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The Real Estate Market: How to Analyze and Predict Cycles | Resident First Focus

Is there a way to know what the real estate market is going to do?

Nope, sorry.

I know you came to this post to try and figure out how to know where the real estate market is headed, but unless you are some kind of prophet or psychic, there is no way to know the future of the real estate market.

However…

While you may not be able to know the future, there are numerous ways we can analyze the past and make some educated assumptions as to the future of the real estate market. This article looks both the definition of the real estate market as well as the leading indicators that drive the real estate market up and down.

What is the Real Estate Market?

Perhaps before we dive into the specifics on analyzing and predicting the market, we should get on the same page as to what we are talking about when we use the phrase “The Real Estate Market.”

The real estate market is a phrase used to describe the overall economic state of real estate, based largely on supply and demand. 

However, the very phrase “real estate market” is a bit more complicated that you might think from first hearing it. While we are referring to the general economic condition of real estate, the devil is in the details.

  • Are we talking about the real estate market in a specific location? Because, as I’m sure you know, real estate prices and demand can differ wildly in different areas. Just ask someone shopping for a home in Southern California versus Iowa.
  • Are we talking about the real estate market within a specific niche, like single family homes, apartments, office buildings, or hotels? After all, it might be a great time to buy a single family home, but it might be impossible to find a great deal on an apartment complex or to build a new commercial office building.
  • Are we talking about the real estate market for a certain type of real estate user? After all, the market could appear very different for someone who is looking to rent a property versus someone looking to buy a property. A buyer might think it’s a great market, while a seller might think it’s terrible.

Therefore, when economists look at “the real estate market,” they could be referring to all these factors at once, but it is likely they are focusing on one aspect or a summary of the whole. Therefore, next time you hear the phrase “the strength of the real estate market” or something similar, ask yourself “what are they really talking about?” It would be silly to say “the real estate market is strong” without any additional qualifiers.

  • Where is it strong?
  • For whom is it strong?
  • For what kind of real estate is it strong?

That said, the real estate market, as mentioned in the definition above, is based on the supply and demand of real estate, so no matter what niche and what location and to what user, there are patterns that we can analyze — and hopefully predict within that niche.

These patterns form what you’ve likely heard before: the real estate cycle.

The Real Estate Cycle in Four Phases

Have you ever heard the phrase “real estate is cyclical?” If not… you are about to:

Real estate is cyclical!

In other words, like the repetition of seasons, breakfast, and that annoying friend who keeps asking you for money, real estate follows a pattern that can be observed and thus predicted. However, unlike the consistency of autumn or the regularity of pancakes, the real estate cycle moves at its own pace, and that is the difficult thing to predict.

The real estate market typically moves through four phases before going back and repeating again. Those phases, as labeled in a recent Harvard Blog post, can be described as:

  • Phase 1: Recovery
  • Phase 2: Expansion
  • Phase 3: Hyper supply
  • Phase 4: Recession

We’ll explore each of these in more detail in a moment, but let me first show you a quick graph that illustrates how the market tends to operate based on these four phases:

Let’s dive into each of these in more detail:

Phase 1: Recovery

During phase one of the real estate cycle (which has no real beginning; we are just picking an arbitrary start point), the market is recovering from the last downturn. The market is no longer in a “free fall,” but has begun to look upward. This, I believe, is the best time to buy real estate: the bottom. (Remember, the old cliche — buy low and sell high!)

This phase of the real estate cycle is represented by high (yet stabilized) unemployment, a high number of home foreclosures, and a lot of fear in the general population. This is the time you’ll hear most people saying, “Oh, I would never invest in real estate. After all, look what it just did! My uncle lost a fortune!”

Phase 2: Expansion

During the expansion phase, businesses are once again adding employees to their ranks, and confidence in real estate is once again growing.

Home prices begin to rise, triggered by a decreased supply but climbing demand, as more and more individuals decide that buying real estate might be more advantageous than renting or living with family. Businesses also decide to expand, thus creating a shortage of available commercial buildings. As a result of this expansion, real estate developers begin to build new homes and new properties to cater to this demand.

During this phase of the real estate cycle, it can still be a great time to invest in real estate. Prices are rising, rents are going up, and people are generally optimistic about the future. Good deals can still be found, as the market is still dealing with some of the foreclosure mess that existed previously, but those deals are not simply lying around waiting to be picked up; they must be worked for.

While this can be a good market to be a part of, during this period of growing prosperity, a major problem is brewing: speculators are entering the picture. Speculators are investors who heavily rely on the future growth of the real estate market to generate profits and base their numbers upon this need. In other words, they begin to pay more for properties than they should because they can. And this leads us to the next phase.

Phase 3: Hyper Supply

The third phase of the market cycle is the “boom” time known as “Hyper Supply.” If you were paying attention to American real estate in the mid-2000s, you’ll recognize this era characterized by skyrocketing prices, mass building projects, and by everyone and their brother wanting to buy real estate.

This hyper supply is largely caused by builders who are paying more for land and construction than they should, basing their numbers on the belief that rents will continue to rise and thus justify their speculation. House flippers do the same thing, as they pay far too much for a property because they know someone else will come and overpay them for the completed flip.

Demand during this time begins to level off as the supply built during phase 2 reaches equilibrium. In other words, during the expansion phase, new construction is being built to accommodate the increased demand for real estate and at some point, it will catch up, and the amount of supply will equal the demand. In a perfect world, the market should stabilize nicely at the point because everyone is happy, but because developing real estate is a slow process that can take years, the construction that began during the expansion phase is continuing at rocket speed. The supply overtakes the demand, and vacancies begin to rise. A house of cards is being built on the greater-fool theory, and it’s just primed for a gust of wind to come knock it over.

During this period in a real estate market, spectacular stories of wealth being generated by real estate are told because, in truth, many people were making money — even idiots! As Billionaire businessman and celebrity “shark” Mark Cuban famously said, “Everyone is a genius in a bull market.” That said, this game of musical chairs will soon come to an end, the music will stop, and many people will be left without a chair.

I would encourage real estate investors to recognize when they are in this kind of market and not get lured by the stories of wealth being made from the greater fool. Be patient, stick to your numbers, and if your numbers don’t work, find a real estate niche that does or be patient and wait for the next phase…

Phase 4: Recession

Finally, the house of cards built during phase two and three collapses.

The building projects that seemed so promising just a few years earlier are unable to sell, driving prices down quickly. Foreclosures skyrocket as more and more owners find themselves underwater and more and more investors find themselves unable to pay the mortgage with the decreasing rents and increased vacancy. Combine this real estate recession with an economic recession like we saw in 2007 and 2008, and you’ll find millions of homeowners out of work, unable to pay their mortgage on their home that they paid far too much for in the first place.

This can be an exciting time for real estate investors, but one that must be carefully examined. While the rest of the world is running around like a chicken with its head cut off, savvy investors are looking for “the bottom,” waiting for the supply to once again dip below the demand where great deals can be found. Once the market hits bottom, this is the best time for a real estate investor to jump in and get some fantastic deals and help save the plunging economy.

I believe far too little has been said about the role that real estate investors played in the past decade in keeping the United States’ “Great Recession” from becoming the “Second Great Depression.” While most of the country had decided they wanted nothing to do with real estate, large and small investors across the country saw the potential during this fourth phase and saved the economy, plain and simple. Yes, the government played a role in steering us away from collapse, but it was the local mom and pop real estate investor that truly saved America.

After the real estate market bottoms out, it begins to rise once again. Confidence begins to grow in real estate and in a cycle that repeats generation after generation, the real estate market once again enters phase one: Recovery.

What Market Are We in Today?

At this point, you are likely asking yourself, “Okay… so which phase of the cycle are we in today?

That would depend heavily on what “market” you are talking about! Remember, the market condition could be different for various niches, different locations, and different users. Therefore, you first need to identify exactly what you mean by “the market.”

  • The commercial or apartment market? (Local or national?)
  • The housing market? (Local or national?)
  • The rental market? (Local or national?)

Do you see how important it is to get specific on what you mean when you say “the real estate market?” There are many “markets” that, while connected, function independently of each other.

At the time of this writing, I believe we are nationally in the “expansion phase” in the US housing market, as new construction has picked up dramatically across much of the continent and prices are climbing steadily. Wealth is being built once again and real estate is once again a popular investment. The US commercial market, however, made be flirting between expansion and hyper supply, as foreign investments into US large multifamily properties has pushed prices exceptionally high, driving cap rates down and making it very difficult for the average investor to find deals on apartment buildings. Again, I am referring to the general “national” feel of these markets, not specifically about YOUR local real estate market. Some local areas might already be in phase three, while others are just starting phase two.

Where Are We Headed?

As they say, the only thing certain in life is death and taxes.

The real estate cycle, while dependable, is not counted among the certain. However, general trends and estimates can be made because of the nature of the beast. The real estate market does operate on a boom and bust cycle, fed by supply and demand, though it is the timing that is difficult to predict with certainty. Outside influences, like interest rates, wars, and who is sitting in the White House, can make a large difference on when the market will peak and when it will hit rock bottom.

That said, some have found patterns even in the timing of the market. Many people subscribe to the “18-year real estate cycle” theory, first outlined by economist Homer Hoyt in the 1930s and later re-popularized by economist Fred E. Foldvary, who accurately predicted the 2008 collapse of the real estate market in his report, The Depression of 2008. The 18-year real estate cycle looks at the previous 100 years in American housing prices and, except for a long winter caused by World War II, has found that the market has generally operated on an average of an 18-year cycle from peak to peak, seeing a peak in 1989 and again in 2007.

I don’t know if 18 years from 2007 (2025) is going to the be the next peak; in fact, I doubt it will be that exact. The important thing about the 18-year cycle is to understand why it has worked not, necessarily the timeframe. There are major indicators that show a change in the real estate phase is about to occur, and smart investors look to those indicators to guide their investments. They recognize when greed is driving prices greater than the math is. They understand when fear, rather than educated decisions, is driving prices down. They look for opportunities when others are ducking for cover.

Finally, understand that wealth can be built in any market if you focus on the essentials and avoid getting caught up in the hype. This is why I stress learning the analysis side of investing so much! When the market is hot, make hay while the sun is shining! When the market is over heated, stick to your guns and hustle for opportunities that work. Or if prices are simply too crazy, find a market that is working.

No one can predict the real estate market with 100% accuracy. However, if you can learn to recognize the market and make choices that ride through any market, you can both build and hang on to some terrific wealth.

What do you think? What market are we in? Where are we headed?

Credit: BP

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