Using Real Estate Trends to Predict Housing Bubbles: Should I Invest Now?

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The Power of Patterns

In 1998, economics lecturer Fred Foldvary claimed that he could predict the next economic downturn. Ten years before the dramatic crash and burn of the US housing market, he wrote “The U.S. economy as well as much of the global economy will very likely fall into a depression in 2008.” The basis of Foldvary’s claim? A simple business cycle graph that shows up in any introductory economics class. His findings are a testament to the power of pattern matching. Keeping track of a few key real estate trends can make the difference between an average Joe and an informed investor. There is no perfect consensus around the validity of the property cycle. But whether you’re considering buying a home or crowd funding with RealtyShares.com, history has shown us that what goes up must come down. Understanding these few key data points is worth keeping in mind when deciding how to invest.

Intro to the Real Estate Cycle

In the 1930’s Homer Hoy, a University of Chicago real estate economist, published a piece analyzing land values in Chicago over the course of 100 years. He observed that real estate prices seemed to flow up and down in a predictable 18-year cycle. His theory was creatively named “The Great 18-Year Real Estate Cycle”. This model seemed like a flawless catch-all for some time. Investors could time the market, buying at troughs and selling at peaks alongside the cycle to make risk-free investments. Of course, it’s never that easy.

Almost half a century later Foldvary added one qualification to this theory to explain a prolonged 40 year gap between 1925 and the 1970 that diverged from the 18 year pattern. He asserted that this deviation was caused by World War II and did not invalidate Hoyt’s work, but demonstrated that cataclysmic events can set the property cycle off its normal pattern. This added a crucial nuance to the previously oversimplified 18-year theory.

Figure 1:

figure 1

There are still plenty of theorists that disagree with the rule of 18 entirely. Some claim that the cycle runs its course every 10 years. Others claim that modern government intervention makes the duration of a cycle entirely unpredictable. The length of a cycle, they stress, depends entirely on when the Fed decides to push on the breaks and how much speculation they need to subdue. This is all to say, take these numbers with a grain of salt.

The 4 Stages of the Real Estate Cycle

So 18 years might be an important number, and perhaps investors should be weary of 2026. But even more significant are the underlying drivers that create the iterative cycle. Understanding the mechanics of what pushes prices up and down will provide investors with a deeper understanding of the macro level patterns they’re betting on with an investment.

What ultimately fuels the cycle is the tendency for real estate supply to lag behind demand. To understand this, there is a generally accepted four-step cycle that involves growth, hyper-supply, crisis, and recovery as described below:

Step I: Recovery

Coming off a recession, prices are at their lowest point in the cycle. Typically an accompanying dispersion of cheap credit and monetary expansion by the government encourages borrowing as businesses recuperate. Employees are hired, empty spaces are rented out and prices begin to climb.

Step II: Growth

Profits increase as rents rise with no new space online. There is a resulting influx of new construction projects as developers are enticed by the prospect of attractive returns. This marks the formation of a bubble. A vicious cycle forms as rents continue to rise and spur new, time-delayed construction. This new inventory is therefore a late response to the supply and demand needs that they were targeting. The relationship between rent and construction starts to become arbitrary. Added speculation that usually accompanies the high prices is the foundation for the artificially high prices that create a bubble.

Step III: Hyper-supply

The bubble has yet to burst – rent still grows since occupancy rates are above the long-term average. However, cap rates are low, underwriting is optimistic, and it is evident that supply and demand are out of balance. A key change: there is finally a slowdown of rental growth that foreshadows a correction of the supply and demand curves.

Step IV: Crisis

Rent revenue finally begins to drop as an overheated market pushes growth below the long-term average occupancy. While no new construction is started, a surplus of inventory from hyper-supply projects comes online and erodes profits and occupancy rates. Faced with the threat of inflation, the Fed would increase interest rates and further constrict the economy, eating at the bottom line and causes economic disaster in the form of declining asset values.

Figure 2: Market Cycle Quadrants

figure 2

Should I Invest Now?

In order to make an informed investment decision we need to break it down a bit further. One must understand the position of a) the target sector and b) desired market along the cycle. According to Figure 2, apartments are just entering the hyper-supply stage, experiencing a .1% drop in occupancy rates in 1Q15. However, apartments in Tampa are close to completing a price correction, within the next six months there may be an opportunity to take advantage of low prices in the region. This is all to say, a little bit of research goes a long way. There is no certainty in tomorrow, but a close analysis of real estate cycles is surely a step in the right direction.

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