The Four Phases of the Real Estate Cycle (and when we'll see the next crash)

The Four Phases of the Real Estate Cycle:

“The next major bust, 18 years after the 1990 downturn, will be around 2008, if there is no major interruption such as a global war.” — Fred E. Foldvary (1997)

If you want to read the ups and downs of the housing market, there may be no better place to turn than the venerable halls of Harvard University to check in with some of the most noted economics and real estate minds in the world.

Just like the cycle of any market, what we do know is inevitable – some call it a downturn or a correction; others a bubble or even a crash – is that what comes up must come down, and then up again.

In fact, these same Harvard economists accurately predicted the financial crash in 2008, or at least the timing of it if not the severity. They didn’t know some complex algorithm or hidden financial secret that the rest of us don’t, they just understood one thing: that any real estate market cycle goes through four phases.

In fact, as early as 1876 an economist named Henry George noted that all real estate cycles move through four phases.

Understanding these market shifts, what causes them and what happens next can empower the average person to make incredibly wise decisions about their real estate holdings far ahead of the curve of public sentiment or knowledge.

Imagine if you had sold all of your property in 2007 before the historic crash? What would it look like if you had kept liquid in anticipation of the Great Recession and had the means to snatch up properties so discounted the banks almost couldn’t give them away? If you knew these signs of a housing market ready to expand and appreciate wildly, you could certainly take advantage of that and when you could ascertain the warning signs that the roller coaster was at its peak and about to go on a wild ride, you could sell, sell, sell way ahead of your unsuspecting and vulnerable neighbors.

Believe it or not, all of that information is readily available. So when will the next real estate crash happen? Read on to find out!

Recovery:

Phase I of the real estate cycle

Having gone through the dark days of the last economic downturn, we all understand the characteristics of a recession, at least anecdotally. Recessions are characterized by:

High rates of unemployment

Decreased levels of consumer consumption

Downturn in corporate investment and expansion into buildings, factories, machinery, etc.

The price of land is depressed. In fact, property and real estate are at their lowest value any time during the four-phase cycle.

But during this phase, the population doesn’t stop increasing, and that means a higher demand for goods and services.

The government typically intervenes during this phase, aiming to spark the economic recovery in the form of lowered interest rates.

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. There might be some small businesses that have to close their doors, but the larger corporations see this valley as a golden opportunity to expand and snatch up invaluable market share.

This expansion includes 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 rates 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.

Expansion:

Phase II of the real estate cycle

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. In fact, occupancy rates surpass long-term averages during this period.

With vacant or available properties becoming far scarcer, opportunistic landlords start to raise rents. Most real estate expenses are fixed so their revenues and profits also increase with these inflated rents. With rents unprecedentedly high, buying vacant land or existing properties for development is more attractive than ever.   

New construction and development begins to boom, but the problem is that these projects could take a long time to get underway and reach completion – sometimes several years. In fact, the average new development takes two to five years to finish. 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.

So by the time this new supply becomes readily available, the climate of high demand, high rates, low occupancy rates, low interest rates and low supply has been active for five to seven years, a period of robust economic expansion. 

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 perception of future growth outpaces the facts, and 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.

***

Tune in for part two of this blog coming soon where we examine the two remaining phases of every real estate cycle – and share these Harvard economists’ predictions for exactly when we’ll see the next real estate downturn.

Forget real estate, stock, and tech bubbles; the first market crash in history was Dutch tulips - Tulipmania.

In recent memory, we’ve seen market crashes and bubble bursts revolving around different commodities: stocks, real estate, technology, mortgages, and even the banking system, itself. The fear and panic from a market crash is downright horrifying, shaking the very foundation of our economy and belief in the system to serve the individual.

But has it always been that way? We can look as far back as the Great Depression in the United States as evidence that this phenomenon of an overinflated bubble meeting a sharp pin prick is not new, but was the stock market crash of the 1920s and 30s the first? Not even close.

In fact, you’ll probably be shocked to hear that the first speculative asset to skyrocket in value and then crash entirely was Dutch tulips. That’s not a typo – I really do mean Dutch tulips. In the 1600s, certain market and geographic factors (and a whole lot of greed and irrationality) saw the price of imported tulips climb so fast – even 1,000% in one month – that some rare bulbs were worth an entire luxury home. Only months later, that same rare tulip wasn’t worth more than a common flower, sending the Dutch economy reeling. The Dutch tulip market crash was such a profound historical event that they even had a name for it: “Tulpenwoede,” or tulip madness.

The buildup.

1593 Tulips were first introduced to the Dutch when traders from Turkey brought them across the seas to Europe. Legend has it that a Dutch ambassador working at the court of Suleiman the Magnificent in Constantinople, Turkey noticed the magnificent flowers and sent some to a Botanist friend in Holland.

The rich had already been in the practice of rampantly collecting luxury items from foreign shores at the time, from seashells to spices to artwork. 

When the Amsterdam stock exchange opened in 1602, bolstered by the Dutch East India Company, a thriving but informal future exchange market blossomed. Soon, flowers became a hot commodity, and among them, tulips were the most coveted.

But what probably launched the Tulipmania value explosion – and subsequent market crash – was a strange twist of fate. The tulip crops were infected with a non-fatal virus known as mosaic, which didn’t kill them, but changed their appearance, causing brilliant “flames” of color to appear on their petal.

All of a sudden, the already coveted flowers became rare and unique trophies for the rich. As a luxury item only available imported from Turkey, they had been selling at high prices before, but once the mosaic virus enlivened their appearance, the price shot up astronomically.

Cashing in on the new tulip craze, but by the 1630s, a few tulip brokerages had opened for business, most of them wealthy merchants in the same tight circle or even family.

The bubble inflates.

Although the supply of new tulips, and especially those with the beautiful mosaic defect, was limited, people clamored to get more as the ultimate status symbol – or means to a quick profit as prices always seemed to rise. When buyers and garden centers bought as many as humanly possible, it further limited supply, fed demand, and skyrocketed prices. Traders and merchants stocked inventories of tulips as fast as they could, with no consideration for cost.

"Neighbors seemed to talk to neighbors; colleagues with colleagues; shopkeepers, booksellers, bakers, and doctors with their clients gives one the sense of a community gripped, for a time, by this new fascination and enthralled by a sudden vision of its profitability," writes Anne Goldgar in "Tulipmania."

Soon, it seemed like everyone was dealing in tulips bulbs, and a huge secondary market emerged where people bet on their future price increases, buying and selling options, not just the flowers themselves. The common perception was that the market for these tulips had no ceiling, as they thought they could easily unload tulips to unwitting foreigners, so people started cashing in or trading their houses, land, life savings, or any other assets they owned to get their hands on more bulbs.

The craze was so out of hand that in the 1630s, a sailor was arrested and locked in a Dutch jail for eating a tulip bulb that he had thought was an onion. It was said that the mistake of eating the bulb was about the same cost as feeding his ship’s entire crew for a year!

Everyone wanted in on the tulip madness, and by 1637, values were shooting up twenty-fold every month.  And then, the bubble hit it’s ceiling over a one month period in 1637, when the price of Switsers, a popular tulip bulb, went up 1,100%, from 125 florins a pound to 1,500 a pound.

Quite possibly, the zenith of Tulipmania was February 5 of 1637, when a historic auction was held in the town of Aikmaar to raise money for orphaned children. The prized sellers at the auction were two varietals of tulips: a Viceroy that sold for $4,203 florins and an Admirael Van Enchuysen that sold for 5,200 forins. Just how much is 4,000 or 5,000 florins? It’s enough to buy a luxury home in Amsterdam at the time. The value of these tulips had reached the point of abject lunacy.

The bubble bursts.

No one is exactly sure what happened to cause the market to crash, seemingly overnight. Some think it was traced to economic irregularities due to the Black Plague spread over Europe. Others think that the greed just hit its zenith, when people tried to sell their options and inventory more than keep buying. Or maybe someone just blinked, realizing the price increases and market craze was unsustainable. But all of a sudden, everyone wanted to sell. And the prices, which had been soaring exponentially every month, began to soften and then fall. The same mob mentality that drove the masses to buy and trade tulips out of greed turned to abject panic to get out.

Prices completely collapsed in February of 1637. Not only did people completely stop buying, but also the huge options and futures market that revolved around the tulip trade was exposed as a house of cards. At the blink of an eye, with no buyers and a herd of sellers looking to dump their tulips or promises to buy inventory in the coming season, sellers, insurers, merchants, and bulb traders went bankrupt.

The crash.

The ensuing crash was such an economic free fall for a good portion of the population that on April 27 of 1637, the Dutch government had to step to try to stabilize the Tulipmania fallout. The federal States-General issued a proclamation that laid out a process for arbitration for those who couldn’t pay their debts or were no longer willing or able to honor their contracts. They offered a solution of allowing people to honor contracts at only 10% of their face values, with local magistrates arbitrating, but even that didn’t help. The panic that swept the nation as people realized they’d cashed in their houses, businesses, life savings, etc. in order to buy simple flowers. No amount of government intervention would help, as people couldn’t even give away the once invaluable tulips and contracts to buy them.

The damage to the Dutch economy was total; even those prudent few people who weren’t involved with the tulip trade felt the impact of the ensuing national depression. For centuries, the aftershocks felt from Tulipmania kept the people, governments, and banks of Holland notoriously risk-averse. And even today, when they see a tulip, they think of something far different than just a beautiful flower.

There are 3 schools of thought when it comes to real estate: The New School, Old School, and Right School.

There are three schools of thinking when it comes to real estate: the Old School, the New School, and the Right School.  I’ll explain all three. 

Old School:

Much of our financial advice comes from our parents, or parents’ parents, who pass down ultra-conservative, Depression era thinking when it comes to money.  Real security came through getting an education and having one good job for life, as was the notion that you should pay down your mortgage and own your home outright as quickly as possible.  Often, people kept the same job for life and bought a home with a large down payment with the intent to stay there for 30 years and never move or refinance. 

Debt was considered bad and to be avoided, at all costs.  During the Great Depression, banks called notes due and repossessed homes at farms at alarming rates.  Your bank deposits and savings were not federally insured and when currency became devalued, many people lost their life savings.  There were no credit cards, auto loans, student loans, or other debt vehicles to contend with.  Many “old timers” considered the safest investment packing a coffee can with money and burying it in the back yard, or holding on to gold, or having slow and steady government bonds.  The fear of loss was far greater than the hope for gain. 

The way to get ahead was to “grind” and “pull yourself up by your boot straps.”  The ultimate goal was to work a very long time so you get a secure pension and have your home paid off in retirement.  These lessons of financial conservatism were instilled in the children of those who experienced the Depression, the Baby Boomers. 

New School:

As the world changed, so did our thinking about money.  Our parents’ advice about money no longer seemed relevant for the new rules of the game.  College graduates entered the work world competing for $10 an hour jobs with $100,000 in student loans.  People changed careers and jobs 5 or 6 times in their lives, and companies certainly had no loyalty, downsizing, outsourcing, and replacing seasoned workers with newer, cheaper employees.  Additionally, most people moved or refinanced frequently, especially when interest rates were favorable and the real estate market was white hot. 

Homes were not just places to live in, but slot machines – a chance to benefit from rising markets and cash in as the equity went up.  Gambles like this were essential to get ahead, as the rising cost of living and wages that didn’t keep pace made it almost impossible to amass a big nest egg or be financially comfortable.  If the investments didn’t work, there was bankruptcy, short sales, loan workouts, and the chance to start over again without the debt following you around the rest of your life.  But if it worked, the pay-off was huge.  Few people worried about paying off their mortgage because it was rare to stay in the same house for 30 years, and that money could be used better elsewhere. 

The way to get ahead was to work hard but to work smart and take risks – the computer age and booms in technology and Internet companies created far more wealth than “keeping your nose to the grindstone.”  Set backs and losses were just an inevitable part of the process of success, and debt was seen as a necessary vehicle that allowed you to risk someone else’s money, not your own.

 

The Right School:

Since everyone is different, there is no one right answer for managing finances and real estate that applies to everyone.  Each situation is unique and should be treated as such - there is no one correct answer for every situation.  Any investment is just a balance of risk and reward, and that applies to your real estate and mortgage choices.  Before making any big moves, weigh all factors and gauge your risk tolerance.  This approach finds a hybrid between Old School and New School methods. 

For instance, a lot of people should have been WAY more conservative with their real estate strategies when the market was hot.  The prevalent thinking was short term, whipped into a frenzy of greed and fear of missing out.  People bought homes they couldn’t afford and treated them like ATM machines, empowered to fail by stated income loans, no money down programs, a frenzy of greed (from consumers to realtors to lenders to banks) and an ever-expanding bubble of rising prices.  A healthy dose of Old School wisdom would have helped prevent the catastrophic real estate collapse that’s taken 5 years to crawl out of. 

Then again, peoples’ thinking is often counterintuitive.  They buy when they should sell, and sell when they should buy because of the aforementioned impulses – fear and greed – instead of any conscious business strategy and clear rationale.  The last couple years (and now!) too many investors and potential homebuyers have sat idly on the sidelines.  Instead, the masses wait for real estate to be “popular” and “hot” and “safe,” again, which means you’re at the top of the roller coaster and it’s the exact wrong time to buy!  Instead, savvy investors take advantage of down markets and apply long term thinking to cash in.  Sometimes, the most dangerous investment is the one you don’t make!     

Which school of thinking is right for you?  That depends on a lot of factors, of course.  How close are you to retirement?  Do you have a family and children to support?  Does your income allow you to amass savings and fund retirement investments?  How well is your money diversified?  Are you prepared for medical emergencies or long-term care?  What is your risk tolerance?  Are you prepared to be a landlord?  How about your tax situation? 

 Sit down with a team of trusted advisors to collect all the information you can so you can make informed choices, not react impulsively.  Your financial planner, tax advisor, insurance agent, mortgage planner, and yes, your Realtor, should all be part of this team.  Set your financial goals and map out the best plan to get there based on the RIGHT school of thinking.