The Common Sense Investor

Doing well in real estate requires an understanding of the market cycle and identifying those points in the cycle that are ideal for buying or selling.

The residential real estate market is quite different than the stock market. Still, both markets are significantly affected by human psychology. In the stock market, you’ll see greater day to day fluctuation that is often based on news reports. With equities, prices rise and fall at a muich quicker pace than in the housing market.

Part of the reason for this difference is that owners of property are much less willing to take a loss on their property than owners of stock are willing to take a loss on their shares. Property owners typically expect for their home to sell higher than they bought it for, so you rarely see steep drops in the housing market. In fact, home owners are often willing to wait out a slow market until they can find a buyer willing to pay a certain price. Stock holders on the other hand, are ready to unload shares when the price seems to be falling, especially if no recovery in sight.

Put more simply, it is much harder for a house to lose its value than for a stock share to lose its value. Companies either thrive or falter. Houses persevere through time with modest upkeep, and continue to perform their function. The frequency of failing companies is much higher than the frequency of failing homes.

While houses can hold their value better than stocks, it is also true that on average they don’t appreciate as quickly as the best stocks. In fact, in many markets, houses simply track inflation. This makes sense since houses aren’t productive, they merely retain their value as a place to live or vacation. Good companies, on the other hand, are productive and do actually make profits.

Still, a lot of people have made a lot of money in real estate. In fact, more millionaires are millionaires because of real estate investing than because of stock investing. So what gives?

Well, a lot of it has to do with understanding the real estate market cycle and profiting from it.

So what exactly is the real estate market cycle? For starters, it is the market process by which home sales get set according to demand. Sometimes demand is high, sometimes demand is low. Demand is going to be set by a variety of factors.

Perhaps the biggest factor for housing demand is “available money.” The recent efforts by the Federal Reserve to lower interest rates in the face of 9/11 and the corporate scandals in order to combat a recession made an excess of money available to the American public. Since everyone wants their own home, or if they have their own home, a bigger and better home, the only factor stopping them from getting such a home is the cost. But the average Joe looking for a home doesn’t actually care about the total cost of the home: he only cares about the cost per month. When the Fed lowered interest rates to historical lows, the average Joe could make his mortgage travel a lot further and buy a more expensive house.

Since less money was being paid towards interest, more money was available towards the principal on the house. But with so much available money for the buyer, the demand for property sky rocketed, as did the total cost of homes.

In addition to “available money” another factor that affects housing demand is location. The more people who want a house in a particular location, the higher the prices are going to go, especially if the amount of housing is limited. Manhattan is a classic example where astronomical prices have moved in because demand is high but supply is low. Vacation locations with plenty of available housing may still have high pricing simply because of demand.

Demand for property determines the real estate market cycle. When interest rate are low, total available money goes up as do the asking prices for properties. When interest rates start to go back up, total available money starts to come down, as does demand. When demand slows, prices either plateau or come down slightly. You rarely see a major housing bubble, but you commonly see a housing plateau. Plateaus are the result of property owners who are unwilling to lower prices below those set at peak demand.

So when in the real estate cycle is it best to buy a property? The sweet spot in real estate is almost always at the peak mortgage rates. This may seem odd, but when mortgage rates peak, you’ll have a market where prices have either plateaued for several years or dropped slightly. In other words, demand will be at its lowest as will relative prices. Sellers will normally even be willing to negotiate a lower price. In the real estate market cycle, when real estate is slowest you will be able to get the best home to value ratio.

So how should you buy? One option is to save up enough cash to be able to pay for a property outright and avoid the higher interest rates in a slow market. This can work if its available to you. However, even if you take out a mortgage at the higher rates, chances are you will soon see rates drop off, offering you the chance to refinance several years down the road.

Ok, but when you do you sell? Sell real estate when interest rate are low, available money is high, demand is high, and prices are artificially inflated because of the economic environment. At this point in the cycle, you are sure to maximize your profits.

In the latest real estate boom, the people who made the most money were not the speculators who followed trends, but the people who bucked the trends, bought property at low prices when demand was low, and then sold their property or refinanced when demand was high and rates were low.

While over the long haul, real estate barely does better than inflation, it can drastically outperform inflation if you understand the real estate market cycle. By following the cycle you can find the opportune times to buy low and sell high.