Real estate is without doubt a cyclical industry, something that that after the recent 15 year boom a lot of real estate professionals had forgotten or ignored. In this article we look at how the US has gone from the boom of the 1980s, to the real estate depression of the early 1990s, back to an easy money growth phase, to bust again. We really do have short memories!

Taking a look back at historical trends can be a valuable protection against loss on your current investment properties and any future real estate investments.

The recent boom in real estate was extremely protracted by historical standards, and the unprecedented levels of liquidity and cheap financing led to a diversion from the typical pattern of a real estate cycle, which consist of three short phases:

1. Upturn phase of 12 to 24 months
2. Mature phase of 12 to 36 months
3. Downturn phase of 24 to 48 months

What we have seen in the last few decades is nothing like this typical pattern – the average home worth has witnessed massive value increase. This article looks at the differences, and the reasons why real estate trends diverted so far from normal patterns.

Real estate in the 1980s experienced a heady boom which was fueled by funding from savings and loans, banks, insurance companies, and other institutional investors.

It was the savings and loans companies that poured oil on this burning fire of dangerous growth: in an effort to take advantage of the real estate boom and high interest rates of the late 1970s and early 1980s, many savings and loans lent money with abandon, often to risky ventures that they were not qualified to assess.

L. William Seidman, former chairman of both the Federal Deposit Insurance Corporation (FDIC) and the Resolution Trust Corporation, stated, "The banking problems of the '80s and '90s came primarily, but not exclusively, from unsound real estate lending."

The 80s boom was followed by a collapse in values in the early 1990s as the Federal Reserve System limited savings and loan funding of real estate investment.

The October 1987 Black Monday stock collapse took 22.6 percent off the Dow Jones Industrial Average, and paved the way for the short, sharp recession of the early 1990s. Although the stock market quickly bounced back, it was the collapse of savings and loans that dragged things down, and whilst most sectors of the economy were robust, energy and real estate tumbled.

The next phase in the real estate cycle was a recapitalization to encourage banks to once again lend to real estate. The major force in this process was the use of Real Estate Investment Trusts (REITs) – these publicly traded baskets of real estate assets provided the liquidity needed to reinvigorate the industry. Until mid-2007 U.S. REITs delivered 25% annualized returns. The REIT boom was augmented by trading of Commercial Mortgage Backed Securities (CMBS) and the real estate depression of the early 1990s, which had seen 30-50% declines in value, was firmly consigned to history. Real estate had become a lot more than just buying and selling houses.

We now find ourselves back in another period of contracting prices. If we consider the typical characteristics of a contraction we can see that nothing much is different this time: the Urban Land Institute describes a typical slump as one where the “supply of equity and debt contract, the financial condition of tenants and mortgaged borrowers worsens, and pessimism sets in. This pessimism is typically even more exaggerated than the irrational optimism that created the preceding boom.”

Taking a look at housing in the US, prices peaked in early 2005, started to decline in 2006, and on December 30, 2008 the Case-Shiller home price index reported its largest price drop in its history. In March 2007, the United States' sub-prime mortgage industry collapsed due to higher-than-expected home foreclosure rates, with more than 25 sub-prime lenders declaring bankruptcy, announcing significant losses, or putting themselves up for sale.

In this slump real estate sits front and center of a broader financial crisis. Although America's housing collapse is considered the cause of the crisis, it in fact results from a web of highly-leveraged financial contracts, and a flawed U.S. monetary policy that made the cost of credit negligible thus fueling leverage. We can say that the crisis in real estate, along with one in banking and credit, and the global reach of the United States led to the financial crisis in which we remain.

No doubt an upturn, a mature phase, and another slump are just around the corner for the real estate sector.

We have all heard that “when the economy catches a cold, the real estate industry contracts pneumonia,” and it’s true that real estate experience bigger highs and lows than most industries. There are a number of reasons for this:

Irrational Market Participants
In booms times investors, and in particular developers, get caught up in the growth story and lose perspective. Many of the decision-makers during the recent extended rise in values had never even experienced a downturn.

Supply Can’t be Controlled
In over-supplied markets landlords do not have alternative uses for their properties so the only way to bring supply and demand back into equilibrium is by reducing prices.

Customers Lose Confidence
Tenant reluctance to enter new leases, and take on excess space for future growth, lead to a sharp reduction in demand. Conversely, growth in real estate is fueled by real estate customers taking on more space than they need in order to accommodate future growth.

Development Lead Time
It takes two to three years to get a development underway, and in a downturn they often come online despite the worsening market conditions. This creates yet more supply which further depresses prices.

Costs are Fixed
The majority of expenses for a typical real estate investor are made up by the cost of debt. If the debt can’t be serviced then foreclosure follows.