Using Real Estate Cycles to Predict the Next Housing Bubble
Why is it that bubbles in the housing market seem to catch so many people off guard?
According to economist Homer Hoyt, based on a detailed study of the Chicago and US real estate markets, concluded that a regular 18 year cycle can be found in real estate dating back to at least 1800. This cycle breaks down into four broad sections.
A recession is usually defined as a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters. Key components of a recession are high unemployment; decreased consumption: and decreased investment in buildings, factories, and machines. The price of land, necessary for all economic activity, is at the bottom of the cycle.
Increasing population creates a higher demand for goods and services. Generally the government intervenes to lower interest rates.
Lower investment costs and increasing demand allow companies to expand. More people are hired, new factories are built and more machines are bought. The demand for land increases.
All real estate channels are affected (office spaces, retail space, residential space, etc.) as companies occupy previously empty spaces and people move into previously vacant housing. The real estate market at this point is in a recovery phase.
As more and more offices and housing are bought and rented the supply of vacancies diminishes. Real estate expenses, as we know, change little year to year. As vacancies fill up prices to purchase and rent go up. This leads to increased profits which in turn attracts new development of redevelopment of existing properties.
We all know that when the demand for goods or services (including real estate) exceeds the supply, prices go up. We must also remember the supply will rise to satisfy demand and eliminate the pressure on rents and land prices.
Increasing supply takes a while, often a long time. Market studies need to be done. Property sales need to be negotiated. Permits and zoning approval need to be obtained. Financing, often difficult to obtain after a recession, needs to be procured. This is when construction starts. For the average construction project it will take two to five years to bring it to market.
While this construction is going on rents and property prices continue to climb as demand keeps increasing and eventually begin to accelerate rising faster and faster.
Somewhere in this cycle a critical point is reached where real estate prices no longer reflect the existing market conditions but the anticipated rent growth or equity in the future.
Investors build this trend into their calculation, believing that the price is justified by future growth. As a result when investors overpay for real estate based on current conditions, the market has entered the expansion phase and the real estate boom is underway.
If real estate occupancy exceeds the long term average then the result will be upward pressure on prices and rent. New construction is financially feasible as long as this upward pressure exists.
When the vacancy rates and unsold inventory increase the tipping point between the expansion phase and the hyper supply phase has been reached. This occurs because the construction for the mid-expansion phase has now entered the market.
Occupancy rates are above the long term average but demand begins to decrease, rent growth decelerates and the demand for vacant housing declines.
When vacancy rates fall below the long term average new construction is no longer financially feasible and stops, but projects already under construction still need to be finished. An increase in supply, with a decrease in demand means that rents and purchase prices on homes will be lower reducing the profits of the owners.
The increasing prices in the economy as a whole that occurred during the expansion and hyper-supply stage will force the Federal Reserve, to raise interest rates. This in turn means that new construction in no longer financially feasible.
Lower rents, less real estate sales, increased vacancy rates all mean less profits for landowners and potential losses for builders. What follows is an increase in foreclosure rates as the market enters recession.
So Where Are We Now?
Tour most real estate markets and you’ll see skylines are filled with cranes: these markets are in the expansion phase. In many, though, rent growth is slowing and they have already entered the hyper supply phase.
Studies predict that the cycle will reach an apex around 2024, unless there is some major unforeseen event. Sure the markets will have occasional slowdowns, bleeps, and burps, but as a whole the real estate industry should continue to enjoy a long period of expansion.