As the adage goes, “What goes up must come down.” And all markets are cyclical, experiencing ups and downs. These truisms certainly fit the current real estate cycle, which is governed by its unique laws of gravity.
To catch the next wave as it’s cresting, you have to first understand and learn how to identify the four phases of any real estate market. Although cyclical by nature, let’s start with the growth and expansion phase, which is followed by saturation and contraction. Next, you’ll experience a decline followed by absorption, and the four-phase cycle is poised to repeat itself.
Growth and expansion
When an area’s housing supply and demand are balanced, that particular market is fairly stable or flat. Increasing demand from job growth and population migration are indicators of a market poised for expansion. And when demand trends upward, the values and rents begin to increase as vacancies decline, which tweaks investor interest.
As this heightened demand outstrips supply, builders and developers start filling the need with new construction.
Once values begin registering higher-than-average rates of appreciation, the media start hyping the market. There is a state of euphoria with what seems like nothing but blue skies ahead. Not wanting to miss an opportunity, investors and buyers jump on the bandwagon to turn a quick real estate profit.
However, the steady price increases make single-family homes less affordable to the average person. This imbalance is temporarily met with lower-cost housing, such as town homes, condos, and apartment-to-condo conversions.
At this point, the market is reaching the cycle’s apex. While the inexperienced are still leaping en masse from the sidelines to buy, the profit takers and experienced investors are selling.
Saturation and contraction
When a market reaches its zenith, it becomes saturated and begins to contract. The signs of a downturn can be subtle at first. For example, once supply has increased to meet demand, marketing times begin to increase and the pace
of appreciation slows. Other indicators such as values, rents, vacancies, and new housing starts also flatten.
To inexperienced investors, it can seem that the market has again reached a balance. However, a hidden element lurks and pushes the market over the edge. It may take time for builders to complete projects and this pent-up supply of new construction to hit the market. Facing increasing inventory and decreasing demand, desperate builders offer buyers previously unheard-of incentives, just hoping to break even.
Decline and recession
Now that the supply outweighs demand, prices will remain flat or start dropping. The decline intensifies with an increase in unemployment, which is often caused by the slowdown in new construction. The housing market plays a significant role in the overall economy, and the ripple effect can be felt in consumer spending, unemployment, interest rates, and revised lending practices.
The number of properties listed for sale and the days to sale increase drastically. Rents often fall and vacancies increase. Many homeowners struggle to pay the higher costs of ownership because of higher real estate taxes and increased infrastructure demands.
This all-too-familiar stage of the cycle had one additional factor that helped tip the scales in 2006 and ’07. The consequences of lenient lending standards and adjustable rate mortgages culminated in the subprime debacle, prompting an already weak market to spiral out of control. Unable to afford increasing payments in addition to discovering
they owed more than their properties were worth, homeowners and investors found themselves in default.
As in any decline and recession phase, record-number foreclosures followed, further increasing the supply and pushing values down. The once-rosy media reports are now full of doom and gloom. Politicians and economists are paying attention; they’ve begun brainstorming on how to band-aid the problems.
Absorption and recovery
Only after the oversupply is absorbed can a market move toward recovery. Properties become more affordable as values decline. With little new construction and foreclosures bottoming out, fewer homes are added to the area’s inventory, allowing demand to close the gap on supply.
Signs that a market is recovering include a drop-off in marketing times, movement toward a balanced vacancy rate, and a reduction in fire-sale incentives. The overall inventory of properties will also decrease. Often measured in months supply,
this number indicates how long it will take to sell the current inventory of properties at the current selling pace.
The shift from recovery to new growth improves greatly with monetary incentives that stimulate business and job development. Areas with strong local government, a solid economic base, and prospects for population growth will recover more quickly.
Putting it all together
The duration of each phase can vary, with a complete cycle averaging between seven and 18 years depending
on key indicators. The fundamental supply and demand levels are heavily affected by population migration and job growth. Other key factors include interest rates, lending terms, rents, vacancies, and investor demand.
Savvy investors know that markets expand, peak, contract, and hit rock bottom. By understanding the four phases, as well as their signs and influences, an investor can time his entry in and out of a market. Ideally the time to buy is at the bottom,
during the absorption phase, or early in the transition to a growth phase. And the time to sell is at the high point of growth, before saturation begins to have an effect.
It sounds simple in theory. Just buy low and sell high! However, timing your most profitable entry and exit points can be challenging in practice.
An investor must fight his natural tendency to follow the herd. When everyone else is in a euphoric buying mode, you might want to consider selling to lock in profits. Alternatively, when everything you read is negative and the vast majority of sellers seem to be slashing prices and unloading properties, it could be a good time to buy.
Rather than trying to time the crest or base of the wave, start targeting the signs that indicate a curve or movement
to a new cycle is imminent.
Source: Growing Wealth
