The Real Estate Construction Cycle

Astute real estate investors always look at the real estate construction cycle before planning to invest. An analysis of the history of the real estate construction cycle will help readers ascertain at which point of the cycle we are currently situated. This information is crucial in determining if now is a good time to buy real estate.

Typically, residential real estate has always experienced dramatic boom periods followed by even more dramatic bust periods. The reason for this is the construction cycle. Typically when the economy is good, employment and wages are increasing and interest rates are declining. New cities and suburbs with new construction and new planned master communities begin to sprout around many major metropolitan areas. As more people move to these new developments, demand for housing increases resulting in new homes selling for a substantial premium to their construction cost.

At this point in the cycle there is a shortage of affordable housing, and a scarcity of rental units on the market. Renters are attracted to potential new developments with favorable terms and low interest rates. Usually, these new developments are within 30 minutes commute of major cities. As housing affordability becomes an issue, more and more buyers and renters begin to explore moving to the "suburbs". The allure of these new suburbs is low crime, good schools, new homes and affordable cost of living. This period in the construction cycle is typically the beginning of the boom period and prices begin moving upwards.

Builders are quick to note this opportunity and begin building as many houses as they can with the expectation of reselling these houses at a huge profit. The big development companies and home builders begin acquiring huge tracts of land with the expectation of building and reselling to new homeowners. At this point the boom is solidly under way and the economy is soaring. Unemployment is low, jobs are increasing, salaries are going up and real estate is increasing in value. This boom period can continue for a few years, typically between 3 to 5 years.

As more and more real estate is developed, there are many new developments. Speculators are drawn to the quick money that can be made by putting down deposits of as little as $10,000 and then "flipping" the contract to potential buyers. Homeowners add fuel to the fire by trading up their equity from their old house to a bigger, fancier house in one of these new developments. Speculators from all around the country begin descending on the "hot" markets where real estate is really booming. Bookstore shelves are lined with titles about how to get rich in real estate and real estate schools are jam packed with people lining up to become real estate brokers.

Unfortunately, this is usually the tail end of the cycle. Some homeowners have moved into houses with exotic mortgages that they cannot really afford. Speculators are beginning to have a harder time flipping their contracts. The reason for this is because there is too much supply. The builders and developers have simply built too much housing too quickly. There is not enough demand to absorb all this housing. Prices begin to stagnate and then begin to decline. As speculators leave the arena, suddenly it feels like all the buyers have disappeared. Articles in the media begin to surface about the "bubble" and potential new homeowners put off buying and decide to rent instead. Investors begin to move their money into other asset classes like stocks and bonds and away from real estate. At this point, the decline begins in earnest. This is the beginning of the bust.

Builders begin to realize how much of an oversupply there is on the market and begin slashing prices. The bust is in full swing and prices are plummeting. Foreclosures begin to rise and the economy begins to suffer. People that are working in real estate related industries like real estate brokers, mortgage brokers, bankers, construction personnel begin getting laid off. All these unemployed people put a drain on the economy as no one feels like spending any more. Banks begin "freezing" credit lines and are reluctant to make loans to anyone other than consumers with perfect credit. It seems like real estate will never recover as prices spiral downward and foreclosures increase. The media is full of articles talking about the real estate bubble. People begin wondering if we are in a deep recession. With all this doom and gloom, there are virtually no buyers for any kind of residential real estate.

Over time, the supply of housing diminishes. Banks foreclose on many homes and then resell them at huge discounts to real estate investors. As many landlords go into foreclosure the supply of rental housing becomes diminished and a housing shortage begins. At this point, things look pretty bleak. This is the point that we are at in the present construction cycle.

Most investors do still not see this since they are not looking at the number of available rental units on the market. Focusing on housing starts, or existing home sales is meaningless for a long term buyer of real estate. Currently in certain cities the rental supply has dried up by up to 90%. We are on the verge of an acute housing shortage. The hardest hit area is the low income market. However, even in great middle class neighborhoods there is an increase of homeowners moving to rentals. Many of these people move into a rental after losing their home to foreclosure. There are an anticipated 2 million foreclosures that will be settled by the end of this year. That is a lot of people looking for rental housing. And remember that most of these people are losing their houses to foreclosure so expect houses to be in much more demand than condos and apartment units.

I am seeing good middle class families with two wage earners losing their houses and looking for rentals. Most landlords are afraid to rent to them. I welcome them with open arms. They are looking for a fresh start and I am very happy to oblige them by providing them with a house to rent. The darkest hour comes before the dawn. In real estate it is when things look the bleakest that it is the best time to buy. Don't wait until the housing shortage is upon us. Buy now while you can choose and selectively pick the cream of the crop. The banks are about to unload a huge amount of houses on the market. I suggest that you start buying some of these houses and start renting them out. The past 2 years have been a very difficult time for landlords and a great time for renters. That is about to change. Soon it will be a good time for landlords (increasing rents) and a bad time for renters (less to choose from and increasing rents).

As the housing shortage continues, real estate investors will begin to notice that prices are down and rents are up. These two factors create a good entry point for long term buyers. At this point in the cycle, houses are selling for a substantial discount to their replacement cost. I am buying houses where the insurance company require almost 3 times the purchase price in replacement cost. For example, I recently purchased a house for $62,500 that required $163,000 worth of insurance That is about as good an indicator that you can get that you cannot build a house for what they are selling for.

In many cases, if you take the price of the house ($62,500) and subtract the price of the lot($15,000) you couldn't even build a wood frame home for the price that these houses are selling for. If I were to ask a builder to build me a 1,500 square foot house for $47,500 they would tell me that this is not possible even if they had zero profit on the project. This is a good indicator that prices cannot go much lower, maybe another 10% down at most. In the case of this house, paying $62,500 or paying $56,250 is not going to make a difference to a landlord that is renting out this house. This specific house sold for over $200,000 just 18 months ago! Sell your stocks and bonds and buy yourself a rental property. You will have no problem renting it out.

As the shortage of housing continues to squeeze renters and potential home buyers the prices will begin to stabilize. Landlords will begin to raise rents and potential renters will become more desperate to find affordable housing. Last week, after I rented out the above mentioned house a potential renter offered me $50 more per month. She was losing her house to foreclosure and was looking for a place for her family to live.

The media will soon begin to question whether the worst is over yet or if there are more declines to come. Don't be surprised if the D word (depression) starts getting thrown around in the media. That will be as good an indicator as any that prices have probably bottomed. Prices will gradually begin to stabilize and then begin to rise and speculators will begin to enter the real estate market looking for bargains.

Then, the prices will begin to rise in earnest. The housing shortage will be so acute that at this point renters will begin thinking about becoming homeowners and the cycle will get ready to repeat itself. As prices rise due to the housing shortage builders will start building again and a new boom will be underway. I don't know if this will happen in 2010, 2011 or even later. What I do know, is that in certain rental markets that I am familiar with, prices cannot decline much more than they already have.

The only thing that matters is whether or not the population will continue to grow. As the population increases, it is only a matter of time before the housing supply becomes a housing shortage. The sunshine states like Florida, California, Arizona and Nevada stand to benefit the most from the impact of significant tourism, aging retirees, population demographics and snowbirds looking for sun.

As long as a case can be made for the population to increase, then it is just a question of time before there is a housing shortage. And as we now know, housing shortages equal a great time to buy. The population of Florida is predicted to surpass the population of New York by 2010. Florida is a particularly compelling place to buy real estate. California, like Florida has all the same variables that create a housing shortage. Increased immigration, increasing population, aging retirees, tourism and sunshine. These are all good reasons why Florida and California are probably the best two states to begin looking for real estate bargains. Nevada and Arizona also offer many of the same benefits. Attractive places to retire with lots of sun are great places to buy rental houses.