Market cycles in real estate create opportunities for investors to recognize value and make a profit when you buy.
Lee Kearney has flipped over 7,000 homes in the past decade. In the crash of 2008, he lost everything, but at the bottom of the market he recognized the opportunity, and was able to make up for his loss.
The market cycle is easier to identify in the past. It has lows and highs which reflect when money is not trading hands to when money is effortless. When you look back in time, you can see the point where buyers are spooked and are no longer willing to buy. This marks the high point and the start of a down market. It is the point where buyers believe there is no more upside left in the market. When this happens, it causes sellers to lower the price to attract buyers.
If sellers are unable to attract buyers quickly with a minor price adjustment, the risk of a crash increases. When this period of uncertainty lingers on, the belief that things are bad spreads, and further reduces the number of potential buyers who are willing to part with their cash.
Sellers who are not property capitalized to hold their property through the slow market cycle, can potentially lose their property. Only when buyers recognize the opportunity and start buying again does the momentum of the market cycle change from downward to upward.
At this point, the market begins to build support as buyers re-enter the market. Buyers are able to pick up deals from sellers who are desperate, or exhausted and fearful that they will not be able to sell their property. As the market continues, sellers continue to raise their price. This will continue for as long as buyers believe there is potential for additional value to be recognized. When the buyers no longer believe there is value in the market, the cycle starts all over again.
Interest Rate Affects Real Estate Market Cycle
There are multiple real estate market cycle drivers. In the single family residential market, interest rates are a primary driver of price, affordability, buyers and sellers behavior.
Most residential buyers are payment sensitive. They can afford a certain amount each month for their housing budget, which is determined by the lenders debt to income ratio.
When you borrow money to buy a house, if interest rates are lower, their payment will buy a more expensive home. The reverse is true when interest rates increase. Instead of a more expensive home, the same payment can only buy a less expensive home.
To help stimulate or extend the market cycle, the Federal Reserve can raise and lower the interest rate charged to commercial banks. This directly affects the interest rates individuals can get for a mortgage, which affects home prices, all the while the buyer payment never changes.
However, as prices continue to increase, regardless of interest rate, eventually, the cost of housing becomes unaffordable. This causes the flow of money to stop, and a potential for a crash increases.
The warning signs were everywhere, in 2005, but few took notice. Money was easy to get. Rates were low, and if you could fog a mirror, you could qualify for a loan.
The Federal Reserve kept interest rates low, which artificially increased drove home prices up. As the prices continued to go up, and lending standards lessened, buyers were counting on the market to continue pushing the values upward.
Because buyers were stretching to get into homes, they had nothing left to save for a rainy day. They were paying all they could to stay in their homes. If anything broke or they had an emergency,
Buyers had no savings. They were living hand to mouth. When the banks failed, money stopped moving. Most of the loans were interest only, or had balloons that came due when no banks were lending. The buyers had loans they could not afford, homes they could not sell and mortgages for more than their homes were worth.
Wages vs Home Price
Wages versus Home Price. In order for prices to continue to increase, wages have to catch up. If wages fail to increase, the demand for home owners will eventually go down. These potential home owners will become renters. More demand for rental units will continue to push rents up.
When demand outpaces supply, prices go up. More renters will push rents up. If wages do not go up with rents, renters will no longer be able to afford their apartment. When renters cannot rent, landlords end up with vacancies.
A vacant property can ruin an investor. When a landlord does not have the capital needed to pay their mortgage, the bank will foreclose. The bank is not in business to be a landlord, so it will elect to sell the property quickly for as much as they can get.
These distressed properties provide a good opportunity for a buyer because now they can buy low and have a cushion between their potential income and their expenses.
In order to extend the market, wages eventually will need to increase.
Investing vs Speculation
Investing versus speculating, the difference is one is following the herd while the other is not. Investing is when you buy at the bottom of the market. This is when others are afraid to invest. The market can only go one way, and that is up.
Speculating is when you follow the herd. You are buying when everyone else is buying, at the top, and you hope that the property will go up in value.
Long Term Wealth
Long term wealth is not determined by the number of doors you own. Many investors think the number of doors measures wealth.
Real wealth is measured by equity. When you buy low, and the market rises like it has for the past ten years, you end up with a lot of equity. If you buy at the high, and prices go down, you have negative equity and a mortgage you can not refinance out of.
In addition to equity, you want positive cash flow. This allows you to maintain the property, service your mortgage, accumulate reserves and potentially distribute profits to investors.
When you buy low and have positive cash flow, you are on your way to creating wealth.
Each week I ask my guest, “What is the Biggest Risk Real Estate Investors face?”
Darrin:I’ve been asking my guests on CREPN Radio if they could take a look at their, you know, investing strategies and how they basically see the market and if they can identify what they consider to be the BIGGEST RISK.
Darrin: And with that, I’d like to ask you, Lee Kearney, what is the BIGGEST RISK?
Lee: If you’re buying an asset today at market value, your BIGGEST RISK is the market risk. Is the risk of that asset going down in value? Now, if you’re buying it wholesale, you don’t bear the same risk. But if you’re buying at a market price today in any primary market, I would say your biggest risk is that that assets gonna go down in value.
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