Quite a few people have asked me, “where are we in the real estate cycle?” I haven’t 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 C.A.R.’s website: C.A.R.’s 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 guage 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.
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% and in 2007: 13.25%.
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. At this time the California CAR index for 2008: 33%, in 2009: 50.75%, and in 2010: 48%.
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% in 2011 and 51% in 2012.
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% in 2013 and 30.75% in 2014.
The 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 of us 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.
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 our 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?
We’re republishing this article to help out our newer readers.
Investors: 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 are in the comments section below.