When it comes to the housing market, plenty of people speculate what might happen next, treating it as some unknown and mysterious entity that’s hard to pin down.
But, in fact, every single real estate or housing market has four distinct cycles. And just like the four seasons of winter, spring, summer, and fall, they each offer their unique advantages and disadvantages, but aren’t inherently “good” or “bad.” (If you’re a homeowner who’s seen your value rise over the last few years, you may refute me on that one!)
Of course, there are also variations, extenuating circumstances, and other micro-factors that play into any market cycle. But, overall, they always follow this pattern – just like the seasons.
You also can’t have one without the others, as the expansions and contractions of each market cycle cause ripples that create and manifest the next cycle.
Today, I’ll follow a little bit of each, so you feel more comfortable and confident with where our housing market may be heading tomorrow – and then, after that.
Phase I of the real estate cycle: Recovery
During the recessionary market cycle leading up to any recovery, the price of land is depressed. In fact, property and real estate are at their lowest value any time during the four-phase cycle.
While demand inevitably marches on and the cost of borrowing money and investing is lower than ever, smart companies start looking to expand their businesses.
The government typically intervenes during this phase, aiming to spark the economic recovery in the form of lowered interest rates.
Smart (and big) companies jump in at a certain tipping point, understanding that this is their opportunity. They expand by hiring new employees, building new factories, plants, stores, etc., and investing in new technology, machinery, and infrastructure.
At the latter end of this phase, the extreme rate of vacant offices, retail spaces, plants, and homes starts to decrease. There is just too much inventory, prices and interest rates too low, and demand too high for economic expansion not to start in earnest.
Phase II of the real estate cycle: Expansion
The real estate market leaves Phase I and enters Phase II of the cycle once companies and consumers have started to purchase or rent most of the available properties, easily tracked by low vacancy rates and shrinking inventory.
With rents unprecedentedly high, buying vacant land or existing properties for development is more attractive than ever.
New construction and development begin to boom, but the problem is that these projects could take a long time to get underway and reach completion – usually two to five years. So, we still have strong demand but supply to fill that demand can’t be built or developed fast enough, resulting in increased upward pressure on rents, land and housing prices.
But, very soon, people start overpaying for existing homes, land and properties. “Investors” and consumers alike start basing the price their willing to pay on the scarcity of supply and the anticipated growth of rent and housing prices – not actual market conditions.
This is a critical point in the real estate cycle, where the perception of future growth outpaces the facts, setting up the perfect storm of conditions for the next phase in real estate – the boom, the bubble, or, as economists call it, hyper-supply.
Phase III of the real estate cycle: Hyper-supply
In Phase III of the real estate cycle, we see a rise in rents and prices as the demand for affordable housing to rent outnumbers supply, driving up costs.
Rising rents make the building of new units more attractive and financially feasible again, so more builders break ground on new projects.
This expansion of new units and rental housing is characteristic of both the expansion and hyper-supply phases of the real estate cycle, as building projects take a long time to initiate and finish.
However, the amount of new inventory for both rental and owner-occupied real estate units starts to saturate the market.
Prices on rentals and homes have also been driven up by demand, but now supply has finally caught up with demand thanks to two cycles of consistent building and expansions, reaching a point called hyper-supply.
That brings the first leak in the boat or indicator of a downturn in the real estate market: increases in unsold housing inventory and higher vacancy rates for rentals.
As all of these builders finish the new home and new rental unit projects they started back in the expansion phase, the number of available units bypasses the need, so we see the occupancy rate climb above the long-term average.
However, rental process and home prices are still rising, although their rate of growth begins to slow, as the saturated market no longer can justify these prices.
Phase IV of the real estate cycle: Recession
With that warning bell, we’ve now moved into Phase IV of the real estate cycle, or recession.
As the market shifts from hyper supply to recessionary conditions, we face the second warning sign of trouble as occupancy rates fall below the long-term average.
Builders and developers are forced to stop new construction. But the multitude of projects they began during the hyper supply phase are still reaching completion.
This additional unneeded inventory leads to lower occupancy rates but also lower rents (and home prices), as buyers and renters have more and more to choose from, which start devaluing real estate.
The third warning sign is upon us, an increase in interest rates, which acts like a match thrown on a pile of dry timber to ignite a full-on housing recession.
Sooner or later, the Federal Reserve is driven to increase interest rates to fight inflation brought by the rapid expansion of prices we saw through the expansion and hyper-supply phase.
As interest rates climb, developers and builders slam on the brakes and stop building any new projects, as an increase in borrowing costs doesn’t make new development feasible or attractive.
However, the market is suffering through dropping occupancy rates, lower rents (and housing prices) because of oversupply, and higher interest rates for home buyers.
In combination, this quickly creates a negative ripple effect across the real estate market and affiliated industries, from builders and developers to home sellers desperate to cash in on the (missed) high point of their equity, landlords, income for realtors, loan officers, bankers, appraisers, title company reps, inspectors, attorneys, construction companies, laborers, etc. all the way down the line.
When vacancy rates start plaguing landowners, sellers, and builders, values plunge, with foreclosures soon following. The real estate cycle has come full circle.