Analyzing Real Estate Markets – Part 3

In my last article, I identified four of the major contributors to the real estate cycle. Now, let’s dig in and discuss more specifically how each of these factors influences real estate markets.

I’m going to refer again to the market cycle diagram I showed you in an earlier post:

It worth noting that many real estate experts and “gurus” have discussed market cycles at length, and each of them has a different way of characterizing the various parts of the real estate cycle. Some refer to four stages of the cycle, some refer to five or six stages, and they all use different terminology that they’ve made up for the parts of the cycle. I guess it helps them sell books. I’m going to keep this simplistic — as you see in the graph above, there are essentially four parts of the real estate cycle. I’ll refer to them as the “Bottom of Cycle,” “Upswing,” “Top of Cycle,” and “Downswing.”

Let’s start this analysis on the upswing of the cycle. An upswing generally result from a local market seeing population growth and expansion in its economic status. Perhaps some big companies are building plants in the local area, bringing hundreds or thousands of jobs to the surrounding towns. All these new workers will need the support of a service industry (restaurants, car dealers, doctors, etc), so the population growth will trend upwards very quickly.

At this point, there is more housing demand than there is supply, so builders will start building new properties, and investors will flock to the area looking for investments. Vacancies drop to near-zero, rents increase, and as rents increase, property values will quickly rise. As prices rise, word gets out that the economy is booming, housing demand is soaring, and property investments are appreciating rapidly. Speculators (those investors who don’t know a whole lot about the business but chase after the hype) move in and start buying properties for far above market rates, hoping to score big in this hot market.

All the while, the builders continue to build as quickly as fast as they can get permits and the housing supply reaches and surpasses equilibrium. It is at this point that smart investors, who bought at the beginning of the upswing, are selling off their properties for huge profits, and speculators are paying top dollar for anything they can get their hands on. This is the end up the upswing phase of the cycle, leading right into the top of the market.

Suddenly, there is more housing available than there are tenants. Builders likely don’t yet recognize that there is an over-building situation, and building projects that were just started will continue for the next year or two, putting even more inventory on the market. As all this excess inventory floods the market, causing supply to heavily outweigh demand. Vacancies start to rise, and landlords lower rents and offer concessions in order to bring in tenants. As rents drop and vacancies rise, speculators panic and start trying to sell their investments. We are now smack in the middle of the downturn part of the market cycle.

As the downturn picks up steam, inexperienced investors will drop prices and take ever larger losses in order to just “get out of Dodge.” The result is a downward spiral of falling property prices. Builders have finally stopped building and are doing everything they can to sell their empty new homes. At some point, vacancy rates and property pricing will level off, and few transactions will be taking place; sellers refuse to drop prices any lower and buyers are still terrified to buy in this market. This is the bottom of the market, and this bottoming out can last anywhere from months to years.

Eventually, assuming the local economy is still strong and population is still increasing, the excess housing will be absorbed by the increasing population and the market will once again start its upswing. Smart investors will invest at the bottom of the market (assuming economic indicators are good, indicating an upcoming upswing) or will invest at the beginning of the upswing.

This is just one of many potential scenarios that might drive a market cycle in a specific location, but most market cycles are driven by the four key market factors we discussed above: population trends, employment trends, overbuilding, and socio-economic trends.

I’ll have plenty more to say on market cycles in future articles…