The real estate market is a dynamic and complex system that goes through cycles of booms and busts. Understanding these cycles is essential for buyers, sellers, and investors alike. This article will go into the basics of the residential real estate cycle and how to use them as lessons for the future.
What is the real estate cycle?
The real estate cycle typically consists of expansion, peak, contraction, and trough. The expansion phase is when the market grows, and demand for homes is high. When prices rise, the sellers have leverage. The peak phase is when housing prices are so high that demand slows down. The contraction phase is when the market prices fall. Finally, the trough phase is when prices are low and demand is weak.
Factors Influencing the Real Estate Cycle
Several factors influence the cycle, including the economy, interest rates, population growth, demographics, and government policies. When in an economic boom, the housing market grows, and demand is high. Conversely, the market may experience a contraction phase during a recession.
Interest rates
Interest rates have a significant impact on the housing market cycle. When interest rates are low, people are more likely to borrow money to purchase homes, leading to an expansion phase. However, as interest rates rise, demand may slow down, leading to a contraction phase.
Demographics
On the other hand, demographic changes like population ageing can affect the housing market. For example, as a generation gets older and becomes empty nesters, they are more likely to move to smaller houses. That may lead to low demand for larger homes. Some generations may prefer living in smaller homes in the city, resulting in increased demand for condos and townhouses.
Government policies
Government policies like tax incentives also play a role in a boom-and-bust situation. Suppose your state offers tax credits to homebuyers who buy in specific areas to stimulate the economy. That may lead to homebuyers flocking to that area, increasing demand and raising prices. On the other hand, strict regulations may make houses in some places more expensive, contracting the market.
Other factors
You probably think that natural disasters like hurricanes can cause housing values to plummet and the market to collapse. But you might be surprised to learn that the opposite often happens, at least in the short term. Finally, foreign investment may increase demand in some areas, driving prices up and making it hard for locals to buy.
When investing in real estate, you must consider these factors that will indicate whether you’re making a good decision. Buying at a high price only for the market to go into a trough phase could wipe out your investment. One example is the UK housing market crash in 2008, peaking at a market value decline of 15.6 percent. It took five years for the values to return to pre-2008 values.
Identifying a Looming Bust
The real estate market can be risky, especially if you are unfamiliar with the signs of a housing bubble. A bust follows what folks call a housing bubble, when the demand for housing exceeds the supply, causing prices to skyrocket. However, this can lead to a market crash when the demand for housing falls and prices plummet.
Here are the warning signals:
Rapid price increase
One of the most apparent signs of an impending bubble is when home prices rise too quickly. That may indicate an overvaluation of the housing market that may lead to a correction. Typically, that occurs in major cities with high demand and limited supply. For example, the San Francisco median home price increased 103 percent between 2012 and 2019, then plunged 29.6 percent in 2019.
Easy credit
Easy access to credit, regardless of your ability to pay it back, is another sign. Lenders that lend money indiscriminately can lead to an upsurge in demand for housing and an increase in prices. That happened in the mid-2000s when US banks gave out subprime mortgages, leading to the 2007 housing market crash.
Flurry of investments
When investors start buying real estate rapidly, you should pay attention. Excessive speculative activity in the housing market typically means they plan to turn around and sell them at a higher price to make a quick profit. That creates unsustainable housing demand and drives prices up. One example is what happened in China in 2014.
Low rental yields
Good rental yields for investment property fall between 8 and 10 percent. Rental yield is the difference between renting property out and your overall costs (mortgage, maintenance, etc.). When the rental yield is less than four percent, that signifies a housing bubble. That indicates that rental income cannot justify high property prices.
In most cases, this happens in areas with high speculative activity. For example, the rental yield in Sydney, Australia, is 2.72 percent. It is experiencing a housing crisis because locals cannot afford to live in the city.
High household debt
Populations with high debt levels indicate a housing bubble because it may mean they borrow more to buy homes. That often leads to a surge in demand for housing and an increase in prices. However, if borrowers cannot repay their debts, it can lead to a crash. One example is Canada, where household debt levels have risen over the past decade. The result is a weak housing market.
Most signs of an impending housing bubble point to an overvaluation of the market. Once you know the warning signs, you can buy or invest in property without too much risk.
Navigating the Real Estate Cycle
Understanding the real estate cycle helps you make informed decisions. However, the timing is also critical. Interest rates can indicate whether you should buy or sell, everything else being equal. When it is low, you should purchase real estate. When it is high, you should sell.
It is also important to diversify when buying real estate as an investment. Consider a healthy mix of areas and property types to spread your risk. When the market values fluctuate in one location, investments in other areas will help you stay afloat. At any rate, you should only put in money you don’t need because real estate investing is a long-term strategy. Be ready to hold on to your properties until the market recovers from a downturn.
Another thing you should consider is buying shares in a real estate investment trust (REIT). These companies buy and manage investment properties for rent, such as apartment buildings. You own a slice of the pie (and the profits) without having to participate actively in the daily operations. If you already own property, you can also choose a property management company to do the same thing.
Suppose you understand the market, have a knack for finding diamonds in the rough, and can undertake extensive renovations. In that case, you can try flipping. It is high risk but high reward.
Finally, start building equity on the property you own. Reducing your mortgage by making extra payments and keeping it in excellent condition increases its value. When a housing bubble bursts, you are in a better position to recover.
Learn From the Past
Given the complex factors influencing the real estate cycle, it’s clear you need to understand the market and exercise caution before diving in. By studying historical trends and understanding the warning signs of an impending bust, you can make informed decisions that safeguard your financial future. Use the past to predict the future and prepare for its possibilities.
