Property Buzz: Understand RECs first and then forecast properly

The last person who tried to draw attention to business cycles was Nikolai Kondratieff, the Russian economist.

Stalin was not impressed and Nikolai (the father of the Kondratieff Wave and hence of the business cycle) was sent to the Gulag, where he died in 1938. This highlights one possible downside of trying to forecast.

I, on the other hand, am going to exhibit devilish cunning and this article is definitely not going to tell you when and by how much the resale premium on your 12th floor two-bedroom apartment with a golf course view will change.

The Dubai market is rife with unfounded rumour and everyone is a market pundit with opinions that are based on anecdotal and unreliable evidence.

One such opinion is that real estate cycles (RECs) are mysterious and dangerous. So here are 12 stark facts picked up from mature real estate markets around the world:

Fact 1: Cycles are natural

Cycles are nothing new and have been with us since time immemorial. In nature, there is an Ice Age every 100,000 years, winter follows summer, sunset follows sunrise and (on a philosophical note) death follows birth.

These are all accepted, inevitable facts which we have built our lives around and we do not normally throw up our hands in surprise and horror when we witness an event such as the onset of summer.

Fact 2: Man-made cycles

Cycles are common throughout the economy, not just in real estate. Economic cycles have been well researched and documented.

Kondratieff's major premise was that capitalist economies displayed long wave cycles of boom and bust ranging between 50 and 60 years in duration and Schumpeter took this idea further. Business cycles and RECs are hence part and parcel of the economic landscape and they cannot be avoided or ignored.

Fact 3: Reason for cycles

The logic for a REC is simple. Over the long term, real estate markets experience periods of excess demand (hot markets or seller's markets), which are succeeded by periods of excess supply (slow markets or buyer's markets).

These swings make up a REC and the cyclic pattern is caused by the market's tendency to self correct. When demand suddenly exceeds supply, property prices rise.

The rise in prices both decreases demand and motivates new supply (construction), allowing supply and demand to balance. Economists refer to this state as equilibrium.

If new supply could be added or taken back quickly, the market would always be in equilibrium, and there would be no REC.

But since developers cannot add or delete properties instantly, a big delay exists between the time a need for more housing or office space is identified and the time new space hits the market. This delay is the reason for the REC.

Fact 4: Why you should bother

RECs are inconsistent and difficult to predict. "Aha," I hear you say. "Then why waste time talking about them?"

The answer is that understanding RECs is key to understanding the real estate market. And proper understanding of the market is key to a profitable investment strategy.

Those who study cycles view market change as normal, rather than as a sign that something is wrong. Furthermore, they have a better understanding of why market conditions are changing.

Fact 5: Correlation between cycles

There is a high degree of correlation between economic cycles and RECs. As an illustration, more economic growth means more companies setting up offices. Demand for office space heats up. In fact even demand for residences jumps since all those staff need to stay somewhere.

The correlation between economic and real estate cycles is probably higher for the office than for the residential market because of the more direct linkage.

Commercial property prices may be more readily forecastable due to the stronger linkage with the economy and major cycles may be foreseen in advance.

Fact 6: Housing cycles

Housing markets are characterised by irrational, adaptive expectations and house prices often deviate significantly from economic fundamentals. A housing real estate market is thus inefficient and hence provides excellent arbitrage opportunities for the investor.

Fact 7: Downturn is also good

For portfolio managers and for investors, analysing the REC by property types can result in better performance depending on the risk/return profile of the manager/investor.

The fact is that in mature markets, the different types of real estate (hotels, office, retail, apartments, villas) are all sometimes on different points on the cycle and this behaviour allows one to pick and choose.

For example, properties recovering from a downturn and hence in oversupply are good for a growth investor who's looking for capital appreciation, due to the cheap prices.

Properties in new construction phase are good for a balanced investor who's looking for both capital appreciation and income.

Hence even a downturn offers opportunities. The other lesson here is that although there may be no real estate asset for all seasons, there is definitely a season for all real estate assets.

Fact 8: Growing economy

In a growing economy, the rising and peak phases of the REC dominate the declining phases (in years) of the REC. Also in a growing economy, the long term trend line for both demand and supply is upward sloping.

What this means is that although there may be hiccups in between when prices do dip, the peak of each new cycle is higher than previous peaks.

Fact 9: Everything is linked

To look at the REC in isolation is a mistake. There are many other cycles that affect real estate cycles.

These include economic cycles (business, inflation, population, employment, technology), political cycles (regulations, demographic changes), physical market cycles (supply, demand, occupancy, property specific) and financial market cycles (interest rate, capital flows).

Understanding RECs also means understanding the related factors/cycles and the nature and extent of their link with the REC.

Fact 10: Each market is unique

Every city has a unique cycle which has its own cycle period and amplitude. This is since each market is influenced significantly by local factors (see Fact 9) which can vary widely between cities.

Hence Dubai may not behave like Houston, London or Beirut, e.g. higher interest rates have led to softer housing markets in the United States and the United Kingdom but this is unlikely in Dubai with a lot of cash buyers.

When one market is in the recovery phase, another may be at or near the peak. This is good for the global investor since return can be maintained/maximised by timing investments in different markets.

Fact 11: Wanted: proper forecasting

The fad among market players in Dubai these days is to sigh, gaze farsightedly and murmur after a long pause that prices will undergo a correction.

This is as simplistic and misleading as putting up a wet finger.

Forecasting RECs is not easy given the lack of reliable, long term data, the multiple interrelated cycles, the various cycle models available and the dynamic and complex nature of most markets.

The good thing is that there is a wealth of research on modelling RECs. For example, there is the Inflation Cycle Model (based on forecast inflation and its impact on revenue and cost) and the Market Cycle Model (based on supply and demand).