– Chapter 1 –
Cycles of Boom and Bust
Those who cannot remember the past are doomed to repeat it.
-- George Santayana
A million years ago, the caveman made an important discovery
about how to adjust to the world around him. Seeing that summer and winter
repeated on regular intervals, he learned that storing food and fuel during
the warm and plentiful times of summer allowed him to survive the lean
and cold times of winter.
Just like the caveman learned how to identify a simple summer-to-winter
cycle, it is possible to identify similar cycles in the real estate market.
The Campbell Method for timing the real estate
market offers compelling proof that it is possible. Like the tides, the
moon, and the seasons, real estate markets also have their cycles. These
cycles are simply natural fluctuations in market activity – alternating
between periods of rising and falling prices. Even though real estate
cycles will always have an element of mystery, and are not as regular
as the cycles of nature, there is no law that states that they have to
catch you off-guard.
Real estate cycles go through stages that are logical,
understandable, explainable, and can be identified by the Vital Sign indicators.
However, before you learn about these indicators, it is important for
you to first develop a clear awareness of the nature of market psychology
and the telltale characteristics that identify when one market cycle stage
is coming to an end . . . and another is just beginning.
It is easy to see why “stage identification”
is critically important for making money in real estate. Timing, and how
well you do, all starts with the stage in which you buy. Of course, buying
in the early stages of a rising market will yield the greatest profits.
Buying in the middle stages of a real estate upcycle will also be profitable,
but it will not result in the huge payoff made from buying in the early
stage. You should also keep in mind that buying in the late stages of
a market upcycle is dangerous; it increases your risk and decreases your
odds of success. In fact, this is the time you should be thinking about
selling (to protect profits), and not buying into an inflated and overpriced
market.
Why Real Estate Moves Up and Down in Cycles
While people who buy and sell real estate are all distinctly
different, as a collective group you can count on them to share the same
predictable tendencies. And it is this unifying factor we call “human
nature” that sets real estate trends in motion and can take the
market from boom to bust . . . and then back to boom all over again.
The first thing to recognize is that people generally have a tendency,
and this is especially true in real estate, to “follow the crowd.”
Driven by alternating periods of greed and fear, or of optimism and pessimism,
or of ecstasy and despair, the human animal can be counted on to march
to a predictable drumbeat. This herd mentality is a big reason why real
estate prices rise – and fall – in alternating periods of
over- and under-valuation.
Secondly, people tend to hold onto the belief that whatever
the existing trend is, that trend will continue to operate in the future.
This phenomenon is most evident at the peaks and valleys of the real estate
cycle, where everybody wants to buy real estate when it is expensive yet
nobody wants it when it is cheap.
This being the case, understanding human nature can help
you make more profitable buying and selling decisions. It will allow you
to overcome your own self-defeating tendencies by becoming a more flexible
and independent thinker. Then, once you can see the market as it really
is – and not be held prisoner by the follow-the-leader mentality
of the crowd – you will be able to be constantly thinking about
change and the best way to deal with it. Last but not least, you will
then be able to identify the market’s direction and anticipate its
next move. In other words, you will be able to tell when real estate is
at a market cycle bottom and when it is at a market cycle peak.
The truth is, great real estate investors are made,
not born. What is required is discipline, a system that tells you
when to buy -- not what to buy -- and a strategic plan for moving money
in and out of the market. And contrary to popular belief, what is not
required is superior intelligence. Even the brightest person will
lose money if he buys near a market cycle peak and the market heads south.
On the other hand, a real estate novice will make money if he or she buys
near the bottom and rides the market cycle up.
Although we would all like to act on “inside information,”
and know the true “scoop” on what is going to happen before
everyone else, the skilled observer who has learned where to look, has
the best possible chance to know in advance where and when
each stage of the real estate cycle is approaching.
Real estate cycles go through four distinct stages that
are predictable patterns of change:
Stage One: The bottom of a market cycle, when real
estate is a bargain.
Stage Two: Prices start to climb. People notice
this, which creates a
demand that keeps prices rising until the demand slows, at which point
real estate becomes over-priced.
Stage Three: Prices hit a peak and level off.
Stage Four: Prices begin to fall. As prices begin
to drop, people hold off
from buying until real estate becomes under-priced and is a bargain again.
Then the cycle repeats itself.
Studies show that as real estate prices move from one stage
to another stage, so does market psychology. What this means is that psychological
change is the engine of the market and that most people’s buying
and selling decisions are basically driven by two powerful emotions, fear
and greed. Fear and greed, however, are poor financial advisors. Greed,
for example, typically leads you into buying at or near real estate peaks,
the times when you should be selling. What is just as bad is that fear
makes you give up all hope at market bottoms, the time when you should
be buying.
If we look at a complete real estate cycle, we will see
that each full cycle goes through identifiable periods of growth, maturity,
and decay, which will be followed by a re-emergence of growth that starts
a new market cycle all over again. It is important to understand that
all real estate cycles are self-perpetuating. In other words, one cycle
fuels the next.
As property values rise higher and higher (during the growth
phase), the seeds of self-destruction are already building in the upcycle.
This is because rising prices eventually reach a high point that curtails
buyer demand. Conversely, as property values fall lower and lower (during
the decay phase), the seeds of regeneration are building in the downcycle.
Because falling home prices eventually reach a low point where there is
an abundance of interested buyers, but few sellers, prices have nowhere
to go but up. For these reasons, all real estate cycles push home prices
only so high – or so low – before they reverse direction.
Stage One:
The Market Hits Rock-Bottom
Stage One is the market bottom. During this time
real estate prices are depressed, often severely. Current business news
is usually terrible. Market analysts tend to be equally pessimistic. A
large percentage of real estate offices have closed, and up to 50% of
all real estate agents may have left the business. Everywhere you go,
you hear about those who are losing their shirts in the real estate market
and the many homebuilders who are in trouble or now bankrupt.
At Stage One, everyone who has been scared or forced
into selling has sold. There are few buyers and few sellers . . . yet
equilibrium between supply and demand has been reached. Prices are unlikely
to fall much lower. Property is cheap and bargains are everywhere, yet
very few have the foresight, or the courage, to step in and buy. Value
is ignored. Blinded by fear and uncertainty, buyers are looking into the
rear-view mirror to see what prices have done in the recent past, instead
of looking through the windshield to see where prices are likely to go
in the near future.
On the other side of the coin, those buyers who take advantage
of this low risk buying opportunity are the ones who make the greatest
profits. To illustrate, let me tell you about a new home I bought in early
1982, which was a time when the San Diego real estate market was depressed
and still reeling both from recession and the negative effect of the 17%
mortgage rates from the previous year.
Buying from a “highly motivated” homebuilder
at the low price of $205,000 – remember, we are talking
about San Diego here – my timing proved to be perfect! (Even though
my Vital Sign indicators were not discovered until 1993, market research
– i.e. “back-testing” – shows these key indicators
signaled a Stage One market cycle bottom for the San Diego real estate
in April 1982.) As luck would have it, the value of the home started to
rise as soon as I closed escrow. A mere six years later (Spring 1988),
I sold the home for $375,000, which constituted an 83% appreciation in
value. This amounted to a profit of $170,000, a staggering 829% return
on my initial $20,500 down payment!
Stage Two:
The Market Blastoff and Uptrend
Stage Two begins when real estate prices slowly
start to rise. As time goes by, people begin to notice that prices are
moving higher, and become more interested in buying. This signals that
the start of a new market cycle uptrend is underway. It is during this
stage that you want to have your money invested in real estate. The earlier
you buy, the better. As demand rises, higher prices are bound to follow.
As more time passes during Stage Two, and as prices
continue to rise, the pain of the last market downtrend starts to fade
from memory. Buyers who have been waiting on the sidelines now start jumping
into the market, little by little pushing prices even higher. Increasing
property values attract more and more people who are eager to buy, which
drives prices higher still. Like a self-fulfilling prophecy, steadily
increasing demand fuels a rising real estate market that starts to feed
upon itself.
This is the growth stage for real estate values.
After a year or so of rising prices, as more and more buyers
stampede into the market, prices continue to surge higher and higher.
Demand continues to build. And as prices go even higher – and property
values start to rise at a faster and faster clip – we see an emergence
of speculators entering the market for one purpose only: to make a rapid
profit.
In 1984, for example, with the San Diego real estate market
appreciating by almost ten percent, I personally started investing in
real estate in a more speculative way. That is, instead of buying “existing
properties” for investment – like I had always done since
1972 – I decided to go into real estate development in order to
speed up the wealth building process. So, with the San Diego real estate
market in a Stage Two uptrend until late 1989, I followed in
my father’s footsteps as a builder, and from 1984 to1988, I successful
build – and sold – over 40 homes and apartment units. With
the “trend as my friend,” my net worth went into a steep upward
climb and the champagne corks were popping!
The point of telling you this story is to underline the
fact that, in the middle of a Stage Two market upcycle, when
property values can start to climb at double-digit rates of appreciation,
rising real estate prices eventually start to make headline news. Typically,
this is when the general public starts to exhibit more and more buying
interest. As they buy in greater and greater numbers, prices are pushed
even higher. The ranks of real estate agents swell to handle the increased
demand. Now the social buzz becomes one of excitement, and everybody is
talking about how people are making a “killing” in real estate.
As the market continues to boom late into the Stage
Two upcycle, the economists and real estate “experts”
are all uniformly optimistic in their economic outlooks. Now, even the
real estate skeptics who had been content to watch from the sidelines
up to this point become convinced it is time to join the party. So they
jump on the bandwagon in huge numbers and rush into the market to buy,
often engaging in overbidding wars to make sure that they won’t
be priced out of the market forever. “Home prices may be high,”
they rationalize, “but they are going even higher.”
The longer the Stage Two uptrend continues, the
more the growing risk that is lurking around the corner is ignored . .
. even after prices reach ridiculous levels. And when the big run-up in
real estate prices sets off the alarm bells, very few are willing to listen.
Unfortunately, it always turns out that what the wise do
early, the foolish do late. The growth phase of the real estate cycle
is about to come to a screeching halt, and money invested in real estate
is now potentially at great risk.
Stage Three:
The Market Hits a Peak
Stage Three arrives when real estate prices reach
a market cycle peak and start to level off. Most people who were interested
in buying, have done so. Real estate is now overpriced.
The “Greater Fool Theory,” which presumes that you can pay
any absurd price for a property, and there will be someone greedier than
you who will buy it from you at an even higher price, has been pushed
to its limit.
With fewer and fewer buyers willing – or able –
to pay these highly inflated prices, demand starts to slow. Oddly enough,
even though the upward trend in real estate prices has stalled, there
are still enthusiasts who believe prices will soon be moving higher again
in the near future. They like to cite “facts” that prove there
is an absolute shortage of housing that will permanently support prices
at these absurd levels.
As more and more time passes with little or no price appreciation
(there is no place left to go), the best informed begin to recognize this
is a real estate “peak.” This is when market risk is highest.
With sluggish demand, a few sellers reluctantly start to lower their asking
prices – usually to “market value” – to attract
buyers. The buyers who jump in do so with the confidence that they are
making a “good buy.” While the momentum of the market’s
upcycle may indeed cause prices to rise for a little while longer, this
is the beginning of the end. Soon, the buyers who thought they were making
a good buy will be kissing their money “good-bye.”
Those who sell at the end of Stage Three –
by design or sheer luck – will be selling at high prices that are
unlikely to be seen for years to come. Those who overstay their welcome
do so at extreme peril.
Stage Four:
The Downturn and Possible Market Crash
Stage Four begins when real estate prices start
to fall. This signals that the market is now turning downward, and it
is during this stage that you want to have your money out of the real
estate market. Sales activity starts to slow because there are fewer buyers.
When prices first start to fall, there is disbelief and denial from sellers,
just like the denial and disbelief you will hear from buyers at the start
of the Stage Two market uptrend.
“Real estate prices will go back up soon,” plead
the real estate agents, who are now all looking for ways to boost their
disappearing sales.
During market downturns, sellers and real estate listing
agents start to use incentives to lure buyers. One common tactic is to
offer a large “selling bonus” (higher commission) to agents
who have buyers who still believe real estate is a safe investment. Homebuilders
use even a wider assortment of incentives to stimulate sales. They try
to “bribe” buyers with free landscaping, new cars, vacations,
and almost anything else you can imagine.
Personally, I liked to use “creative financing”
as a way to attract buyers during a Stage Four market downcycle.
In 1980, for example, with mortgage rates at 13% and rising, a highly
inflated San Diego real estate market finally started to deflate. I owned
about eight to ten rental properties at that time, and many of my real
estate brokerage clients were investing as well. Because our rentals were
all highly leveraged in order to “max-out” our returns during
the late 1970’s upcycle, most of our properties had a negative cash
flow, meaning the rental income did not cover the holding costs.
With San Diego real estate prices now dropping each month
(along with the cash reserves in our bank accounts), my clients and I
knew we had to act fast. To solve the problem, we sold nine or ten rental
properties within two to three months with “no money down”
and “no new bank financing” required, a strategy which is
the essence of creative financing. By doing this, we were able to sell
quickly at high prices, eliminate negative cash flows, and protect our
“paper profits.”
After one or two years into a Stage Four decline,
demand continues to slow and the reality of falling prices becomes increasingly
obvious. To many, the unthinkable is now unfolding: real estate can actually
go down in value. Prices may be lower by 10-20% from the previous peak.
While most sellers have given up hope of making a profit, many are adamant
about not taking a loss. They try to sell their homes for exactly what
they paid. However, unless the price of a property has been “marked
down” sufficiently to be attractive to a dwindling pool of buyers,
the amount of loss continues to grow.
If the real estate market goes into a severe decline, home
prices can fall by 20-30%, or more. The value of vacant land really gets
smashed; it can drop by 50%, as I know from personal experience. After
my partners and I bought two multi-family building sites – one for
$600,000 and another for $370,000 – at the peak of the San Diego
real estate boom in 1989, the market crashed. By 1992, both pieces of
land were sold for their loan amounts. With the complete loss of our down
payments, plus three years of $6000-per-month holding costs, the total
loss was nearly $600,000. (It was this financial disaster – plus
another caused by my decision to build an eight-home subdivision at the
same time – that led to the discovery of the Vital Sign indicators.)
When the market gets really bad, sales activity slows to
a crawl. Real estate agents are now exiting the business in droves. A
market that was once driven by greed is now driven by fear. The local
economy is depressed and unemployment is high. With layoffs getting worse,
an increasing number of property owners are now having trouble making
their mortgage payments. In desperation, they phone their real estate
agents and say, “I need to sell my home immediately.” Some
agents reply, “Sell to whom? There aren’t any buyers.”
Other property owners don’t want to make their mortgage payments because
they’ve become what is known as “upside-down,” meaning
that they owe more on their homes than their homes are worth. Whatever
the reason, the result is the same: foreclosures skyrocket, putting even
more downward pressure on already depressed prices.
At the end of a Stage Four decline, when despair
is most rampant, the market eventually finds a bottom. After the huge
fall in real estate prices, the bells start ringing again . . . this time
as a major opportunity to buy.
The dark skies begin to clear and the sun begins to shine
again, signaling the dawn of a new market cycle uptrend. If you have the
knowledge to recognize this as a market bottom, have money and the courage
to act, you are now in the perfect position to make the buys of a lifetime.
Real Estate Cycles Play a Vital Role in Your Life
Know this: even though the population continues to grow
and there are more and more governmental programs – called “safety
nets” – in place to prevent serious downturns in our economy
(at least in theory), real estate cycles will always exist. The forces
of supply and demand are so powerful, and shifts in market sentiment from
optimism to pessimism are so strong, that even government action cannot
prevent periods when property values fall.
Both from a study of history as well as this author’s
personal experiences, what the market gives, the market can also take
away. For this reason, when you buy a home – and when you sell it
– real estate timing will be central if your goal is to increase
your wealth.
Because of the long-term nature of real estate ownership,
for many it is difficult to grasp the true potential of buying and selling
according to market cycles. For others, especially the inexperienced with
dollar signs dancing in their eyes, the expectation often exists that
real estate is the place to make a spectacular killing regardless of when
they buy in the cycle. Either way, this lack of market cycle awareness
not only limits profits, but it also creates unnecessary exposure to risk.
Knowing that real estate cycles exist, however, is not enough.
To take advantage of them, you must know how to anticipate their arrival.
The Best Time to Buy and Sell? Just Ask the Market
Real estate cycles – and trends – don’t
just happen by accident. They are not random events that occur for no
reason. Instead, they are set in motion by a series of economic events
that create supply and demand imbalances in the marketplace, circumstances
which can be directly measured by the Vital Sign indicators.
The Vital Sign indicators prove that in order to stay ahead
of these trends, you don’t have to be the smartest person in the
world. You don’t have to figure out what the baby boomers are going
to do about housing, whether inflation is going to get better or worse,
or how the war on terrorism is ultimately going to impact the economy.
While all these topics may make for interesting discussions at your local
Starbucks, you don’t need to know these answers to make intelligent
real estate decisions.
Furthermore, even if you could answer these kinds
of questions, it still may not be enough. The reason for this is that
real estate trends are influenced by a whole host of market forces –
interest rates, the expansion or contraction of the economy, consumer
confidence, income levels, inflation, population trends, changes in the
tax laws, and even war. To complicate matters even more and add to the
confusion, at any point in time, some of these market forces are exerting
a positive effect on real estate prices while others are exerting a negative
effect.
So, how can you figure out what real estate prices are
going to do next?
There is only one answer, and if you want to know for sure,
the market itself has it.
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