RELATIONSHIP BETWEEN ECONOMIC INDICATORS: THE REAL ESTATE CYCLE

The real estate cycle starts when the economy is growing slowly (Fig-3-3). Interest rates are declining, wages, inflation and commodities are stable. This is the time when real estate developers recognize the opportunity provided by low cost. Believing in better business conditions ahead, and the resulting need for office space and housing, they begin building new office space and housing with a distinctive character to attract new buyers. Borrowing activity increases to initiate these projects.

Soon, other developers recognize that something unusual is happening and maybe someone knows more than they do. They also recognize that because of lower interest rates, this is a good time to increase construction. This involves more bank loans and employment to build new offices and new houses. Bank loans, as a result, start increasing more rapidly.

As the economy improves because of this building demand and increased overall business activity, prices of houses and offices eventually start appreciating faster. This process attracts more developers, more bank loans are therefore required, and a new housing and construction boom is underway. Initially, banks feel comfortable with these loans because of the strong construction activity, especially in light of the fact that prices for office space and housing continue to increase.

At some point, however, development becomes over-extended. Interest rates begin to rise because of an overall strong economy. The new houses and office buildings are not bought or rented right away as borrowing costs make new investments unattractive. Eventually, some price concession has to be made to sell the properties. Rents and prices of houses decline, and as new developers recognize that the building boom does not offer the profit potential that they realized earlier in the cycle, they stop building. Of course, this has a negative impact on the overall economy and a negative effect on employment and income.

Demand for real estate declines, caused not only by overbuilding but also by increasing interest rates. Eventually, prices of new construction actually decline. Builders find themselves overextended and banks realize that their loans cannot be serviced anymore due to poor profitability of the construction industry. These are times when banks’ insolvency begins to be an issue and becomes more acute as the slowdown continues. This is usually the time when lending officers increase the spread between the interest they charge and market interest rates to protect themselves against marginal borrowers and to improve their profitability, thus worsening the negative impact of rising interest rates.

This process causes further slow down in overall business activity until the cycle starts over again when interest rates decline due to the slow demand for money, not only from the construction sector, but also from the rest of the economy. Eventually, the business cycle stabilizes, and the opportunities seem to be on the horizon again as cost of raw materials, labor, and money decline to a level attractive enough to start the new real estate cycle. Examples of real estate cycles can be found in the United States in the 1980s and in Japan and Asia in the 1990s.

The real estate cycle is strongly influenced by trends in the economy and trends in interest rates and commodity prices. The strong increase in liquidity from 1992 to 1993 created a strong economy, and during that time, interest rates were also declining with fairly weak commodity prices, in particular lumber. However, the strong growth that took place in 1994 caused interest rates and commodities to rise in 1995.

The outcome was that real estate stopped expanding, reached a peak, and declined mildly in 1995, due to the sharp increase in commodity prices and interest rates in 1994. The subsequent slowdown in the economy in 1995 created the condition for lower interest rates, and therefore, the construction business revived again in 1995 and 1996 in response to lower interest rates and lower commodity prices.

(From Chapter 3 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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