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 my property ties into the greater real estate market and when I need to become greedier or more conservative in my real estate activities.
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What is the real estate market?
Before we dive into the specifics on analyzing and predicting the market, we should get on the same page as to what we are talking about when we use the phrase “the real estate market.”
“The real estate market” is a phrase used to describe the overall economic state of real estate, based largely on supply and demand.
However, the very phrase “real estate market” is a bit more complicated than you might think upon first hearing it. While we are 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 specific location? Because, as I’m sure you know, real estate prices and demand can differ wildly in different areas. Just ask someone shopping for a home in Southern California versus Iowa.
- Are we talking about the real estate market within a specific niche, like single-family homes, apartments, office buildings, or hotels? After all, it might be a great time to buy a single-family home, but it might be impossible to find a great deal on an apartment complex or build a new commercial office building.
- Are we talking about the real estate market for a certain type of real estate user? After all, the market could appear very differently to someone who is looking to rent a property versus someone looking to buy a property. A buyer might think it’s a great market, while a seller might think it’s terrible.
Therefore, when economists look at “the real estate market,” they could be referring to all these factors at once, but it is likely they are focusing on one aspect or a summary of the whole. Therefore, next time you hear the phrase, “the strength of the real estate market,” or something similar, ask yourself, “What are they really talking about?” It would be silly to say “the real estate market is strong” without any additional qualifiers. Consider:
- Where is it strong?
- For whom is it strong?
- For what kind of real estate is it strong?
That said, the real estate market, as mentioned in the definition above, is based on the supply and demand of real estate, so no matter what niche, location, or user, there are patterns that we can analyze, and hopefully predict, within that niche.
These patterns form what you’ve likely heard before: the real estate market 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. This is when the savvy investor looks to buy new assets.
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.
Great strategies: Flipping, wholesaling, buy-and-hold, multifamily, private lending, hard money lending
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 (i.e. not Silicon Valley or New York).
Housing prices start to rise. Homebuilders 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 perfectly 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 of how aggressive or defensive we should be when we price our deals. Furthermore, the wisdom of the crowd can influence even the most sophisticated investors. The only way we can lessen its hold is to recognize what’s transpiring in the market.
Great strategies: Buy-and-hold, multifamily
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.
Great strategies: Buy-and-hold, multifamily
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 are able to 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.
Great strategies: Private lending, hard money lending
Look beyond market cycles when deciding to invest
Decide what market to invest in, and begin to research that market. Focus on job growth, which should average at least 2% growth for two consecutive years. To access data for jobs in a market, Google the name of the city and “job growth” or utilize the Bureau of Labor Statistics to gather employment data for a specific city. Look for companies announcing a move to a market and become familiar with employers in your market.
Target markets that are experiencing household and population growth. Household growth is a more powerful barometer because households are the ones that become clients.
Study the demographics of the market and look for a higher percentage of millennials and Baby Boomers. The middle-aged demographic tends to have families and is more apt to become homeowners.
The specific property you are looking at should drive your investment decision—not macroeconomic forces. You shouldn’t pull money out of your house to buy any piece of property because interest rates are low. And if interest rates are high, you aren’t going to pass on an investment that makes financial sense.
Macroeconomic indicators are great for cocktail parties and useless debates. But if you want to be successful in real estate, you need to know what your financial goals are. What makes a potential deal good for your financial goals? What’s going on in the neighborhood you invest in? And how can you make an offer that takes into consideration the potential risk of being too pessimistic or optimistic regarding the real estate market?