A once-famous economist by the name of Henry George wrote a theory of economic booms and crashes in his work, Progress and Poverty. The theory is now taught in the world’s best real estate schools, including Harvard, Stanford and Princeton.
Henry George identified the root cause of the speculative rise in real estate prices, which cuts into the earnings of labor and capital.
He began to notice that real estate values rise at a faster rate than general economic growth because of two unavoidable facts:
- Land is not produced. Its supply is fixed.
- Land is needed for all production and lifestyles.
As we have seen, this creates a tendency for real estate rents and mortgage payments to take an ever-greater share of a family’s budget.
The power of land to destabilize the economy gets much easier to understand when we realize that land value forms a majority of the collateral security for large bank loans.
In the run-up to the "Crash of 2008," a huge portion of the overall debt was secured by owner-occupied real estate. In many cases, a family's home was their only form of savings and they expected the real estate's appreciated value to ultimately provide for their retirement. Real estate values were steadily increasing and land seemed like a very sound investment.
Buyers borrowed extra money to build large, expensive homes and many homeowners borrowed still more money against their home equity, hoping to enjoy their appreciating land values now and later.
The problem is that real estate, like all assets, has a cycle of appreciation and depreciation. The key is understanding the cycle and how to buy low and sell high.
The Phases of the Real Estate Cycle:
- Phase 1 – Recovery
- Phase 2 – Expansion
- Phase 3 – Excess
- Phase 4 – Recession
The four phases of the Real Estate Cycle have played out for at least the last 100 years in the United States. Although the timing for each phase is slightly different, the overall growing and retracting pattern play out again and again.
Phase 1 – Recovery
The first phase of the real estate cycle generally occurs after a decline in the market. This is when the price of land and real estate is at its lowest point in the cycle but is steadily increasing.
As the downtrend of the market begins to stabilize, recovery invites investors into the marketplace at considerably lower prices. Vacancy rates across all real estate asset classes, such as office buildings, retail malls and single-family homes begin to decrease. Companies start to expand and families move into previously vacant homes.
This phase of the cycle is the best time to purchase real estate assets with a more favorable rent-to-buy ratio and an expected increase in equity value in the coming years.
Phase 2 – Expansion
The second phase of the real estate market cycle is based on expansion. This is the period that sees rapidly increasing prices as demand begins to outpace supply.
The transition from recovery to expansion occurs when real estate buyers and investors have absorbed the excess inventory. As the supply continues to shrink, prices begin to climb rapidly as the market starts to favor sellers instead of buyers.
In recent years, this phase is generally associated with lower interest rates, allowing more money to flow into the real estate markets. For the investors that got into the market during phase one, this is where their profits begin to show.
Since many real estate expenses are fixed (except taxes in most states), this leads to a dramatic increase in revenues and profits. Increased profits attract more investors, which in turn allow new developments of vacant land and redevelopment of existing properties to begin.
Although this new demand triggers construction in hopes of increasing the supply, the lengthy process generally takes months or years to add new homes to the market. By the time meaningful amounts of new housing inventory have hit the market, the overall market expansion has been steadily rising without the benefit of new supply.
During this time occupancy rates, rents and asset prices have been increasing. The cycle begins to reach a point in which rent and price growth is accelerating. This causes many investors and buyers to adjust their forecast to reflect the accelerated growth rate.
Buyers, believing the price is justified by predicting continued growth, begin to overpay for real estate assets in contrast to current market conditions. This part of the cycle is generally referred to as a housing bubble.
Phase 3 – Excess Supply
During the second phase we noted a shortage of supply in real estate inventory in relation to buyer demand. This caused an increase in prices of real estate assets and related rents.
The third phase begins to take effect once we see an increase in real estate absorption rates. In plain English, this means that houses begin to sit on the market longer. This is considered to be an increase in unsold inventory in the market due to peak prices and new supplies.
This can begin to occur for many reasons including peak prices, increases in mortgage interest rates and new supplies of real estate inventory. The increase in inventory may be due to age demographics as well as older generations tend to downsize to prolong their retirement savings and cash-out of their real estate investments while prices are high.
These factors combine to form a point where home prices no longer rise and begin to decrease as market demand flattens and supply increases.
Phase 4 – Recession
The final phase of the long-term Real Estate Cycle is a transition from excessive supply to a downturn in prices. The major indicators for this phase are declining occupancy rates, increased mortgage delinquencies and lowering absorption rates.
During this phase of the cycle, new construction comes to a halt in fear of declining prices, but projects that started during phase three will begin to hit the market, adding to the supply and worsening the decline.
In general, rising interest rates are a macroeconomic trend that causes issues during the recession phase. This occurs due to the rapid increase in prices throughout the economy that accompanied the expansion in the earlier phases.
The rapid growth in prices, also known as inflation, will sooner or later cause the private central bank known as the Federal Reserve to fight inflation by incrementally increasing interest rates.
The increase in interest rates has a direct effect on owner-occupied homebuyers and investors alike. This is due to the purchasing power of mortgage-backed financing. On average, a one percent increase in a 30-year fixed mortgage will equal around a 10 percent decline in purchasing power. This means homeowners will only be able to afford homes of lesser value, adding to the lowering prices due to excessive supply.
Lower occupancy, a higher market supply and plummeting prices; all of these factors combine to feed a downward spiral that leaves poorly-timed investors and over-leveraged homeowners in the dust.
The downturn in the real estate market has an enormous impact on the economy as a whole, which, in turn, pushes the housing market down further.
The most interesting aspect of the Real Estate Cycle is the consistency of the trends. Economist Homer Hoyt studied the broader US housing market going back to the year 1800 and discovered that the Real Estate Cycle has a fairly reliable 18-year rhythm.
Hoyt’s findings included just two exceptions: World War II, and the mid-cycle peak created by the Federal Reserve’s doubling of interest rates in 1979.