The Real Estate Cycle and the Depression of 2008

Fred Foldvary

May 4, 2007

Real Estate Network - Leavey School of Business

Good evening!

Real estate has been in the news just about every day

as sales have slowed down

and housing prices have fallen in many places.

Many recent buyers now face rising mortgage cost that they can’t afford.

The real estate chickens are now coming home,

but why did the chicken cross the road in the first place?


There are all kinds of opinions

about what’s going on and where this is all heading.

But forecasts are generally useless without

a theory or explanation that fits all the pieces of the puzzle together.

Unfortunately in the field of economics,

there is no consensus theory of the business cycle.

Most economists today think that booms and busts

are caused by unexpected external shocks,

such as an increase in the price of oil,

or the eruption of new technologies.

Those explanations imply irregular economic fluctuations.

But in historical fact

there have been quite regular boom and bust cycles.

The problem is that there is no one single business cycle.

There are major cycles,

combined with minor ups and downs,

plus small random fluctuations,

so if you look at GDP year by year, it looks irregular,

but if you see the cat in the drawing,

you can see a clear cyclical pattern.

The economy is like those pictures

where there is a jumble of lines,

but there is a picture in the drawing,

and if you look hard enough, or know how to look,

you can see the design, such as a cat, and

once you see the cat,

it then seems obvious where the cat is.

Real estate economists recognize

that there has been for a long time

a boom-bust real estate cycle.

During the 1930s,

real estate economist Homer Hoyt

discovered an 18-year cycle of real estate in Chicago,

which coincides with the business cycle

for the economy as a whole.

Every depression is preceded by a boom,

and real estate dominates the boom.

Real-estate values and construction have peaked

one to two years before a depression,

indicating that real estate boom is a cause of the downturn.

There have been recessions that were not

caused by real estate.

For example, the recession of 2001, and previously in 1970.

These were relatively minor downturns.

The 2001 recession

which followed the huge technology boom here

would have been a very minor downturn if not for the 9/11 attack.

So here we have the cat,

and this chart lets the cat out of the bag.

But data do not create theory.

By itself, this evidence does not provide an explanation.

You should not believe this chart until you understand the explanation.

Here are the parts of a cycle.

The puzzle in the cycle is the downturn.

Why don’t economies just keep growing steadily?

Why do they peak out and turn down?

The key to answering the puzzle is not at the peak but

in the middle of the boom.


At the middle of the expansion is the point of inflection.

The slope of the cycle curve is the first derivative,

the change in output during a small time interval.

The second derivative,

for those who know calculus,

is the change in the slope,

the change in the rate of growth.

At the peak of the boom,

the point of inflection,

the second derivative,

which shows how fast the economy is growing or shrinking,

changes signs.

It changes from positive to negative.

When the second derivative is positive,

that means that growth is speeding up,

the economy is growing faster and faster.

When the second derivative flips to negative,

that means that growth is now slowing down,

the economy is still growing, but at a slower pace.

If that second derivative stays negative,

growth slows to zero,

the cycle peaks out,

and then growth turns negative,

the economy slides into a recession.

At the bottom of the cycle,

the economy is depressed,

so it is in depression.

OK, so how does this happen?

Why does the change in the rate of growth turn

from positive to negative?

The story begins with capital goods.


Capital goods are goods that have been produced but not yet consumed.

We can think of capital goods as the tools used in production.

Capital goods include machines, buildings, and inventory.

Capital goods have a time structure.

The ones at the top are the higher-order goods,

and those at the bottom are lower order.

The higher order goods take a long time

until investors get their money back.

Those at the lowest order, such as inventory,

turn over quickly.

The higher-order the capital good,

the more sensitive it is to interest rates.

With inventory, you don’t care what the interest rate is,

because your capital is tied up for a short time.

But with capital goods of highest order,

such as real estate construction,

your money is tied up for a long time,

so the rate of interest becomes very important.

High interest rates flatten the structure of capital goods.

Think of trees that take 50 years to mature.

If the tree grows 3 percent a year in value,

but the market rate of interest is 4 percent,

you won’t plant the tree.

If the market rate is less than 3 percent,

the trees get planted.

[high, low]

If the interest rate is set by the free market,

there is no problem.

More savings lead to lower interest rates,

and the reduced consumption

is offset by greater investment,

especially in the higher order capital goods.

But in our economic system,

our central bank,

the Federal Reserve system,

manipulates interest rates.

When the news media announce

that the Fed is reducing interest rates,

the relevant rate is the federal funds rate,

which is the interest rate banks pay

when they borrow funds from other banks.

The Fed does not set that rate,

it targets that rate,

by manipulating the money supply.

The Fed lowers the federal funds rate

by buying treasury bonds,

and paying for them

by raising the reserves or money held by the banks.

Our money is fiat money,

not backed by any commodity,

and the Fed creates money out of nothing by decree.

The Fed goes “poof!”

and the bank now has more money in its reserves,

money that can be lent out.

The Fed-created money

acts as though there were more savings.

Banks lower their interest rates

to loan out that extra money.

At that lower interest rate,

there is more investment in higher-order capital goods,

such as real estate construction and development.


It’s important to recognize that this new investment

is artificially boosted

by the manipulation of interest rates by the Fed,

as these investments would not have been made

with the higher interest rates

that a pure market would have set.

The problem is that the public’s planned savings

did not change.

So the new investment

competes with consumption in the market,

and so prices rise.

The new money creates price inflation, but

prices don’t all rise at the same rate.

Prices rise faster where the new money is being loaned out,

such as for purchasing and constructing real estate.

So we may not see much increase at first

in the consumer price index,

and it seems like “inflation is under control”

but in actuality,

there is high

asset price inflation,

rising real estate prices

and a rising stock market.

But capital goods are only half the story.

Land is the other half.

As the economy recovers from a recession,

at first there is a decreases in vacancies,

and then when vacancies are low,

rents rise, and the price of land rises,

and then speculators buy real estate

as they expect rentals and prices to keep rising.

When real estate prices rise,

its is really the price of land rising,

not the value of the buildings.

Land values rise

because there is a fixed supply

and a rising demand.

In California,

the supply of land for development has been artificially reduced

with stringent restrictions on zoning and land use.

Then in spite of or because of

the limitations set by Proposition 13,

local governments impose multiple taxes

on development and real estate ownership:

1) Developers' exactions or impact fees

2) Tax increment financing

3) Property-related so-called "fees"

4) Parcel taxes on the square footage of improvements

5) special assessments

6) Real estate transfer taxes

But the biggest reason why land values rise

is the humongous implicit subsidy

granted to real estate owners.

Public works and civic services

increase the value of land

and little of this is paid

from property taxes specifically on land

so these public goods

get capitalized

as higher land value and more rent.

Tax advantages

such as reduced or eliminated capital gains taxes

and tax deductions for mortgages and property taxes,

make real estate that much more attractive,

but none of this really benefits a new buyer,

because he pays for all this

in the higher price for land

unless land values keep rising.

So the whole system depends on ever increasing land prices.

As an economy expands,

and land prices go up,

leveraged ownership can reap huge profits.

The speculative demand for real estate

makes prices rise even faster.

We have seen real estate prices double

during the past several years.

Obviously this is not sustainable.

The Fed lowered the federal funds rate

down to one percent

after 2001,

which also lowered other interest rates.

Real estate purchasing, construction, and land values

have all escalated,

exactly as theory predicts.

Economist Robert Shiller

in book Irrational Exuberance

says that we are experiencing

the greatest real estate boom in history.

What has made this boom

even bigger than previous booms

is the huge explosion

in the secondary loan market.

Bankers sell their mortgages to government-sponsored enterprises,

popularly called Fannie Mae and Freddie Mac,

which in turn sell guaranteed bonds to the public and to insurance companies.

Fannie and Freddie themselves have implicit guarantees

from the federal government.


With these guarantees and

government-sponsored mortgage resale markets,

banks go hog-wild,

lending out interest-only mortgages

and adjustable-rate loans

to buyers with not so good credit.

That’s the sub-prime market we’ve been hearing about.

Fannie and Freddie

have not reduced the risks of default,

but have spread them throughout the economy.

There is a tendency

to loosen lending standards during a boom,

since if a loan goes bad,

higher prices will bail out the loan,

but when property prices stop rising,

and defaults go up as they are now doing,

banks tighten lending rules,

but this only reduces the demand for real estate even more

which makes it more difficult to sell, and

puts a downward pressure on prices.

Eventually, a great increase in the money supply

creates price inflation in consumer goods also,

and the monetary authority

then reduces the rate of growth

of the money supply,

and interest rates rise.

High interest rates

plus high prices for real estate

then choke off new investment.

Remember the point of inflection,

where the second derivative

turns from positive to negative.

Business expands

when it expects higher profits.

Business reduces investment when they expect lower profits.

They expect lower profits

because costs have gone up.

The most important costs for investment

in higher order capital goods

are for interest payments and real estate.

During the peak of expansion,

both of these costs rise,

and so the rate of investment growth falls.

The change in the rete of growth turns negative.

Higher costs eventually choke off new investment.

That lowers demand for other goods,

and then the economy plunges into a recession.

This is exactly what happened in Japan

after its boom of the 1980s.


Real estate prices then deflated

from their lofty heights,

as the Japanese economy stagnated for a long time.

Mortgages are paid from wages and profits, so eventually,

real estate prices stop rising.

The real estate market plateaus.

Sales volume drops, as it is now doing,

but most owners refuse to sell at prices much lower than they were.

The large number of properties on the market then

dampen new construction,

which then reduces the demand for durables

such as furniture, appliances, and office equipment.

With rising unemployment and interest,

some owners can’t afford to pay their mortgages,

and they go into default.

More properties get dumped on the market.

When the economy goes into recession,

people lose their jobs,`

businesses fail,

and then real estate prices collapse

as owners are forced to sell and banks unload properties.

Banks fail, enterprises go bust, unemployment soars.

The Fed now faces a financial dilemma.

The past growth of the money supply

will increase price inflation.

But if they slow down the growth of money,

interest rates rise, and slow down the economy.

There is nothing the Fed can do

to prevent the next recession

because the fruits of the previous expansion of money

are now ripe

as high real estate prices and rising defaults.

We are heading down the river

to a financial waterfall,

and expanding the money supply

won’t do any good now,

since at the peak of the boom,

inflation is expected

and no longer boost output

but just increases prices.

So, what about the timing?


Historically, the recession begins soon after real estate peaks out,

and it looks like the peak occurred last year, in 2006.

The last real-estate depression was in 1990.

Adding 18 years to that puts the next depression in 2008.

This is not a new forecast.

Back in 1997

I published an article on the business cycle

in the American Journal of Economics and Sociology

in which I predicted a recession in 2008.

The real estate cycle since then

has been right on track

towards the depression of 2008.

Could the recession start this year, in 2007?

I think a recession is unlikely before 2008

because commercial real estate is still strong,

and business investment is still strong.

But the rate of growth is already decreasing.

The exact year of the recession cannot be forecast precisely

because the Fed can alter the timing,

and we don’t know what the Fed chiefs will do.

If the Fed lowers interest rates substantially,

the recession will still come, but later.

Past evidence can give use clues to the timing,

and about two years after the peak seems to be

the average time interval from the real estate peaks

to the following recession and depression.

That’s why I continue to think

that 2008 is the most likely year for the coming depression.

And it will probably be a severe recession and depression,

given the huge increase in real estate prices,

and the huge previous expansion of the money supply

which has created large economic distortions.

There are signals we can watch

that will indicate that the recession is about to start.

Watch business profits, business investment, and non-residential construction.

The focus today is mostly on residential real estate,

but what turns that second derivative negative

is less investment by business,

and that follows lowered profit expectations.

Since the economy is already slowing down,

as the rate of growth diminishes,

the signals indicate

that we are approaching the peak.

There are also several real estate indexes we can watch.

A new real estate signal is the

S&P Case-Shiller Metro Area Home Price Indices,

associated with a new futures market in real estate prices.

[San Francisco]

Another signal is the

iShares Dow Jones US Real Estate index, symbol IYR,

which seems to have topped out on February 2007.


The inverse of that index is the

ProFunds Short Real Estate Inv fund, symbol SRPIX,

on which you can make money as real estate falls.

The iShares Dow Jones US Real Estate fund, ETF,

also looks like it topped out in February.


So what is different today from past real estate cycles is

that it is possible to hedge from or speculate on

a real estate decline,

but this won’t prevent the downturn.

So, as the economy head towards the coming waterfall,

we can’t stop it,

some will profit from it,

most folks will suffer losses, some great losses,

from the coming real estate collapse and economic depression,

but at least, if we understand the real estate cycle,

we will have the satisfaction of knowing why

we are suffering from the crash, and

just maybe, next time around,

we will be better prepared to handle it.

One thing I can predict with absolute confidence

is that government chiefs, and even most economists

will not learn the right lessons from the collapse,

and history will repeat itself,

as it always has.

Thank you, and I’ll be pleased to answer any questions.