In my last column, we starting a discussion about economic cycles and the importance of being able to both understand and predict them. That column concluded by pointing out the fact that in reality there is not one but two cycles running concurrently, but out of sync. These two cycles feed on each other. The first cycle is the economic cycle; the second is the real estate cycle.
A good model of cycles looks like a mountain-like graph, which shows the roller coaster effects of the cycle. Below is an example of two complete cycles of both the economic and real estate cycle and how they interact with one another. In the chart below, the economic cycle is depicted by the black line and the real estate cycle by the blue line. As noted above, these two cycles run together but slightly out of sync.
First, let us examine the causes and effects of the true economic cycle through an elementary discussion of basic economics.
If we look where the mountain peaks and starts back down (show by the red arrows), this is the beginning of a recession. Recessions are a contraction period due to a reduced demand for products, which is a result of a previously weakened economy.
Because of this weakening, corporations will steadily reduce inventories and employment. An increasingly high unemployment further reduces the need for new products. This process feeds on itself until the supply and demand have finally stabilized. During this period, new corporate expansion has long since come to a halt.
If we look at the real estate industry during this economic down turn, we will see this translates into low absorption of new office space due to the corporate inactivity. Additionally, there is an oversupply of residential housing due to unemployment, which creates a buyer’s market in residential housing; and likewise, there is a high vacancy factor in multi-family projects. Since real growth is recessed, these markets will also feed on themselves until their supply and demand ultimately stabilize.
Now leaving the real estate sector and going back to the economic side of this example, as we come through the bottom of the recession in the economic cycle, we start up into a demand/growth period.
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After all supply has finally been absorbed and inventories depleted, the demand naturally starts to exceed the supply. Industry, still very cautious, wants serious confirmation prior to unbundling itself. These time lags usually create even greater shortages.
As the demand continues to escalate, the wheels of progress slowly start to turn, thus creating new jobs. New employment continues to spur on the recovery as new incomes create new product demands. Then new corporate expansions start which furthers this process.
Translating this back in the real estate world, office space will become scarce. This is a result of the two-year time lag, from project inception to project completion. The reason there is a two-year time lag is because it takes two years to conceive, finance and build any new project.
In addition, more employment means new worker salaries and therefore new money for new home purchases – which produces a need for even more product. Apartment vacancies diminish, creating additional demand for more multi-family development. As a result, more and more jobs are created, which spurs on the economy.
This is the growth/expansion cycle personified. Money from the investment industry for new expansion becomes more and more available. Because of the availability of money and the apparent historical strength of the economy, more and more entrepreneurs appear in all industries.
Still more product becomes available until they ultimately catch up with the bulging demand, and then finally exceed it. If we could slow the stream of new product supply at this time, to stay constant with the demand, a period of steady growth might exist for some time until it is finally upset by some monumental crisis.
However, due to the opportunities that continue to be apparent, our entrepreneurial spirit and the continuing expansion of more and more new investment capital demanding placement, an oversupply of product is ultimately created.
Unfortunately, all good things must end, and such is true with the expanding growth economy. This is the peak in our roller coaster ride. Once again, in real estate this would mean additional office space under construction when there is already a two-year supply and record new apartments and housing starts when they too are already over built.
At this point, it is important to note that builders will build as long as money is available, regardless of need for their product. You cannot blame them; that is the way they make a living. If the investor is driving the builder by giving him money, then the investor has the ultimate responsibility for what is happening in the marketplace.
As the oversupply hits the marketplace, strong competition begins. This unfortunately leads to reduced profits in business.
As more and more product is produced, with the demand staying constant, profit yields become less and less, creating a slide down the backside of our roller coaster. As the realization of the oversupply sinks in and the conservative, contractionary philosophy begins, jobs are lost. This causes an additional softening in product demand, which further weakens the economy.
This loss of purchasing power works dramatically against the oversupply. Once again, the process begins to feed on itself and we enter a full recession, bringing the economy cycle back to where this illustration began.
Obviously, this is an over simplification of the way our economy runs, but it is very accurate. In my next column, we will further explore the interaction between the economic and real estate cycles and show the relationship between investment capital and the press.