Investment risk and uncertainty in the real estate housing markeIn my blog last week I discussed targeting great tenants and rehabbing the fixer upper, in my 3 part, Becoming a landlord series, today I’m going to discuss how to detect a looming market collapse. The housing market follows a cycle that can be tracked, in fact you can look back in history as far as 1818 and see that the real estate cycle is generally completed within an eighteen year window. Throughout history there are a couple exceptions to this eighteen year window one being World War II and the second being in the late 1970’s when interest rates nearly doubled. So if you know that the housing market completes its cycle every eighteen years then the second very important piece of information you need to know to predict the next housing market collapse is where we are in the cycle. There are four distinct phases in the real estate cycle.

Phase 1Market collapse is noted by a continued increase in the vacancy rate and a stop in new construction but completion of housing started in the Oversupply phase.

Phase 2- Recovery can be be distinguished of housing is greater than the demand and continued new construction.

by a lull in new construction and a declining vacancy rate.

Phase 3Growth can be categorized by an increase in new construction and a continued low vacancy rate.

Phase 4Inundation is when the supply of housing is greater than the demand and continued new construction.

I’m going to go into a little bit more detail in regards to each of these four real estate phases below.

Phase 1- Market Collapse

You know you are in the midst of a market collapse when vacancy rates are higher than the long term average and new construction stops. Some of the projects started in the inundation phase will be finished up and continue to flood the market adding additional inventory which in-turn decreases occupancy and rental rates even further, this is a big hit for property owners that quickly diminishes any profits.

The federal reserve generally raises interest rates at this time to slow the inflation of housing prices that accompanies the growth and inundation phase and is a good indicator of things to come. The good news about the higher interest rates is that it generally stops further development because it’s no longer profitable and so it dramatically slows market inundation (phase 4). The real estate market has a rather large effect on the economy as a whole and a snow ball effect drives the market even further down. When profits fall below a landowners costs, foreclosures follow and the real estate cycle is reset.

Phase 2- Recovery

We know what happens when the market collapses unemployment rates are higher, people quit spending money, companies tighten there belts. The price for land and property is at its lowest point (hint: this is a good time to buy). To sweeten the deal and make investing in real estate even easier, the recovery is often jump started by the government lowering interest rates. Another key ingredient to recovery is an increase in population which in-turn increases the demand for goods and services.

With an increase in demand and a lower cost to investing, companies are now able to once again build and grow their business. Jobs are created, industry takes off and with that there is a need for land, commercial space, and residential properties. The vacancy rates decrease across the board and the economy as a whole starts picking up pace.

Phase 3- Growth

The transition from the recovery phase to the growth phase occurs when families, individuals, and companies have purchased or rented most of the available buildings and demand is higher then supply. Because the vacancy rate is low and demand is high landowners can raise the rent. This is great news for landlords as most real estate expenses are fixed costs (mortgage, taxes, insurance, etc), increased rents are pretty much a dollar-for-dollar increase in profits.

With the now higher profit margin in real estate developers come a running to develop vacant land. With the new development satisfying the demand for properties the rents will equalize, prices will increase slowly and development will continue as needed, right? Well….. not exactly, with real estate there is a 2-3 year lag at a minimum in need/demand and the finished product being on the market and available. Developers have a lot of work to do before the finished product is available to consumers. Some of that work includes; securing financing, negotiating land sales, obtaining building permits, and of course the actual construction.

In the mean time rent rates have continued to increase and investors start speculating and calculating into their formulas that rents will continue to rise. This creates a point in which real estate prices are artificially driven up based on this speculated increase and the housing bubble begins.

Phase 4- Inundation

The first sign that we’ve crossed the threshold and have entered into the inundation phase of the real estate market cycle is when there are homes sitting vacant for sale on the market for over 30 days. As long as the occupancy rate exceeds the long-term average, rents will continue to rise but at a much slower rate then what was occurring in the growth phase. As long as rents are increasing new construction will likely continue. Should developers stop building because the number of units being completed are creating a surplus of houses, yes! Do developers stop building? No, not usually. Home prices are high, rents are high, it’s a landowners dream if you bought at the right time (the beginning of the recovery phase). This is the point in which the bubble pops and a market collapse occurs.

What phase are we in now?

Since the market collapse we experienced in 2008 we’ve seen recovery and in some locales across the nation we are in the expansion phase. If the research holds true and history repeats itself we are set to experience many years of expansion with the real estate cycle resetting in around 2025. That forecast does not account for government intervention or other things that may happen between now and then. It’s a very interesting topic and would love to hear anything you may have to add, different predictions or models that you may follow to predict a market collapse.