Understanding Housing Cycles

8 min read

Real estate is one of the driving factors of the economy, affecting numerous industries like employment, banking, and construction. Published in December 2018, Statistics Canada’s 3rd Quarter report on national wealth states that real estate accounts for 76% of Canada’s wealth and has been steadily growing since 2007. To investors, this indicates a healthy, growing market, and therefore, a good opportunity to plant investments. For agents, this may also signify more revenues as more people are drawn to buying properties. Homebuyers may find buying properties in Canada to be expensive, but considering historical trends, real estate seems to continue rising and may ultimately give more value to their homes over time.

But like many trends, the housing market, stable as it may seem right now, will also have its highs and lows. Real estate is not a completely invulnerable market. Like any other sector, it is a wheel that follows a pattern of crashes and booms. These peaks and valleys may seem arbitrary or fortuitous, but smart investors understand that most, if not all, industries are cyclical. They will leverage their familiarity with these cycles and use it to time their investments, thereby getting more valued properties at discounted prices and increasing revenues.

This concept was first observed by Henry George, an American economist, who noticed that the real estate market followed a simple and consistent cycle. Real estate professor, Dr. Glenn Mueller, then took George’s research and simplified the cycle into four phases—recovery, expansion, hypersupply, and recession. Surprisingly, these phases tend to repeat over time. Using the works of Henry George, Professor Fred E. Foldbarry wrote in 1997 what he believed to be the next major crash in the US, which would be 18 years after the US downturn in 1990—and so it did in 2008, with what is now known as the US’s great recession. This illustrates how a good understanding of the local market’s current position in the cycle is key to evaluating profit opportunities and risks of loss.

Recovery Phase

The recovery phase is the period when the market is rehabilitating from the previous recession. The preceding crash makes prices of land and labor cheaper and increases unemployment rates and the number of vacancies. This may seem like a bad scenario but can also be seen as an opportunity for profit. Keeping in mind the cyclical nature of real estate, experienced investors will expect an upward trend after a recession.

Although occupancy rates during the recovery period will still fall below the overall long-term average, a steady increase in demand will also be seen from homebuyers who are able to acquire houses at very low prices. Thus, vacancy rates decline during this phase as well. And as the vacancy rates fall at a steady rate, and demand increases with the economy’s recovery, home prices subsequently go on an upward trend.

This phase is actually the most ideal time to build new constructions and make use of the cheap land, high unemployment rates, and accessible labour on the market. The period begins mostly as a buyer’s market. The recession leaves a lot of homes unsold, compelling brokers to encourage sales by lowering housing prices.

The steady rise of rent prices and the dwindling of vacant dwellings are an indicator that the market is already in the middle or late part of the recovery phase. Additionally, in this stage, new housing starts cannot be seen as much because of stricter financing—a byproduct of the previous recession. However, as the recovery phase comes to an end, more building permits are issued thanks to the continuous growth of demand and occupancy rates approaching the long-term average.

Expansion Phase

The economic development during this phase is most likely back to normal. Employment rates are higher than before, and the rents and property prices start to rise even more due to declining vacancy rates. Here, developers take notice of the ongoing demand for real estate and the steady rise of property prices, incentivizing them to build more structures.

A clear sign that the market has entered the expansion phase is the sudden increase in housing starts or housing permit issuances. Unfortunately, developing these properties takes time. Housing starts at the beginning of the expansion period aren’t much help in satisfying the current demand for new properties.

In the middle of an expansion, however, the market sees a hyper-growth of rent. Since at this point the new developments have been finished, the vacancy rates maintain a decline. As a consequence, rent prices appreciate.

Because demand outpaces supply, investors tend to bring more money into real estate. They are seduced by year-on-year rent and purchase price increases. Higher occupancy rates seem to fuel the buying frenzy in this period.

Essentially, the expansion phase is the seller’s market. A lot of buyers would want to buy properties in this period despite the existing low supply of dwellings available. Even though developments are already happening here, these developments are still under construction and not ready for occupancy. The low supply would eventually be exhausted in a short time due to high demand. This time, investors foresee a boom in the real estate market, leading them to invest more in property development. However, the forecast also leads to hypersupply.

Hypersupply

This is the result of the previous phase’s demand for new construction that was propelled by higher occupancy rates. However, real estate construction takes time, and the demand in the housing market may decline over time as new constructions from the expansion phase are added into the market and also as property prices rise. This signifies the tipping point of the equilibrium of supply (number of homes) and demand (buyers). Everyone, at the beginning of this phase, starts to take notice of the real estate market. Seeing only the great number of new homes developed and economic trends that show no signs of deceleration, people may feel compelled to buy properties, thinking that the acquisitions will make them more profit in the future. However, more astute investors who acquired properties during the recovery or the beginning of the expansion phase will already be selling those properties.

The biggest red flag during the period of hypersupply is the increase in unsold properties. Because the properties developed during the expansion phase has just been added to the market, vacancy rates steadily increase in the hypersupply period. The market is saturated with new homes, but the demand is no longer there. Consequently, this stage in the cycle is also characterized by declining housing starts.

At the onset of hypersupply, the occupancy rates are still above the long-term average. Rent growth is still positive but in decline. As the phase progresses, the occupancy rates gradually decrease into an equilibrium. However, once occupancy rates cross the threshold and dip below the long-term average, then one can say that the market has already entered the recession period.

Recession

The supply of previously constructed properties during the expansion and hypersupply phases have already been completed during this phase. However, the demand is still on the decline, forcing the market to pull down prices for the purpose of liquidating those construction costs. Vacancy rates are still higher than the long-term average, and occupancy rates are below it. No new constructions are observed during this phase, which leads to a lower employment rate.

The clearest signs that the market has already entered the recession phase is a rental growth of either zero or a negative number. Vacancies are on the rise; consequently, property prices may be priced lower than usual. Also, there will be less to no issuance of building permits during this phase.

Clearly, this is not a good time to liquidate assets. Property values are so cheap that these investments would result in losses rather than the projected profits. Investors who invested during the hypersupply stage should wait a little bit more for the market to recover in order to mitigate the possible losses if assets were to be liquidated during a recession. However, it will take a very long time for the market to recover if, during the expansion and hypersupply phase, there were a lot of housing starts that were not completed before the recession.

On the other hand, for shrewd investors, this is the right time to buy properties as the prices are so cheap. Those who were able to liquidate their assets during the late expansion or early hypersupply stages can use their profits to acquire more properties during a recession, capitalizing on the cheap property prices driven by oversupply. This is the right time for developers to buy more properties and maximize profits. It is true that investing in real estate is a good choice, but one should also consider where the industry is in the market cycle. In order to determine whether or not it is the right time to invest and before deciding to buy or sell, it is prudent to look at trends, both historical and anticipatory.

Housing market trends, however, are not universal. A market trend in one place may be different from another. Even patterns seen on a national level may not be applicable to a specific province. Conversely, regions that have nothing to do with each other may experience similar trends. For example, the US market crash of 2008 doesn’t necessarily affect the real estate market of Canada, but that is not to say that the latter will never experience the same phenomenon; in fact, a recession is inevitable. However, this is little cause for worry as long as investors pay attention to housing cycles and make disciplined, data-driven investment decisions.