Real Estate Cycle - Part 2

Part 2:   -   Why the cycle repeats

In the last post we set out the basics on the real estate cycle which was provided by Akhil Patel at Ascendant Strategy.

So you may be thinking: that sounds plausible. But why does the cycle repeat?

The reason is actually quite simple.

There are three factors of production: capital, labor and land.

Capital and labor you will be familiar with, because your Econ 101 textbook would have discussed these at great length.

But the third factor is land. Here, your modern economics books will be useless as they don’t discuss it at all.

This is strange, because it was well known to the great classical economists, such as Smith and Ricardo.

And it is what happens to land that is key to the cycle.

This also means that economic experts, who haven’t been introduced to land as a main factor of production, won’t be able to see it.

It’s all about the location

Land is important because economic activity takes place in specific locations. This makes these locations very valuable, because it is possible to generate a lot of wealth in good locations. And sites in good locations are rare and limited in supply.

This means that rents and prices go up and people are prepared to pay them because a good location is unique and you need to be there to do business.

The other thing to note is that when an economy expands the value of the real estate in good locations goes up. Economic growth creates wealth. Which means people are willing to pay more to be in the best locations.

But this invites speculation.

Think about it. You could own a patch of dirt in the middle of a growing city, do nothing with it and ten years later it would be worth several times more because there would be higher demand for it.

This makes real estate uniquely suited to speculation. As investors pile in, using bank credit to acquire sites, the price goes up and up. This creates the boom and bust dynamics that we outlined in the earlier post.

The same action causes the same reaction

But then you might be thinking: OK, so now I see why the cycle arises. But surely, we are not going to repeat the same mistakes over and over?

My response is: has anything really changed?

The structure of the economy is fundamentally still the same.

People will still speculate in real estate and it will lead to the same consequences. In fact, there are signs that this will be even bigger than before. Blackrock is now the USA’s largest landlord and institutional investors are using their enormous financial firepower to acquire real estate.

The speculative excesses this could lead to are mind boggling.

What you do as an investor

However, what drives the boom bust cycle makes real estate a key part of an investment portfolio because you get the possibility of yield and capital growth (coupled with leverage if you are using bank finance to purchase real estate).

But the key is to invest in good locations.

And get your timing right.