Real Estate News & Commentary

The 4 Phases of the Real Estate Cycle (& What All Investors Should Know About Them)

Expertise: Personal Development
15 Articles Written

Quite a few people have asked me, “Where are we in the real estate cycle?”

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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 cycle.

Real estate regularly goes through multiyear cycles of boom and bust periods. These cycles can be broken into four periods: peak, contraction, trough, and expansion. 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 greedy or conservative in my real estate activities.

4 Phases of the Real Estate Cycle

To illustrate the cycle, I will use the California Association Realtors affordability index. According to CAR’s website, its Traditional Housing Affordability Index (HAI) measures the percentage of households that can afford to purchase the median-priced home in the state and regions of California based on traditional assumptions. Let’s go back to our last real estate peak in 2006 to see how this one metric can be used to gauge where we are in the cycle.

Of course, if you want to do a thorough analysis of the market, you will need to examine multiple variables, such as unemployment rates, interest rates, inflation rates, home construction rates, and consumer debt ratios. But for our analysis here, I will stick with the HAI.

Peak

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). Going back to 2006, the housing affordability index for the state of California was 12.25 percent. In 2017, it was 13.25 percent.

coworkers in office point to screen of laptop on table

Related: The Real Estate Market: How to Analyze and Predict Cycles

Contraction

The panic selling begins. You begin to see rapid price reductions for homes on the MLS. Unemployment increases. Houses are taking even longer to sell on the MLS, and housing affordability begins to increase. New home construction freezes. The federal reserve starts lowering interest rates. The CAR index for 2008 was 33 percent, 2009 was 50.75 percent, and 2010 was 48 percent.

Trough

Housing prices begin to stabilize. 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 percent in 2011 and 51 percent in 2012.

Expansion

Housing prices start to rise. Home builders return to the market, and we see a surge in 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 percent in 2013 and 30.75 percent in 2014.

Real estate cycles can last decades or more. Sometimes it sends 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. This provides us with a physiological distance from the world around us.

know-submarkets

Related: Understanding the Real Estate Cycle (& Why NOW is the Time to Buy!)

When the market becomes overheated, you’ll start hearing, “Well, this market is different because X won’t happen again, and interest rates are low, so I better pull the trigger before the Fed takes action.”

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?

Do you try to predict real estate cycles? At what stage of the real estate cycle do you think we are in?

Let me know your thoughts in the comment section below.

    O'brian
    Replied over 4 years ago
    Great overview of the different phases of a real estate cycle Jordan! You mentioned the rate of construction a couple times as another indicator of what phase in the cycle we’re in. During expansion, new home construction is growing and during a contraction, new home construction is shrinking. For anyone interested, the US Census Bureau puts out a ton of useful data tracking new building permits, home starts, completions, etc by state, county, and even metros. Here’s a link to their new residential construction: https://www.census.gov/construction/nrc/index.html
    Jordan Thibodeau Rental Property Investor from San Jose, CA
    Replied over 4 years ago
    Thanks O’Brian!
    Jim Garcia Involved In Real Estate from Castle Rock, CO
    Replied over 4 years ago
    Great article. All real estate goes through cycles and I agree with you. Douglas County CO real estate market is interesting. Prices have been going up steadily (about 1% per month since 2011). Price of housing has risen such that some new home Buyers can’t purchase a home even with 4% interest rates. I agree with you 4 cycles. For our market it continues to keep going higher and higher as people continue to relocate here. Our cycle may be a bit longer than the norm. If there is a norm in real estate. Thanks for sharing.
    Jordan Thibodeau Rental Property Investor from San Jose, CA
    Replied over 4 years ago
    Eek. Sad to hear new home buyers are priced out of the market in your area. Thanks for your comments and analysis.
    Sky Shah from Grand Prairie, TEXAS
    Replied over 2 years ago
    I agree first, find and focus on the deal that works then look at the macro the part u have no control of.
    Aaron Wright Investor from Collinsville, Illinois
    Replied over 2 years ago
    When you say “inflation” increases, do you mean the money supply, or are you talking about price inflation? Also, if we go into a contraction now, the Federal Reserve has very little room to attempt to respond with an adjustment in interest rates. That cannon has been fired, so to speak.
    Andrew Syrios Residential Real Estate Investor from Kansas City, MO
    Replied over 2 years ago
    Good rundown!
    Rob Cook from Powell, WY
    Replied over 1 year ago
    Thanks, Jordan. The last paragraph is the key. Right on.
    Max Feldman
    Replied over 1 year ago
    Hi Jordan, have you written (or plan to write) any articles on how to perform a thorough analysis that considers the following (you mention these in your intro): 1. unemployment rates 2. interest rates 3. inflation rates 4. home construction rates 5. consumer debt ratios