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Understanding Economic Cycles for Real Estate Investing

Posted by Walnut Street Finance Team on Jun 5, 2019

Experienced real estate investors often come to believe they have a solid understanding of economic cycles — and that they know where they are in the present cycle. You see this as they share thoughts and experiences to explain what made their last deal perform well or bottom out, as well as when they predict their next successful deal. But the truth is a little different: there’s a dynamic quality to real estate and economic cycles, and no one can predict them well enough to perfectly time their next sale or purchase.

In his book, Mastering the Market Cycles, Howard Marks puts a fine point on the matter. “[T]here’s usually a line that stretches from lower left to upper right” (on a y and x axis), while “another line fluctuates up and down around it.”

Visualize this fluctuating line as a huge pendulum. It oscillates back and forth, its center point positioned immediately above the other line (which represents normalized long-term economic growth). The vacillation is the result of all decisions made by people in the market. This is what drives supply and demand in the marketplace, with all corrections and excesses included.

Closeup of woman's hands measuring bar graph with tape on blackboard

The economic growth line is known for its intrinsic magnetic pull, better known to economists as “mean reversion.” This means, even with quick and short-lived shifts in the market, the pendulum will always find its way back toward the growth line — this represents the long-term average of all sets of data.

The quickness and power of the swing is equivalent to the distance and speed with which it traveled away from the line. Simply put, the higher the pendulum rises, the lower it falls. The result can vary from a slight correction to a devastating crash (like the 2008 meltdown).

Marks’ book explains the market cycle in a fairly straightforward manner. He notes that “positive events and increased profitability lead to greater enthusiasm and optimism,” which helps generate an upward swing for the pendulum. And the pendulum is further pushed upward when better investor psychology creates increased market activity — and this action drives prices higher. The higher prices eventually give way to greater risk, causing the pendulum to make a final push to its highest point. When it appears the cycle has become unstoppable, “asset prices and the level of activity go too far to be sustained,” resulting in the pendulum topping out. At this point, the built-up force careens back toward the straight line, crossing it entirely and descending into negative territory, where it continues to dive until the energy caused by the excessive rise is absorbed by the corrective downs.

Knowing How the Pendulum Works Can Inform Investment Decisions

Understanding the pendulum’s position gives you the information you need to determine whether your next real estate investments should be aggressive or if you should play it safe.

Bearing all of that in mind, it is still unwise to try to time the real estate market. Don’t jump in because you think the pendulum is rising or hastily retreat if you forecast an imminent fall — this sort of behavior is what the psychological herd thrives on, and can result in monumental excess and heartbreaking corrections.

The best strategy is to develop a general understanding of where we are in the cycle — meaning up or down, and to which degree — and adjust your investment behavior accordingly. Even in terrible markets, profitable opportunities can be found.

In practice, the best way to navigate the fluctuating economic cycles is to be a first mover (i.e., aggressive buyer) when the pendulum appears to have reached its bottom, then play it smart and steady when the pendulum reaches its peak. That sounds great, but those are difficult waters to navigate, even for the most experienced and level-headed real estate investors.

Where is the Pendulum Now?

It’s clear that real estate growth has begun to slow, but prices are still rising. Likewise, it’s obvious the pendulum is above the line, on its descent back down. But “when,” exactly, is the big, unanswered question. What we do understand is the return to equilibrium should be without serious consequence, as the pendulum didn’t have a strong upward momentum to begin with.

There was optimism that helped cause the recovery, but it was not misplaced. In fact, many experienced investors would describe it as a “disciplined recovery;” meaning the pendulum’s velocity on its swing downward will not cause the type of disruption we lived through in 2007 and 2008.

So What’s Your Next Move?

Keep an eye on the pendulum through indicators, both objective and subjective, pertaining to your local market. For example, dependable, measurable data points are available to help inform your opinion, such as days on market and negative deviations in sale versus list price. On the subjective side, observe and scrutinize the psychology of various market players. Find out what real estate agents are reporting about buyer behavior. 

How do you recognize a positive shift in the pendulum after a down market? The real estate crisis showed us that the market recovery began in 2009, when only a few concluded the market had bottomed out and it was going to recover.

Have Faith in the Economic Growth Line

When you pay attention to the mean reversion, it's easier to be rational about the market. The straight line is like a magnet to the pendulum, always drawing it back. That’s why real estate investing has been a winning proposition year after year.

In the last economic downturn, some believed we were far under the economic growth line, so they put their efforts into investing capital while the market was where it was. With that in mind, even if you choose to buy when the market is up, the economy will continue to rise — history has proven that you’ll be okay.

There are a lot of real estate investment opportunities, no matter what part of the economic cycle we find ourselves in. Just don’t get bogged down by negative psychology, and be brave enough to be a first mover.

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Walnut Street Finance Team

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