Understanding the Real Estate Cycle

June 16, 2012

Topics: Real Estate

Real estate is a cyclical business and like any other industry or market, it goes through periods of contractions and expansions. These booms and bust takes place in different cities, states, and countries. Understanding the real estate cycle is critical for real estate investors, realtors, and developers.

A common misconception among many real estate investors is that prices are always going towards equilibrium and that the market sets a fair price. This belief is misleading because markets are rarely in equilibrium â they fluctuate between overvaluation and undervaluation, like a pendulum. The market swing between phases of excess and shortfall due to market imperfections and time lags as information slowly spreads among market participants. Excess inventory and shortfalls are caused by time delays of new housing developments. Shortages in inventory make developments profitable; while excess inventory curtail prices and limits the profits of the real estate developers. This process creates a cyclical real estate market.

Real estate is also a function of jobs â and a strong local economy will produce a health real estate market. A vibrant economy with high paying jobs is the foundation for high property values. Looking at a home price to income ratio you can determine whether housing is overvalued or undervalued based on historical data. Specific geographic information can be found at zillow.com

The table below shows the highs and lows in the real estate cycle in the United States over the past 200 years. The average length of the real estate cycle is about 18 years.

The next chart shows fluctuations in real estate prices in the United States since 1987. As the chart indicates, we just went through a real estate boom with prices reaching multi decade highs. As with all other markets; a boom is followed by a bust. But the market donât just go back to its equilibrium or fair market value â it tends to âovershootâ and multi decade highs are followed by multi decade lows.

The real estate cycle can be described as a sine curve oscillating between trend lines. The period of expansion and contraction are easily identifiable if you look at a longer time horizon. The period of expansion below the trend line is known as ârecoveryâ, and the area above the trend line is known as âprosperityâ. The period of contraction above the trend line is known as ârecessionâ and the area below the trend line as âdepression.â

A typical real estate cycle typically follows the pattern below:

- Business upturn: the economy is expanding, typically at a time of low real interest rates and available capital. This leads to an increase in economic activity and a rise in demand.

- Business downturn: interest rates rise in response to the boom as competition increases for available capital. This leads to a business down turn.

- Slump: supply is plentiful and prices remain low as a result. Prices fall to its lowest levels during this stage. During this phase inventories are steadily being depleted without much new development.

- The next cycle: After a period of low prices; inventory has become scarce again. This will lead the cycle to repeat.

Looking at a long term chart; it may appear that real estate always appreciates in value. But what you really see is the depreciation of the (US dollar) unit of measure. The real estate cycle is better illustrated by measuring houses against a constant like gold; which holds its value better than fiat currencies. The chart below measures the value of an average house in the US in ounces of gold.

Understanding the real estate cycle and being able to identify what stage the market is in is vital for any serious real estate investor. There are opportunities in both booming and busing markets. Expanding markets give flippers opportunities to make quick profits while contracting markets offer more value and an opportunity for investors to acquire rental properties at bargain prices.

To learn about trends and spot the next investment opportunity read the Casey Report from Casey Research. It's a monthly investment news letter that breakdown economic trends in a way that is easy to understand. They make recommendations based on economic reality and their track record is several times better than the market or any mutual fund for that matter.