The Real Estate Cycle and the Depression of 2008
May 4, 2007
Real Estate Network - Leavey School of Business
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,
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.
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.
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
as higher land value and more rent.
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
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.
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,`
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.
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.