Real estate cycles
Keeping in mind the cause-and-effect relationship between supply and demand, we can now examine the cyclical nature of the real estate market. A real estate cycle (see Real Estate Cycles) is frequently described as either a buyer's market or a seller's market. A buyer's market indicates a surplus of supply and a downward price trend, favoring the purchaser. In a seller's market, supply is short and demand is high; thus, prices are forced upward by the competitive market situation.
Real Estate Cycles
Because the term cycle implies repetitive, ongoing fluctuations in price, the buyer's and seller's markets are equal and opposite partners in the cycle. Thus, we can begin at any stage of a real estate cycle to examine the total cycle's fluctuation. If we enter a cycle somewhere near its peak, we can observe a shortage of supply, high prices as a result of competitive bidding, and, logically, high concurrent profits for sellers. Such high profits act to attract new investors who wish to capitalize on the opportunities, and it is reasonable to assume that new construction will take place, regardless of costs. With new buildings available as additional inventory to satisfy demand, the market cycle will level temporarily and then start to fall until supply exceeds demand. At this point, the cycle has reached its valley, and conditions are those of a buyer's market.
Other catalysts can affect a cycle, acting to speed it up or slow it down and to raise or lower its peaks and valleys. Included among these catalysts are tax reforms, interest rate fluctuations, a depression or recession, or even a national crisis such as 9/11, to name a few.
The inherent imperfections of the real estate market contribute to the perpetuation of the cyclical trend. Lack of communication among real estate building contractors, coupled with the time lag between the start-up and the completion of buildings, is a major factor in this problem. Another problem arises when contractors base a decision to build on gut feelings instead of market research. Real estate tends to have a longer contraction phase than other types of industry. A manufacturer of appliances may lay off workers and cut back production to ride out a contraction in the market. The owner of an office building still has the same amount of space to lease, and therefore, may stay in contraction longer.
Entering the market at the peak of a cycle involves planning, possible rezoning, and financing, as well as labor and material acquisitions in anticipation of construction. When building continues at a feverish pace to capture the profits of backlogged demand, little thought is given to overbuilding until the inevitable occurs and supply exceeds demand.
Now the situation is reversed, with few buyers and many alternative properties from which to choose. An associated lowering of prices results until little, if any, profits are left. Building ceases and market conditions continue at a low point until the excess supply is absorbed, at which time, the market begins to move toward the peak again.
Bubbles are a frequent phenomenon in the real estate cycle. A bubble is a sharp rise in real estate prices, fueled by speculation among those who operate under the greater fool theory of real estate investing. The greater fool theory supposes that whatever price is paid in a rapidly rising market, some fool will pay more to purchase it from the current investor. Fortunes are made during such times, until the fools are sated, prices decline, values crash, money becomes tight again, and there are long lines at bankruptcy courts and foreclosure auctions. The Federal Housing Finance Agency maintains statistics of home prices in markets around the country. There are various rules of thumb for signs of a bubble, but most can be summed up by answering this question: "Are local price increases significantly greater than national averages, and is there any identifiable economic factor, other than speculation, that would explain the increase?"
Despite the cyclical short-run fluctuations in any real estate market, property values, in general, rise over the long term. However, this trend is based on a summarization of activities involving many properties. Any individual property may react cyclically or counter-cyclically to the general activities of the marketplace, much as individual stocks gain or lose value within the stock exchange. Real estate investors are cautioned to consider each purchase carefully from both its micro and macro positions in the realty market. Investors must be aware of the long-term aspect of real estate investments.