Understanding property cycles
I've often said that until you have invested through a full property cycle, you don't really fully appreciate the property markets.
You see… though many books and articles refer to the average annual compound growth of property as 10%, it is NOT constant each and every year.
Property values tend to rise in cycles. In some years there will be strong growth and in others there will be no growth or negative growth.
A simplistic version of the cycle goes something like this…
As populations grow there is an increased demand for property and this causes an increase in rents. Slowly this causes property values to increase because financial returns have increased. Builders and developers hop on board and start constructing new dwellings as property developments become more profitable. Over time this leads to an oversupply of property which eventually results in rent reductions and slumping property values.
Yes, despite what many agents will tell you, property values may fall and often have. Then in other years, values may rise by over 20%.
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 property booms – in the following years: 1981; 1987; 1994; 2003
But these cycles do not 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.
Looking at the graph below, it shows that over time property prices increase (green line) and in good locations property values double every 7 to 10 years.
At some stages of the cycle property values increase and they stay flat or decrease at other times during the property cycle, but ultimately they have a long term increase in value as depicted by the green line.
At various stage in the cycle property values exceed this underlying long term trend (such as in boom times) and at other stages fall short of this long term underlying value such as during property slumps.
History shows that the property cycle consistently passes through 4 phases:
© 2007
The BOOM PHASE –
This tends to be the shortest phase of the cycle. During the boom property prices increase rapidly – often by more than 20% per annum.
The boom often begins slowly as investors recognise that property returns are increasing with increased rentals and slowly increasing property prices.
As the boom continues a whole generation of new investors come in to the market driven by property seminars, the press, 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 of properties 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 properties 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 property prices falling.
During the slump property 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 their properties. When they do this in a falling market with few buyers, they exacerbate the slump.
This is also the stage when many new home buyers get into trouble. They 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 property markets don't usually jump from aperiod of negative sentiment to the next upturn. There is usually a short phase where the various econo
mic factor catch up with each other – they stabilize or get back into equilibrium.
Things get back closer to the average – I guess that's how averages work.
The UPTURN PHASE
During the upturn, vacancy rates slowly fall, rents start to rise, and property values start to rise 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. Property values generally start increasing in the inner ring, more affluent suburbs and those close to the CBD or the beaches driven initially by owner occupiers looking to upgrade their homes. Over the next few years increasing property 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 property 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 not yet convinced that property is a good investment.
This is the time that many builders and developers buy properties and commence development projects to have them completed by the late upturn or boom phases of the cycle.
Investors slowly get back into property as conditions seem more favourable. They see property values increasing and are concerned that they may miss out if they don't buy a property. This is also the time that many first home buyers enter the property 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 investment returns decrease.
And.....we start all over again
Michael - propertyupdate.com.au
4/06/08