Analyzing Real Estate Markets – Part 1

This is the first of what will be many articles on the topic of Real Estate Market Understanding and Analysis. The reason this topic will garner so much attention is because — in my opinion, at least — the ability to understand market trends and to analyze the state of real estate markets can be a key deciding factor between success (and degrees of success) and failure in this business.

Let me explain:

It’s pretty well-known that almost all real estate markets increase in value over time. In fact, if you were to plunk down money for real estate at almost any time and place in the U.S. in the past 150 years, over the subsequent 25 years your money would very likely have increased in value. This is what makes real estate such a safe and profitable investment over the long term.

But, while real estate almost always trends upwards in value, it also almost always goes through cyclical periods (cycles) where values drop for some period of time before continuing their upwards trend. This is what a typical real estate cycle might look like:

In a typical real estate market, these cycles will continue to repeat. And, in general, the upswing part of most cycles will be higher than the subsequent downswings; this means that average prices over long periods of time will trend upwards.

So, while in some respects real estate is a no-brainer investment (again, prices almost always tend to increase), there are two major risks that these real estate cycles pose:

1. If an investor buys at one of the peaks in the cycle, his investment is likely to go down by some percentage before the next upswing occurs. During this period, rents may drop, vacancies may rise, and if the investor hasn’t planned for this temporary downswing, it could put so much financial pressure on the investor that he can’t afford to keep his investment;
2. Real estate cycles can last anywhere from a year or two up to a decade or two. So, while an investment made at a real estate peak will almost certainly go up in the long-term (assuming the investor can hold it long enough), that “long term” could end up being 10 to 20 years. Many investors don’t want to wait 10-20 years to see positive returns, and additionally, the longer the investor needs to wait for a positive return, the more likely that the total annualized return rate will be low.

On the flip side of those risks, let’s say an investor is able to acquire property during one of the low points in the market cycle. With the typical real estate cycle lasting at least a few years, this investor will likely see his investment continue to appreciate for the during of the upswing in the cycle. If he then sells his investment around the next cycle peak, he can easily see returns on the order of 5x or 10x his investment.

For example, let’s say an investor has found a place in the US where the real estate market is just getting ready to begin its upswing (keep in mind that cycles are localized events — the market in Houston, Texas may be in a completely different point in the cycle than the market in Austin, Texas). And let’s say this investor plunks down $100,000 as a down payment on a $1M property. Over the next five years, the property increases in value by 50% (not unrealistic in a hot market). So, this property has gone from $1M to $1.5M in price in that time. The investor’s equity is now $600,000 (the original $100,000 plus the $500,000 in appreciation), a six times return on his investment!

While those are large numbers, this is a completely realistic scenario. And in fact, many investors made many millions during the recent real estate boom (again, it may not have been a boom everywhere, but it was in certain parts of country). Unfortunately, the investors that bought at the top of this boom are going to experience the two risks I highlighted above — many will not be able to afford their properties when values drop, and the rest may need to wait 2, 5, or even 15 years to see positive returns.

If you got nothing else out of this post, hopefully I’ve conveyed a few basic things:

• Real estate will generally tend to appreciate in value over time
• This appreciation, while likely over long periods of time, are not guaranteed over shorter periods of time due to the cyclical nature of the real estate market
• Understanding these real estate cycles — and what causes/affects them — can prove the difference between marginal long-term returns and huge short-term returns