The conversation that is going around the real estate industry water cooler is, “Are we in a bubble in the Bay Area and when is it going to burst?”
Real estate is cyclical and the market is always shifting. Shifts are easy to understand and they are never unexpected but rarely predictable.
The 4 Phases of the Real Estate Cycle:
As early as 1876, Henry George observed the cycle through which real estate markets move. His findings can be summarized as follows:
Phase I: Recovery
We know the characteristics of a recession: high unemployment; decreased consumption; and decreased company investment in buildings. The price of land, essential for economic activity, is at its lowest.
The key ingredient for investment and expansion is typically advanced by government intervention in the form of lowered interest rates.
With increasing demand and lower investment costs, companies expand businesses; Hire more people, build new, and buy more.
Expansion adds to the demand. Vacancy decreases; as companies use previously empty buildings and individuals move into previously vacant homes.
Phase II: Expansion
Recovery to expansion occurs when companies and individuals bought up or rented most of the available buildings. Occupancy begins to exceed the long-term average.
Increased profits attract new development of vacant land or redevelopment of existing properties.
The cycle reaches a point at which rents are not simply going up—they are going up faster and faster. Investors build this trend into their forecasts. The price of land begins to reflect not the existing market conditions but rather the anticipated rent growth to come.
Investors, believing the price is justified by the future growth, overpay for the land relative to the current market, and start building for a future market. The boom is officially on.
Phase III: Hyper Supply
As long as the current occupancy rate exceeds the long-term average, there will be upward pressure on rents. As long as there is upward pressure on rents, new construction is financially feasible. This is the case for both the expansion and hyper-supply phases.
The first indicator of trouble: an increase in unsold inventory/vacancy.
Wise developers, noting the change in direction of rent growth and factoring in the likely consequence of units currently under construction being completed, should choose to stop building. If you find such a developer, please let me know.
Phase 4: Recession
The second indicator of trouble: occupancy falls below the long-term average.
New construction stops, but projects started in the hyper-supply phase continue to be delivered. The addition of surplus inventory leads to lower occupancy and lower rents, which significantly reduces revenue for landowners.
The third indicator of trouble: an increase in interest rates.
The increases in prices throughout the broader economy that accompanied the expansion and hyper-supply phase will force the Federal Reserve to fight inflation by increasing interest rates.
Vacancy stalks landowners and, as revenues fall below landowners’ fixed costs, foreclosures follow.
The duration and frequency of the real estate cycle
Perhaps the most stunning aspect of the real estate cycle is not its inevitability but its regularity.
Economist Homer Hoyt, found that the real estate cycle has run its course according to a steady 18-year rhythm since 1800.
Where are we now?
As 2016 is underway (10 years after the peak and 8 years after the crash), San Francisco is well into the expansion phase with only 2.5 months worth of inventory but excess amounts of new construction underway (according to the San Francisco Development report).
Last month saw greater pressure on the single family market, as compared to condominiums and TICs. While purchasers had bid approximately 5% over list price for condos/TICs, single family purchasers bid almost 15% over list price. It also took longer to sell condominiums, with a median market time of 26 days, versus 17 days for single family homes.
There is even greater strength in the middle one-third of the single family market ($1.2MM – $1.66MM), with properties trading for 25% over list prices. The highest tier of the single family market ($3MM+) has also performed well as of late, with over 20 properties going into contract since the beginning of May.
The National Economy continues to show signs of strength, with Reuters News reporting that “The S&P 500 ended at its highest closing level in seven months, while the Nasdaq minted its seventh straight day of gains.”
The recent strength in the labor market coupled with inflationary pressure make it more likely that the Fed will hike rates this month.
The question to ask yourself: where will I be when the market shifts in trong>2024?
Should you sell now, while on top of the market, or can you hold off?