In my last column, we explored the interaction of the economy and real estate cycles and how they are not the same. In that column, we used the graph below to look at the two cycles.
As you can see in the above chart, the ongoing economic cycle, shown in black, does not run simultaneously to the one occurring in the real estate industry (shown in blue), but usually precedes it by as much as a year. Contrary to popular belief, the real estate cycle is not fed directly by the local or national economic cycle, but instead by what we will call the “investor demand” cycle. Likewise, the investor demand cycle is also not fed by the real economy, but instead fueled primarily by what investors are reading or hearing from the media. This information shapes their decisions.
It is through the investor demand cycle that money flows, in the form of financing, into the real estate industry. These investors, both institutions and individuals, are the savings and loans, banks, insurance companies, as well as, pension plans, public and private syndications, and wealthy individuals.
The reason the real estate cycle lags behind the economic cycle is that the media can only report data and statistics concerning the economic cycle after they have been accumulated. In addition, their true job is to report what they feel we are most interested in hearing. If they miss the public’s interests too consistently, they are not going to grow.
By looking at our original economic example and tracking what the media are reporting and how the investors are reacting to it, we can see how these two cycles interact.
Using the chart above, starting at the bottom of the economic cycle, we are at the pit of the recession. During this period, the media would be reporting what I will call “Bad Press.” Top stories, because it has been so bad for so long, would probably be exploring the more tragic, human side of problems caused by the bad economy. Unemployment and the pain of failed, small businesses, etc. are the primary economic news.
Since the news has been bad for some time before this bottom actually occurs, the investor and his funds have long since fled this marketplace. Because of the investor’s alarm, he will have sought new places or areas for his capital to be invested. The real economic recession, therefore, will become paralleled with a subsequent, complete halt of development in the real estate industry.
As the true economy starts to climb out of the recession, a real demand/growth cycle will be in effect for 6-12 months before any new improved statistics can become available and subsequently reported. During this economic startup period, since no new positive statistics are yet available, the news from the media will be flat. Since flat news is uninteresting, the local media will choose to report on non-economic issues. The national media will be diverting investor awareness to areas of the economy and country that are currently booming, such as maybe the stock market or what is happening in China, etc. Since investor awareness is diverted to where the “Good Press” is, no new construction money will be available to this real estate market from investors.
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Because such little money is available, very little new construction is contemplated. As the current supply of realty inventory is absorbed, the newly developed projects of the inside investor will gradually start to appear. As this occurs, some members of the media will see the turnaround more quickly than others and release some brief, positive stories. However, once scared away, the investors will require overwhelming proof that the market is strong and very safe before they will choose to re-enter it.
During the oncoming, stronger economic upswing, the press will start to give more and more positive signals. The first substantial proof of the recovery, in the form of statistical data, will now finally become available and be published.
The press, because of these confirming statistics, now will swing into a full “Good Press” mode. Reading the repetitive “Good Press,” investors finally start to appear. Unfortunately, however, because of the lack of development activity, real shortages are already present and are now getting worse. The reality of the two-year time lag from project contemplation to project completion will over-exaggerate this shortage problem, causing even higher increases in rent and sales prices. Total consumption of the available material and labor force will drive the prices upward and thus creates the long awaited boom period for the real estate industry. The “Good Press” keeps getting better and stronger, and the money that had just previously started to trickle into the market now comes flooding in.
The institutional investor, finally feeling safe because it can no longer be criticized, opens its money gates. As new businesses are formed and economic expansion continues, everyone and his brother begin to enter the real estate industry to capitalize on the boom.
The problem, at this point is that the real economy has just begun to peak and start its normal slowdown. However, it will be a year before the statistics finally confirm this slowdown, during which the period the “Good Press” will still run at full steam. Meanwhile, every small investor in the country is now aware of the “Good Times” in real estate and wants a piece of the action. Billions of dollars demanding placement through the private syndicators will become available. The financial institutions, having a difficult time competing, will become even more aggressive in lending.
By this point, when the building should have stopped, it just now shifts into high gear. Two years of oversupply is built-in approximately a six-month period. In addition, as we discussed in my last column, builders will build as long as they can get money, and the investors, following the positive press, are only too happy to comply.
Then, unfortunately, the historical bad statistics finally become available and confirm the reality of a recession, which has now really been underway for the last 6-12 months, and the “Bad Press” begins. The non-sophisticated investor remains for a while longer, but the institutional investors, coming face to face with reality on the front page of their newspapers, slam on the brakes. People, who thought they had strong banking relationships find out that they have no banking relationship. Many businesses that could have survived with a prudent working banking relationship will now go bankrupt, furthering the economic collapse.
Within a short period, the reporting becomes “Very Bad Press.” All remaining investors flee the market, which is just prior to the bottom of the real economy’s recession cycle.
For the next period, “Very Bad Press” becomes the word for the day, and big headlines appear regularly. The slide into total recession occurs almost immediately as soon as the money vanishes. Only projects that have been pre-funded will start during the period that follows. Soon, we are at the point, which this example started.
In my next column, we will explore a method I developed to predict where we are in the real estate cycle and what will happen next.