“The first principle is that you must not fool yourself, and you are the easiest person to fool.” — Richard P. Feynman, Nobel Prize-winning physicist
Real estate goes through multiyear cycles of boom and bust periods. I break the cycle into four periods: peak, contraction, trough, and expansion. This is a mental model to understand how many properties tie into the general real estate market.
4 Phases of the Real Estate Cycle
To illustrate the cycle, I use the California Association Realtors affordability index. According to C.A.R.’s website: C.A.R.’s Traditional Housing Affordability Index (HAI) measures the percentage of households that can afford to purchase the median priced home in the state and regions of California based on traditional assumptions.
Everyone wants to buy real estate. The fear of missing out is leading to panic buying. Real estate prices have reached a new high. Appreciation is decelerating. Properties are taking longer to sell. Housing affordability is not within the range of an average family. The housing affordability index for the state of California in 2006: 12.25%. And 2007: 13.25%.
The selling begins. Home prices fall. Unemployment increases. Houses are languishing on the MLS listing, and housing affordability increases. New home construction freezes. California CAR index for 2008: 33%, 2009: 50.75%, 2010: 48%.
Housing prices begin to stabilize. Few people are willing to invest in real estate. Investors with experience, capital, and track records are able to raise funds for investing. Think when the CAR affordability index was 52.75% in 2011 and 51% in 2012.
Housing prices start to rise. New home construction starts increase. Unemployment decreases. Real estate becomes popular again. Think when the CAR affordability index was 36% in 2013 and 30.75% in 2014.
The real estate cycles can last decades or more. No one knows where we are in the cycle. It only becomes clear years later.
So if we can’t time the cycle, why should we care about it?
The wisdom of the crowd can influence even the most sophisticated investors. The only way we can lessen its hold is to recognize what’s transpiring in the market. This provides us with physiological distance from the world around us.
People who are unable to do so will find themselves trying to buy real estate for the sake of buying or due to the fear of missing out. There’s a huge difference between buying a property and investing in a property. You buy a home to live in. You invest in a property because it will provide you with a healthy return on your dollar.
When the market becomes overheated, you’ll start hearing, “Well this market is different because X won’t happen again, and interest rates are low, so I better pull the trigger before the Fed takes action.” The specific property you are looking at should drive your investment decision. Not macro economic forces. You shouldn’t pull money out of our house to buy any piece of property because interest rates are low. And if interest rates are high, you aren’t going to pass on an investment that makes financial sense.
Macro economic indicators are great for cocktail parties and useless debates. But if you want to be successful in real estate, you need to know what your financial goals are. What’s going on in the neighborhood you invest in? What makes a good deal for you? How you can go about financing the deal?