Experts often use baseball as an analogy for where we are in any given real estate cycle. For a new cycle, we might be in the first or the second inning. As the cycle moves on, we might be in the top of the seventh. If a cycle seems to be going for particularly long, some might claim we’re in “extra innings.”
But anecdotes aside, how can we determine where we are in a real estate cycle? More specifically, what evidence do we really have that a real estate recession might be on the horizon?
Signs of a Recession
1. We’re in Phase III of a Real Estate Cycle
Since 1800, the U.S. real estate market has run its course in a remarkably predictable pattern, with cycles lasting about 18 years on average (with some notable exceptions). Harvard professor Teo Nicolais explains that cycles can be divided into four quadrants:
- Phase I: Recovery: This phase is characterized by high unemployment, decreased consumption and low land prices. This is the lowest point in a real estate cycle.
- Phase II: Expansion: During this phase, vacancy rates decline and new construction picks up.
- Phase III: Hyper-Supply: This phase is marked by an increase in vacancy and unsold inventory, and serves as the first indication of trouble in the real estate cycle.
- Phase IV: Recession: The recession period is characterized by increasing vacancy, specifically, occupancy rates that fall below the long-term average. This is when we expect new construction to slow, if not stop altogether.
The last cycle lasted from 1990-2008 before the massive collapse during the Great Recession, 18 years on the nose.
There are certain statistics worth looking at when trying to understand whether we’re in Phase III of the real estate cycle. You’ll want to monitor things like apartment vacancy rates. Are they rising or are they falling? How long are properties sitting on the market before being sold?
What’s happening in the construction industry? Is there a lot of new construction or have new starts been declining? A good way to evaluate these datasets is by looking at year-over-year comparisons at both the national and regional levels.
The Yield Curve Is Flattening
Another indicator that a recession could be coming is when we start to see the yield curve flattening. Typically, we’d expect to see short-term bonds pay a lower interest rate than long-term bonds. A flattening of the yield curve happens when the gap between short- and long-term rates declines. An inversion, where short-term rates are higher than long-term rates, has preceded each recession since the Great Depression.
Why is this such a big deal? Consider this: Banks borrow at short-term lending rates and lend at long-term rates. The greater the difference between the two, the more profitable it is for banks to lend. When banks stop lending, new construction grinds to a halt and the economy can spin into a recession.
A more definitive sign that a recession is coming is when the yield curve actually inverts. An inversion is generally a sign that at any moment, a real estate bubble could burst.
Home Sales Are Declining
Another indicator that a recession could be on the horizon is when we see home sales start to decline. In advance of each of the last three recessions, real estate lingered on the market and often experienced tremendous price cuts before being sold. In particular, we want to look at single-family home sales when looking for evidence as to whether a recession is on the horizon.
According to William Emmons, an economist with the Federal Reserve, single-family home sales are a more reliable predictor of economic growth (and decline) compared with other housing indicators. This is because other metrics are national in nature and don’t reflect whether the deterioration is affecting all regions.
Emmons recommends single-family home data be evaluated in conjunction with other indicators that a recession may be looming, specifically noting the Treasury yield curve as one indicator that has a remarkable track record for forecasting potential downturns.
The Bottom Line
Nobody can say with exact certainty when the next recession will hit, but these indicators can help investors understand whether to expect a downturn in the not-so-distant future. This is not necessarily a reason to panic. In fact, some of the most lucrative investments are often made during economic downturns. The fact of the matter is: investors must remain cognizant of where we are in the real estate cycle and manage their portfolios accordingly.
How have recessions affected your real estate investing, and how do you prepare for the next one?
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