Could we have predicted the housing crash of 2008? And with some degree of accuracy? Sort of.
But to understand what happened, we have to go way back to the late 1800s, when a man by the name of Henry George first noticed a very peculiar yet seemingly consistent 18-year cycle through which real estate markets seem to move. With a few exceptions only during periods of extreme social and economic turmoil (e.g., World War II and the hyper-inflationary years in the 1970s that led to a peak), this cycle has repeated itself with remarkable consistency for over almost 200 years.
|Peaks in Land Value Cycle||Interval (years)||Peaks in Construction Cycle||Interval (years)|
Source: Fred E. Foldvary, “The Depression of 2008”
Look at the intervals between the cycles! The long cycle from 1925-1973 was due to the Great Depression and World War II essentially delayed by a couple of decades what would have been a real estate boom in the 1940s.
The very short cycles that peaked in 1979 and 1989 were both immediately following a sharp interest rate increases by the Feds. Interest rates rose from 5.5% to 11.20% between 1977-1979 and from 6.7% to 9.21% from 1987-1989.
Market Cycle: Recovery Phase
Since the recent real estate crash that bottomed out in 2011 for most markets in the US, we’ve been on a consistent and steady recovery ever since. In fact, some markets had property values that were already back to their 2006 peak year highs by late 2017 and early 2018.
A recovery is also typically further fueled by government intervention in the form of lower interest rates, which has been at or near historical lows over this past decade, thus shortening the impact and duration of the recession and speeding up the recovery due to easier access to cheap financing for home buyers.
And with increasing demand and lower investment costs, companies expand their businesses. They hire more people, open new headquarters, rent more office space, buy more equipment, etc… The adding of jobs drives residential demand, driving up rents and property values. Home builders slowly start to build more again, as we can see in the steady climb in housing starts since 2012.
Vacancies across all real estate asset classes (office, retail, residential, etc.) will begin to decrease as companies use previously empty buildings and more people move into previously vacant homes.
Market Cycle: Expansion Phase
With vacancies in many markets beginning to approach their lowest points since 2007, the transition from recovery to expansion phase has taken hold by 2018.
During the expansion phase, we’ll see occupancy begin to exceed the long-term average. And as vacancies drop, property owners will start to raise rents. We’re already seeing double-digit rental growth in both the commercial and residential markets the last couple of years.
As rents go up, so does profits. Increased profits then attract more builders, developers, and investors who will want a larger piece of this growing profit pie. As we can see from this chart, rental rates have steadily risen since 2012, after staying relatively flat from 2008-2012.
But won’t the laws of supply and demand kick in to curb the rise in profits? Yes, it will eventually. It just takes time in real estate. Any new supply (of homes, apartments, offices, etc…), takes time to come into the market. Deals must be negotiated, studies conducted, land graded, permits applied for and obtained, financing secured….all of these things are not easy as banks can still be overly cautious during this period as the recession is still fresh on their books.
Even with financing, many construction projects take years to complete, especially for commercial real estate. Meaning that during the first years of expansion, demand will begin to outpace supply, leading to ever-increasing occupancy and higher rents.
But rents won’t just be growing, it will grow faster year over year. It will be accelerating. And as investors get more aggressive with their underwriting assuming this rental growth, they drive up sale prices, creating a buying frenzy and ultimately the next big market boom.
Right now in 2019, we appear to be in the late Expansion phase and in some cases, some markets already appear to have entered the next phase: Hypersupply
Market Cycle: Hypersupply Phase
During the expansion, economic growth continues to drive demand and push vacancy rates lower in real estate, driving rents up. And as long as rents continue to trend upward, new construction will continue to look financially attractive for investors, drawing more investment dollars ever into the market. This leads to not just more supply of new units, but also to rising property prices as buyers bid up the values of existing inventory. Look at the hypersupply phase from 2003 to 2006, when permits for housing starts shot way up.
So how we know when we’ve finally crossed from expansion into hypersupply mode?
When there is an increase in unsold inventory in the market. This occurs as new completions from the mid and late expansion phase begin to saturate the market with a glut of new inventory, far more than the market demand could support at the current property prices.
Because vacancy rates are still well below the long term average, rents are again rising, but the rate at which they are rising slows down: rent growth is no longer accelerating, but rather decelerating until ultimately, it reverses direction and we see vacancy rates start to go up again.
This is the most definite sign of a shift in the market—when rental growth decelerates.But because investors will continue building and bidding up property values until it’s too late, the market crashes, and we enter the recession phase.
Market Cycle: Recession Phase
The glut of new supply finally overpowers the market, driving rents and prices down, and vacancies start to climb.
Here the transition from the hypersupply (the boom) cycle to the recession occurs when rental growth rate slows to zero and becomes negative (i.e., rents begin to fall) while vacancy rates start to increase and rise above the long term average rates.
New construction finally dries up, and fewer new projects start (look from 2008-2012, where housing permits for new construction fell by nearly 80% from peak levels).But the many projects began during the tail end of the building boom continue to saturate the market. The continued addition of inventory leads to more vacancies and lower rents.
Finally, to address rising inflation concerns due to the recent boom, the Federal Reserve may even start to raise interest rates, which will make financing more expensive and help further accelerate an end to the boom.
The combination of higher vacancies, lower rent received on those occupied units, and increased interest expenses on more expensive financing will quickly make deals less profitable and less appealing to investors.
Property values then begin a steep decline as property values fall, sometimes as much as 50% or more from peak values. Depending on the market, property values can take up to 3 to 5 years to hit bottom.
Smart and savvy investors, who have predicted and planned for all this, would have sold their properties well before the peak, being conservative not to risk getting caught in the crash.They were getting out as early as 2003 and were mostly in cash before 2006. Then they acquired property at their lowest prices between 2009 through 2012, sometimes getting properties at pennies on the dollar.
Market Cycle: Where are we now in early 2019?
It’s important to remember that the Great Recession of 2008 wasn’t entirely unpredictable and unforeseeable. Based on what we’ve learned so far, that crash happened almost on schedule.
Today, most real estate markets are well into the expansion phase while some appear to have entered the hypersupply phase with the significant jump in building activity and inventory in the pipeline.
With the crash of 2008 fresh on our minds, we hope always to be wary of the next major crash. But if the real estate cycle holds true, then that won’t happen until after the next peak around 2023/2024, with a recession or crash coming in around 2026. Property values should then bottom out several years after that.
However, with a growing trade war between the US and China, growing uncertainty in the global equity markets, we could see a shortened cycle where everything is sped up a full 2-4 years early. This would have been even more likely had the Feds followed through with their originally planned interest rate hikes for 2019.
Over many cycles and long timeline, the cycles appear remarkably consistent and predictable, as long as there aren’t significant external market forces to artificially slow or speed up the cycle. But in any given market cycle, it is anyone’s guess how things will turn actually out.
What do you think?