The Real Estate Cycle

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By Michael Douville - Real Estate Market Analyst

I have seen this before... History repeats itself on a regular basis. This real estate downturn is different from the previous downturns, but the components are the same. Business managers and investors are charged with obtaining the highest return possible, and greater and greater risks are taken to obtain diminishing returns in a crowded marketplace. Investors recognize and exploit the opportunities the market presents, while later in the cycle speculators enter to "get rich quick," and the cycle ends badly.

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This current downturn is bad, but not as bad as the 1979-1982 or 1989-1992 downturns the U.S. experienced. The response by the Federal Reserve, in dramatically lowering interest rates, averted a downturn in the Real Estate Industry in 2000-2001. It could have occurred then as a result of the busting of the dot-com bubble and the 9/11 tragedy. Although there was a slowdown in activity, we saw no price decline.

It has been 16 years since the end of the last Real Estate recession. A vast group of middle-aged managers, business owners, entrepreneurs, and homeowners have never seen the price of their home drop. This group of buyers has enjoyed a steady rise of 4-7% per year in the value of homes in the U.S. since 1992. The U.S. residential real estate market and the mortgages underwriting them have been considered the safest in the world. As a result, this current pricing decline comes as a shock to many. It is, however, very typical of a correction and cleansing of the market.

If there had been a published weekly chart (as we have now) during the 1989-1992 recession, the change in Residential and Commercial Real Estate prices across America would have also been negative. Back then, as is the case now, foreclosures were high; estimates indicate that over 400,000 properties became lender-owned. The excesses in the market were also being worked out at that time. The S&L crisis was underway and conventional lending was scarce.

In the years prior to the Resolution Trust Corporation (RTC), the savings and loan industry had been deregulated allowing greater participation in joint-ventures and greater flexibility to finance riskier, but more financially rewarding projects. Then, as now, bad real estate loans destroyed financial institutions. Between 1986 and 1996, the number of Savings & Loans in the U.S. declined from 3234 to 1645. The RTC was liquidating valuable properties at incredible prices: commercial and residential prices had to compete with aggressive asset managers, and so the average homeowner removed their properties from the market and waited. Those that had to sell, sold competitively. Just as today, those who purchased last lost the most money. Large builders went out of business: home construction dropped from 1.8 million units to under 1 million with the ensuing loss of high paying jobs. Banks and S&Ls went out of business, as did brokers, title and mortgage companies. There were huge losses... The cycle completed and restarted.

I believe the current cycle is ending. The downturn will not be pleasant, but I expect we are already in the process of healing. Secretary Paulson and Federal Reserve Chairman Bernanke have acted; liquidity is being restored to the financial markets and soon confidence will be restored as well. Slowly, the oversupply is being cleared. There has been an increase in sales every month since January and the pending sales for June showed an increase as well.

Builder traffic is slowly returning. The FHA/VA financing limits have been increased, and conventional conforming limits have been increased as of this July. The nationwide theme is affordability. As home pricing regresses to the mean, the huge price jumps of 2004-2007 are being negated. Thus, more and more buyers are able to purchase through traditional mortgages and underwriting criteria. The market is bumping along at the bottom, and the trend is for stabilizing home prices; however, the large price drops are fading.

The stronger markets should recover first, however, I expect we will still require another 12-18 months to complete the process. There will be additional pain; there will be additional problems. There will be arguments as to the fairness of the Housing Relief Bill, just as there were about the RTC. Still, capitalistic markets will operate on the capital and the liquidity provided by the "emergency measure or bailout."

What is an investor to do?

If history is a guide, fortunes will be made. Value is being restored to selective markets, and prime properties are available at discounted prices. Over the next 12 months, investors will be able to exploit the distressed properties and "special situations" that will appear in a universe of potential investment properties. Prime properties at great prices are available at values that will not be available again until the end of the next cycle; perhaps we will be lucky enough to enjoy another 16 years until the cycle repeats.

Full Disclosure: Michael has agreed to Wall Street Greek policy to not author articles about securities he personally owns or holds beneficial interest in. In the event of a special case, Michael will make full disclosure of ownership or beneficial interest. The work of contributors to Wall Street Greek is their own, and may not necessarily agree with the opinion of the site or its founder, and does not constitute financial advice. Please see our full disclosure at the site (Wall Street Greek).