowdown in Mid-Cycle
Somewhere in the middle of the recovery cycle, the stock market and gross domestic product (GDP) decline, but land keeps its value. Gas, oil and electrical utilities rise, the bond market experiences a yield inversion and the Federal Reserve raises interest rates.
Upswing
In this phase, a land boom begins from the rapidly rising prices of real estate. Municipalities increase their spending on construction of new and upgraded public works. The real estate market heats up. Interest rates for borrowers start to rise, but it’s easy for investors to obtain credit.
Finally, however, the cost of real estate starts exceeding real valuations because the demand for land and buildings has turned into a frenzy. Real estate activity starts to slow, but confidence in the economy and in generous investment returns remains high.
Peak
Finally, the economy stalls, and real estate supply exceeds demand. Vacancies decline and rental rates fall. The first peak is real estate, then the stock market tops out and, eventually, GDP goes into negative territory. A recession ensues. There’s a crash —it’s usually the stock market first, followed by GDP and finally real estate. Loans from financial institutions dry up, unemployment rises to new heights and doom and gloom reign supreme.
How to Anticipate a Crash in the Real Estate Market
Many years ago, miners kept canaries in cages deep in the mines where they worked. If the canary died from poisonous gases or lack of oxygen, the miners knew they had precious little time to get out of the mine with their lives. Just as miners had their canaries, real estate investors have other signals that can warn them that a crash is coming.
Peaks in land values: Look for broad and rapid increases in land valuations as well as construction activity. The St. Louis Federal Reserve Bank is a wonderful source of such data.
Interest rates: Interest rates increase. The yield curve inverts (when short-term interest rates are higher than long-term rates). An inverted yield curve reveals an unstable economy lies ahead because the short-term risk is higher than the long-term risk.
Sector balance changes in the GDP: As economic activity slows in business and government circles, household economic activity becomes a larger piece of the GDP pie.
Budget surpluses: When government takes in more tax money than it spends, there’s a surplus. Budget surpluses may suggest that when they planned their budgets, governments underestimated business activity. The economy is doing better than expected.
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Where do we stand today?
Because of life after COVID-19 and the current war in Ukraine, market signals seem confused at the moment. Or maybe it’s not confusion but that market cycles are taking place in a much more condensed time frame.
On July 27, 2022, the U.S. Federal Reserve increased the federal funds rate by 0 .75%, the second consecutive increase. This increase was designed to stem a high inflation rate of 9.1% in June and 8.5% in July, the highest rates since 1981. In spite of the high inflation rate and increasing interest rates, the U.S. reported an increase of non-farm payrolls of 528,000 in July, with a decrease in the unemployment rate to 3.5%. These numbers blew the Dow Jones estimates of 258,000 and 3.6%, respectively, out of the water. The July numbers brought the unemployment rate back to pre-pandemic levels and tied for the lowest unemployment rate since 1969.
What about housing? In June, new housing starts dropped 2% month over month to its lowest point since September 2021. July sales of previously owned homes fell almost 6% compared to June and were down almost 20% from the same month a year ago. The median price of a home in the U.S. in July was $403,800, showing an increase of 10.8% over last year.
So What Now?
Inflation is high and interest rates are rising, but the labor market is booming. Right now the negative GDP numbers mean little. Housing starts and sales are starting to slow, but housing prices are still rising. Geopolitical situations are uncertain because of Russian’s war on Ukraine and increasing tensions between China and Taiwan. Political discord continues to increase in the U.S.
What should an investor do as far as real estate is concerned? The real estate market may be reaching the end of an upswing and getting to a peak, so if valuations of your property have increased well over the past few years, it may be a good time to think about selling. If you’re a new investor, you may still find good deals available for reasonably priced real estate, but you’ll have to look long and hard. In either situation, however, it’s always good to remember to proceed with caution.
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