“Over the course of my career I’ve heard investment in real estate rationalized by easily digested statements like “they’re not making any more” (in connection to land), “you can always live in it” (in connection with houses), and “it’s a hedge against inflation” (in connection with properties of all types). What people eventually learn is that regardless of the merit behind these statements, they won’t protect an investment that was made at too high a price.” – Howard Marks

Market cycles are not only a reflection of financial past, present and future but also of investor and consumer psychology. Understanding the psychology that influences the ups and downs of a cycle will allow you to do two important things.

  1. To understand specifically what part of the cycle we are in during any market
  2. To position yourself within the cycle strategically so you can profit from market conditions

To demonstrate my points I will reference real estate and lending data from 2006-2019. I’m choosing this time period because the 2007-2008 financial crisis occurred in recent memory and will provide a practical and real application to the psychology underlying all cycles.

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  • Positive events lead to optimism

Consumers began signing subprime mortgages from private mortgage brokers starting in 2006. Quickly,  providing cheap and easy money to unqualified borrowers with sneaky terms became a mainstream practice. By 2007, homeowners weren’t able to make payments. By 2008 property prices declined by 30% from the year before. Investors became weary of risk, consumers didn’t believe it would ever get better, the economy was in shambles — there was no hope. Notice the effect of “no hope” had in the coming years… property prices in 2009, 2010, 2011 and 2012 were even lower than in 2008. It leads you to ask, which came first : lower property prices or lack of consumer confidence? One thing is for certain, the only thing that can turn a bad day into a good day, or in this case down years into great years, are a series of fortuitous events like more government spending, increase in employment opportunities, and steadily increasing home prices, to name a few.

  • Improved psychology encourages increased activity even when there is greater risk

From 2008-2012 property prices were very low. Consumers weren’t sure if prices would ever rise again. Following a bust or crash in the market, there is a combination of low prices and lack of consumer confidence that makes the market a risky one to be active in. But bold investors took those risks because they saw small positive events that the average person didn’t see. By taking this risk and building new homes when no one else was investors injected society with hope. In down times, society looks to investors to provide improved psychology by taking a risk in an environment where no one is willing.

  • Combination of improved psychology and increase in activity causes prices to rise

Investor optimism, taking the risk, buying low, improving by adding value and then selling higher, leads to a shift in consumer confidence which, along with other factors, starts an upswing in the market. This occurred in 2013. To better understand the flow of ups and downs within real estate cycles we must understand the answer to the following question.

What makes the real estate cycle different from other financial cycles?
The long lead times for real estate developments and real estate transactions. Depending on the size of development it can take between several months to several years to complete development of a property that, upon completion, impacts the market by either placing downward or upward pressure on prices, depending on levels of demand and where we are in the market.  That is why it took several years, between when investors took the risk and began buying after the bust (~2009) to when we started seeing signs of a new boom (2013). Keep in mind, market conditions can change significantly while developments are taking place.

  • Rising prices leads to even more activity

With prices high the laggard investors who didn’t get in early (who were too late for the real profit) begin believing in real estate again and they start buying out of fear of missing out. Sellers start selling because they recognize that they can get top dollar for their property. This psychological trend was seen from 2017 – 2018.

  • Prices continue to rise and consumers forget about downtime’s ever existing leading activity levels to go beyond sustainability

This is seen when prices go higher than already recorded historic highs. 2017 median sales prices in the San Fernando Valley eclipsed the previous record high experienced in 2007, just before the economic bust that brought home values down 30%. After the 2017 high we experienced we continued to see appreciation in sales price through 2018 and now through 2019. In 2019, interest rates have also been reduced to a historic low. Consumers are feeling good. Buyers understand that sales prices are high but are justifying those sales prices because interest rates are low and giving them an opportunity to still feel good about their purchased. Sellers are thrilled at the opportunity to sell high, especially because demand for their home is picking due to the low interest rates. While some people are aware that an adjustment is looming most are so consumed with their own lives and busy chasing their own American Dream that they have forgotten about the recent downtimes we experienced as a nation.

Why are interest rates and lending requirements so important in determining where we are in the real estate market?

During better economic times, lenders become more optimistic and willing to provide capital. The optimism leads to cheaper and easier financing, this leads to more buying and more development because cheaper money means higher projected returns. More and more developers follow the leaders meaning longe and longer lead times between developments (i.e., projects are always going on). Interest rates set the tone — the period between the start of planning and the opening of a building is often long enough for the economy to transition from boom to bust. The builders who get started at the perfect time will prospect yet many developers who start projects in obviously good times (i.e., when interest rates are low and prices are high) often open their doors in bad times, leading to unfilled supply that puts downward pressure on rents and sales prices. These bad times cause the level of development to be low and the availability of capital to be constrained and lending to become more difficult. Interest rates and lending in general to play off the fact that there are significant time lags in real estate, changes in interest rate can often provide insight into current market conditions and foresight into future market conditions.

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From the eyes of the every day consumer the news is positive now. The psychology of buyers and sellers are good which creates for a healthy and balanced real estate market. When news turns less positive the resulting price correction will cause the psychology of the people to become less positive, which encourages decreased activity that causes downward pressure on prices. Compared to this time last year, San Fernando Valley is seeing less supply and equal or greater demand. The next stage of the cycle will contain less demand and too much supply.