Back in 2018, Robert Shiller, founder of the eponymous Cape-Shiller index, warned that the housing market was becoming overheated. While it’s anyone’s guess whether we are due for another crash, we can look at market indicators for clues about where we are in the real estate cycle.
The Four Phases of the Real Estate Cycle
The real estate market isn't completely random. As far back as 1876, Henry George observed that housing is a cyclical business.
Phase I: Economic Expansion
- When businesses are growing and consumers are buying, the housing market tends to boom. Buyers flood the market and housing prices go up. It becomes a seller's market, as properties are frequently overbid.
Phase II: Hypersupply
- At some point, either developers overbuild or consumers can no longer afford the sky-high home prices. Houses sit vacant on the market much longer.
Phase III: Recession
- A combination of factors such as high housing costs, rising interest rates or a cooling economy contributes to a housing slow down.
- Homeowners find their mortgages underwater and walk away. We see begin to see an uptick in foreclosures.
Phase IV: Recovery
- Eventually, property prices fall enough to lure buyers and investors back to the market. So begins the cycle again.
Economic Indicators of the Real Estate Cycle
Phase 1: Economic Expansion
In good times, when the economy is growing, unemployment is low, and wages are increasing, the real estate market goes through an expansion phase. A growing GDP means corporations hire more people, invest money into R&D, and open new offices. This leads to more building permits, new shopping centers, and more construction. Buyers, flush with more income, flock to the real estate market. As a result. housing inventory becomes tight. This is reflected in high property prices and fast appreciation.
The Case-Shiller index tracks the prices of detached, single-family homes. It measures appreciation using the repeat-sales method. In other words, it tracks properties that have been sold at least twice to measure how quickly the properties are appreciating. since mid-2012 in February. This suggests the expansion phase is losing steam.
The chart above shows the home prices index displayed along with the CPI, which measures inflation. Not only are housing prices setting new highs, but they are once again running ahead of inflation.
Phase 2: Hyper-supply
In the hyper-supply phase, new construction initiated during the expansion phase begins to flood the market. With enough new inventory, supply begins to outpace demand. If developers aren’t aware of the softening conditions, or if they don’t react quickly enough, the market will head towards a downturn.
The first sign that we are headed to oversupply is an increase in unsold inventory as reflected by the amount of time homes are sitting unsold on the market.
Monthly Supply of Housing
Months of supply is the measure of how many months it would take for the current inventory of homes on the market to sell, given the current pace of home sales. For example, you can see the ratio peaked to 12.0 at the height of the 2008 crash. This means, for every 12 houses sitting on the market, one is selling each month. The Months of Supply was 6.0 in March 2019. Though we are nowhere near 2005-2007 highs, the indicator has been trending up over the past few years. In hot markets like California, we are now seeing the highest months of supply of homes in places like San Diego and Los Angeles, since 2012. As a rule of thumb, six months (or fewer) of supply indicates that we are in a seller's market. By contrast, six months or greater of supply indicates an excess of inventory.
In this cycle, unaffordability is the reason for the housing sitting vacant longer, rather than overbuilding (as was the case in 2008). In the most competitive markets, for example in California, household incomes just do not justify current property prices. When home prices become unattainable to most people, something has to give. We might be in for a round of price reductions to bring valuations back in line with wage growth.
Phase 3: Recession
In the latter parts of decline, real estate prices drop significantly and foreclosure inventory jumps. In decline, inventory can sit for a long time. Recessions go in hand with high unemployment trends and a larger contraction in the economy. Right now, unemployment rates are quite low and GDP growth is still decent, but if macro-economic conditions worsen, we would see it reflected in the housing market. It's also worth mentioning that not all recessions are the same. And there are good reasons to think we won't experience the same hard landing we did in 2008.
- Banks have much stricter lending standards. The great recession of 2008 so severe in large part due to systemic problems in the mortgage and financial industries.
- There isn't nearly as much excess housing supply as there was in the years leading up to 2008
- The Fed is keeping interest rates low. Even in an overheated market, low mortgage rates are really effective in getting buyers to bite.
Phase 4: Recovery
Eventually, prices find a bottom and start to stabilize. Buyers come back on the market because the economics of buying are now better than the economics of renting. Investors come back on the market when they find deals that allow them a high cash on cash return.
So Where Are We in the Cycle?
- Keep in mind that the housing market is really thousands of local markets: it can be the case that Seattle is cooling while Pittsburg is just getting started. However, looking at national indicators, it does seem that we are in the Hyper-Supply phase of the real estate cycle.
- Properties are sitting on the market for longer, and we are seeing a record number of vacancies.
- Whether this is a temporary slowdown or the harbinger of worse conditions to come is anyone's guess.
- However, buyers should be especially restrained about dropping a lot of money on real estate this late in the game.