Real Estate Cycle Part I

For some time now I have been working closely with a brilliant economist out of the UK regarding real estate market cycles.   I wanted to share with you some of his comments on the real estate market cycle in a two part blog.  - DJ

By:   Akhil Patel

Part 1: What investors need to know about the real estate cycle

If I were to tell you that property investors could have known in advance that the property market was going to tank from 2006 on wards and that they could have avoided losing the trains that were wiped off the value of real estate: would you have believed me?

Well, now that The Big Short has shown that some investors exploited the financial meltdown you may think that it is possible. But the book and film make it out that you have to be super smart, a total contrarian. And have access to people to do research for you.

They made it seem like it was a one-time event.

Even those super-smart guys don’t get it. That’s the long and short of it.

Here is the thing: economies are very cyclical. And the economic cycle is very regular. You can trace it back to 1800 in the US brackets and even further back in Europe). And at the very end of every cycle there is always a blast which is led by land (real estate).

Let that soak in for a minute.

Once you understand this, you will be able to use this knowledge to improve your investments in measurably. And the key to the cycle is real estate. I will tell you why in a separate post.

But here is what you really need to know.

The real estate cycle affects the whole economy. And it lasts on average around 18 years.

Think of it as a play with four separate Acts

Act 1: from recession to recovery

The cycle starts out as the wreckage of the previous cycle is cleared away, where economies move from recession back to growth and business conditions pick up, unemployment comes down and consumer spending returns. 

This process takes time; and during it there is a lot of anxiety and social unrest because it takes a while for everyone to feel the recovery. We’ve seen a lot of that in recent years.

But the recovery continues behind the scenes so to speak. During this time stock markets are rising and smart property investors are jumping into good value deals.

Act 2: the mid-cycle slowdown

After several years of economic growth, falling unemployment – usually around 6-8 years – you may sometimes get a dip or even a recession.

People get worried about the recession and all of the fears of the last meltdown come back. But this is generally a business-led downturn, e.g. where supply outruns demand.

You don’t tend to get much by way of bank failures; and property markets may dip for a year or two but it is not an outright crash because the economy has not built up speculative excesses.

However, most policy makers (and indeed market commentators) won’t be able to tell the difference between this slowdown and the major recession/depression that characterizes the end of the cycle.

(In general, don’t expect to get much insight from these sources).

Act 3: the boom

Once the mid-cycle slowdown behind us, the scene is set for the boom. As recoveries come quicker there is more confidence and growth is often higher. The characteristic of this part of the cycle is that speculation plays as much of a role in this boom as does business expansion, though standard economic data may not be able to distinguish between the two. 

People have money and they want to spend it. And invest it in assets that will grow in value.

In this phase of the cycle, higher demand for real estate (land) is more obvious; and land is more expensive to acquire, mortgages comprise an increasing proportion of the loans made by the banking system, the quality of a bank’s loan book is increasingly predicated on high real estate prices.  A characteristic of this phase is easy credit and relaxed lending standards. 

The lynchpin of the system is real estate – banks lend to people to acquire it; a significant proportion of household wealth is tied to it; businesses use it as collateral to obtain finance to invest in expansion; it significantly underpins the wealth of many major stocks; and major industries that account for large proportions of GDP (e.g. construction) are completely tied to it.

The final part of this phase is frenetic real estate activity, called by some the Winner’s Curse phase. All the while, the scene is setting for the climactic peak and crash.

In total the boom tends to take around 6-7 years.

Act 4: the peak and bust.

The economic expansion crescendos to the peak introducing the the final great act of the cycle: the bust.  At some point the cycle can no longer continue to support ever increasing real estate prices.  I

In markets characterized by speculation, if prices are not increasing they are falling.  As speculation stalls, prices fall, dramatically. 

Unlike other contractions, the problem with such falling values is that the banking system faces the real possibility that loans outstanding exceed the collateral value of assets they were created against and that people are no longer able to meet their loan obligations. 

Such problems disrupt the normal operation of the banking system (e.g. inter-bank lending) and can lead to a full-blown economic crisis.   They also result in the need for large scale intervention in the banking system by government; the cost of such bailouts is often huge additional borrowing which then results in reduced public spending in other areas, exacerbating or prolonging the recession.

But eventually the wreckage is cleared away, over time, typically 3-4 years, and the scene is set for the next episode in this age-old tale of boom and bust.

The diagram below provides a stylized view of this four-part drama.