The Cycle That Residential Real Estate Markets go Through

*Occupancy is used throughout this article which also means  inventory available in terms of the resale market

Real estate moves through quite an interesting cycle and we don't always know the timing of it or when it's going to happen but we do know that real estate moves through a cycle. The real estate cycle is described in a four-phase breakdown best explained by Glenn Mueller who is a professor at the University of Denver. Glenn perfected the real estate cycle and illustration after building off the research of early economist Homer Hoyt who first did research on cycles back in 1933. This model dates back to the 1870s and the truth of it is still present and something we see throughout the world in every market. It is a tool we can use to measure and help understand where we are in the cycle to make informed decisions moving forward.

The economy (nationally and globally) goes through cycles and so does real estate. It is important to mention that while commercial and residential markets move through the same four phases of the cycle they can't be looked at the same way because commercial real estate is an investment process while residential real estate (homes) is a production process. Commercial real estate has two separate cycles: physical and financial. The “physical market cycle” is the interaction between users (demand for space) and developers/owners (supply of space) in an individual market. On the other hand, the “financial market cycle” deals with the prices of commercial real estate and is driven by the capital markets (the interaction of buyers and sellers of properties) which have evolved from local to national, to public and now global in nature. This article will focus on the residential cycle and a later article will go into the commercial cycle.

The economics of everything always comes back to supply and demand. Supply is always fulled by demand but demand can have multiple factors feeding into it. Residential and commercial have different forces affecting demand for a product. Residential demand is generally fuelled by the need for a place to live and commercial demand is fulled by financial and space markets. So both go through the same cycle but each has different demand forces. Some markets will have a stronger demand for housing than others because of a stronger employment sector. Demand for housing in the Lower Mainland has for the longest time always been strong due to a diverse and demanding job market, a beautiful location and high immigration. Every year the Lower Mainland welcomes about 60,000 new residents which is why so many local investors break the golden rule of "cash flow is king" and just buy for the appreciation.

Phase 1: Recovery Phase

During the recovery phase, we have just gone through a recession so have high unemployment, high vacancy, low prices, low rents, low home prices, the bottom of economic activity. The demand for space/stuff grows organically. people are still having babies and companies are still selling stuff. That built-up demand starts to slowly bring us out of the recession through the recovery phase. The recovery phase is typically helped by government intervention such as low-interest rates and other stimulants that drive investment to the market area.

How we measure the different phases and where we are is we look at occupancy rates. can be in terms of rented units or look at the number of inventory available for sale. In the recovery phase, we have low occupancy and as that economic activity takes place more and more rental units become rented. More and more homes for sale get purchased.

Phase 2: Expansion

From the recovery phase, we move to expansion. When current occupancy exceeds long run occupancy then we kinda no we have gotten out of the recovery phase as more units are occupied then have been long term. The significance of that is now we begin to see upward pressure on rents/prices. We tend to see upward pressure when occupancy is high, inventory is low and that takes place during the expansion phase. We're now running out of space, because of that scarcity, rents/prices are going higher but we're not seeing a lot of new demand.

The expansion phase will continue to see occupancy go up, upward pressure on rents and typically the only thing that will turn that around is the addition of new supply. As we start to make our way through the second phase is when developers respond to high occupancy/rents/prices and start to build more units. When the new supply comes online is when we start to see that thirst being quenched within the market. Markets such as Vancouver will spend the majority of there time in this phase of the market. Demand is quite consistently outpacing supply and some years more so than others but for an area that is bringing in 60,000 new people a year, it is easy to understand why we are always "expanding" and therefore will not spend much time in the recession and recovery phases.

Phase 3: Hypersupply

We then transition to phase 3, Hyper supply. We know we have transferred from phase two to three once occupancy starts to decrease. What causes the decrease is typically due to seeing new units come online resulting in more homes available than are being absorbed so we start to see occupancy decrease. What can also happen and generally in smaller markets or one industry towns is a shift to phase three & four rather abruptly due to a big employer leaving town and without any new construction happening there is an oversupply of homes causing the market to crash. This is why I will only invest in towns offering a diverse economy such as Kamloops, BC or anywhere in the Lower Mainland for example. Throughout phase two and three current occupancy is still above the long-run average occupancy. Whenever there is that scarcity in the market for supply we still see upward pressure on rents/price. In phase three we still have above average occupancy, therefore we have above-average rents/prices and so builders are saying to themselves this is great we should keep building. The problem in real estate is it takes a really long time for a new project to come online. Start to finish for a project can be between 3 - 5+ years and that long development period is largely responsible for the boom-bust nature of the real estate cycle. By the time units do come available can be long after they are needed.

In phase three we see rents/prices going up but occupancy going down. The rents/prices go up because current occupancy is above the long-run average but occupancy is trending downwards to eventually get out of this phase and is being pushed typically by the introduction of more units. This is a great time for developers to hit the breaks. To say we're not going to add more units, we see a recession coming. Not only is occupancy decreasing we have a bunch of new units in the pipeline being released over the next couple years, let's go ahead and stop building for now. The problem is majority of developers are either not willing to pause and hit the breaks or are not paying enough attention to the market so they continue to build and the car runs off the cliff leading us to the next phase of the real estate cycle which is a recession.

Phase 4: Recession

The tell for when we transfer from phase three to four is when the current occupancy falls below the long-run average. Suddenly now not only do we have enough units coming online we have so many units coming online that we are developing an abundance of vacant units. Recall it takes an average of 3-5 years for a project to be released, all of the units developed in phase two and three are now being delivered in phase four long after there is no longer a need for additional supply. This pushes prices down, pushes occupancy down, developers go bankrupt, they stop building and that eventually leads to the bottom of the real estate market where we have very low occupancy, we are in the middle of a recession and it is only when that occupancy stops coming online that we begin the process of phase one and we start the cycle all over again.

This has been measured for over 200 years and there is data that shows this cycle continues to go and it is typically around an 18-year cycle but of course that depends on what is going on in the market. This should help to explain the cycle that residential markets go through

Conclusion

Markets sometimes can move backwards if there is a non-market shock such as the introduction and influence of foreign buyers. Canadians invited the world to Vancouver for the 2010 Olympics and then the government incentivized wealthy families to bring their money to Vancouver. That combined with low-interest rates and a cheap Canadian dollar made for a long period in the expansion phase. In 2016 the provincial government started to try and reduce the dramatic increase in price Vancouver had been seeing by introducing a 15% foreign buyers tax which resulted in a price decline for 5 months, however, that was not enough to deter demand as pricing started to increase again for 17 months before reaching a peak in June 2018. It was at that time further measures were put on both domestic and international buyers resulting in a market that has been relatively balanced since then.

Now that I have gone over all of this high-level information explaining how the market cycle works and when home prices will fluctuate the question that needs to be asked is, does any of what was just talked about matter to me? The answer for the majority is no because the average home buyer is looking for a home for the family. When buying a principal residence you do not need to worry about the highs and lows of the market mainly for two reasons:

1) You are selling and buying in the same market so even if you sell your home in a low market you will be buying in the low market so it makes up for it, and;

2) If you buy at the top of the cycle and six months later the market crashes 20% it doesn't matter because you are not selling months after buying a principal residence and it is very challenging to predict when the market will crash and how hard. This is a principal residence so you most likely will be living there for years to come therefore will ride out the market and eventually come out on top because real estate is a long term game.

Whom the real estate cycle does apply to is mainly investors. Using and understanding the phases of a cycle can help to forecast returns, timeline and an exit strategy. What I don't want anyone to take away from this is I should wait till a recession to buy because there is money to be made in every phase. Those who wait for the big crash will have a much harder time getting wealthy than those who find the opportunities in each phase of the market. The effects of a recession on real estate in Canada are far less than our neighbours to the South largely due to stricter lending practices. Looking back to the 2008 recession, home prices for Vancouver peaked in June and started to head down hitting a bottom in March 2009 resulting in a 13.9% decrease in pricing. If you bought at the peak of the market it would've taken 1 year and 10 months before prices were back at the levels you bought. The recession had a whopping 9-month effect on the real estate market before heading up again which it did fairly consistently for 10 years before hitting a high in May of 2018. The S&P 500 on the other hand peaked in October 2007 and headed down for 1 year and 5 months resulting in a 52.56% loss. If you bought at the peak it would've taken you 5 years and 6 months to be back at where you bought in. Moral of the story, don't wait to buy real estate. Buy real estate and wait.

*Information pertaining to the four phases of a real estate cycle was largely gathered by Harvards Teo Nicolais