I’ve often said that until you have invested through a full property investment cycle, you won’t fully appreciate the real estate markets.
You see…though it’s often said that property values increase by about 8- 10% each year in Australia, this is not constant each and every year.
Values tend to rise in waves. In some years there will be strong growth and in others there will be no growth and in every property cycle there are times when property values fall.
How a property cycle develops
A really simplistic version of the cycle goes something like this…
As our population grows there is an increased demand for real estate and this causes an increase in rents and in demand for new homes from owner occupiers.
Slowly this causes property values to increase because of the forces of supply and demand. Some people buy new homes while others get started in real estate investment. At the same time builders and developers hop on board and start constructing new dwellings to meet the increased demand.
However the pendulum tends to swing too far and over time we get to an oversupply of dwellings which eventually results in rent reductions and slumping home values.
Yes…despite what many agents will tell you, real estate values may fall and often have. Of course in other years, values may rise by over 20%.
How long do property cycles last?
Putting a timeframe to these cycles is not easy.
Looking back over the past few decades cycles in Australia have generally lasted about seven to nine years and property growth has peaked– in other words we had real estate booms – in the following years: 1981; 1987; 1994; 2003; 2010
But these cycles don’t exist because a number of years have passed. They occur because of a combination of factors and influences such as the state of the economy, social and political issues.
The fact is that looking back over the last 30 or 40 years well located properties have seen their values double every 7 to 10 years. However, at some stages of the cycle values increase and at other times they stay flat or decrease.
As shown in the graphic above, at certain stage in the cycle property values exceed the underlying long term trend (such as in boom times) and at other stages they fall short of this long term intrinsic value (such as during property slumps.)
As I’ve said the pendulum always swings too far in the world of property investment.
History shows that the property cycle consistently passes through 4 phases:
The BOOM PHASE –
This tends to be the shortest phase of the cycle.
During the boom real estate prices increase rapidly – often by more than 20% per annum.
The boom often begins slowly. Recognising that property returns are increasing investors come back into the market often at the same time as home owners push up demand for and this slowly leads to increasing property prices.
As the boom continues a whole generation of new investors come into the market driven by the hype in the media, property seminars,those reality renovation TV shows and the like.
Greed starts to kick in, as does speculation.
This was evident during our last property boom when many investors bought properties off the plan. They hoped to on sell their properties at a profit, many never really intending to settle on these, because often they didn’t have the means to settle these properties. (Unfortunately many were caught out.)
Fear also drives property booms as investors see property prices going up all around them. They are worried that thy may miss out on the profits the boom has delivered to other investors.
Not understanding the dynamics of a property cycle, many of these beginning investors become overconfident at a time when they probably should be the most cautious and they are prepared to overpay just to get into the property market, pushing up property prices to levels that are (in the short term at least) unsustainable.
At this stage of the market properties often sell for more than their asking price as eager buyers compete with each other to snap up any property that comes on to the market. Vendors also become greedy pushing up asking prices and this just feeds the property boom.
As the boom moves on many builders and developers flood the market with new properties to meet the increasing demand from owner occupiers and investors, but invariably they eventually flood the market with too many properties. This excess supply is one of the factors that eventually brings the boom to an end.
Another reason property booms typically come to a halt is when, in an attempt to slow down the property markets and keep a lid on inflation, the Reserve Bank increases interest rates and the banks limit credit.
This leads to the…
The SLUMP PHASE
This is often characterised by an oversupply of dwellings due to the over exuberant activity of builders and developers.
This causes increasing vacancy rates and decreasing investment returns.
Property prices stop growing and in some cases drop. If there has been a prolonged boom phase, this is usually followed by a longer and deeper slump phase with a greater likelihood of prices falling.
During the slump real estate is out of favour in the media and investors often struggle with decreased cash flows, higher interest rates and stalling values. They often consider selling up. When they do this in a falling market with few buyers they exacerbate the slump.
This is also the stage when some new home buyers get into trouble. They’ve often overcommit themselves during the boom by purchasing properties they could not afford and to interest payments that could just afford. And now as interest rates have risen, some have difficulty keeping up mortgage payments and the only way out for them is to sell their properties at depressed prices. This often leaves them severely out of pocket and with a residual debt.
The STABILISATION PHASE
Our markets don’t usually jump from a period of negative sentiment to the next upturn.
There is usually a short phase where the various economic factor catch up with each other – they stabilize or get back into equilibrium. Which eventually leads to…
The UPTURN PHASE
During the upturn, vacancy rates slowly fall, rents start to rise, and property values start to increase slowly at first.
This phase creates great opportunities, but these are not usually easily recognised by most investors.
At the beginning of the upturn phase of the property cycle interest rates are usually low and it is easier to get finance.
Real estate values generally start increasing in the inner ring, more affluent suburbs and suburbs close to the CBD or the beaches driven initially by owner occupiers looking to upgrade their homes. Over the next few years increasing values ripple out to the middle ring suburbs and eventually, sometimes after a number of years, to the outer ring suburbs.
By the middle of the upturn real estate is generally affordable and returns from property investment are attractive.
Investors begin to enter the market. In particular professional investors take advantage of the opportunities of the upturn phase, but beginning investors are often not yet convinced that real esate is a good investment.
This is the time that many builders and developers commence development projects in order to have them completed by the late upturn or boom phases of the cycle.
Property investors slowly get back into the market as conditions seem more favourable. They see home values rising and are concerned that they may miss out. This is also the time that many first home buyers enter the market.
Property values usually increase gently during this stage (usually less than 10% per annum) and do not rise sharply until the boom phase of the cycle.
At the end of the upturn phase of the property cycle real estate prices have risen substantially and property is becoming less affordable. As prices rise property investment returns decrease.
And…..we start all over again.
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