Real Estate Investing Model: How to predict real estate prices
Ever wonder when’s the right time to buy a house? Ever wonder if you should invest in real estate now, or wait because you think that the real estate market will fall?
Most industry analysts try to “guess” when the real estate market will turn. Or they throw out meaningless words such as “housing is in a bubble”, which tells you NOTHING about WHEN housing prices will go up or down.
Here’s a quantitative way to predict big turning points in the housing market.
The Model: Activity leads price
Here’s the real (inflation adjusted) median price for new homes sold in the U.S.
As you can see, 2008 was not a unique experience. Inflation-adjusted housing prices in the U.S. have fallen before – they tend to fall in every economic recession (with the exception of the 2001 economic recession, which was a business-driven instead of a consumer-driven recession).
So how do you predict the future DIRECTION of real estate prices?
Simple. Activity leads prices. You can use “activity” in the real estate market to predict turning points in the real estate market.
Real estate activity and prices usually move in the same direction, EXCEPT at turning points. Activity is a leading indicator for prices at turning points.
When real estate prices are rising and activity starts to fall, it means that real estate prices will soon peak.
When real estate prices are falling and activity starts to rise, it means that real estate prices will soon bottom.
New Home Sales (activity) vs. Median Prices
The following chart demonstrates that New Home Sales tends to lead median prices.
New Home Sales usually tops before Median Prices top.
New Home Sales usually bottoms before Median Prices bottom.
Building Permits (activity) vs. Median Prices
The following chart demonstrates that Building Permits tends to lead median prices.
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Building Permits usually tops before Median Prices top.
Building Permits usually bottoms before Median Prices bottom.
Housing Starts (activity) vs. Median Prices
The following chart demonstrates that Housing Starts tends to lead median prices.
Housing Starts usually tops before Median Prices top.
Housing Starts usually bottoms before Median Prices bottom.
Why activity leads prices
It’s very easy to understand why this leading-lagging phenomenon exists. You’ve probably seen it in action. All you need to do is walk down your neighborhood street and observe the “For Sale” signs.
Unlike the stock market, real estate is a low-liquidity market. You cannot put up a “For Sale” sign right now and get a “bid/ask” the next second. It takes weeks/months to close a deal.
At peaks in the real estate market
Imagine a bull market in real estate. Prices are going up, people are buying and selling houses, etc. Towards the end of the bull market, there are more sellers than buyers. People generally:
Think that real estate prices are “too high”, or…
They can’t afford to buy houses, so…
They put off purchasing houses.
Also, the central bank is probably raising interest rates towards the end of the economic expansion, which means that mortgage payments suddenly become more expensive. Many investors in real estate probably face a cash crunch.
This results in a sudden flood of homes for sale in the market, and not enough buyers (demand) to meet that increased supply.
Real estate is also a very interesting market in the way it reflects human psychology. It demonstrates that the majority of humans focus on the trees instead of the forest: they care so much about small gains, that they end up with a big loss.
Here’s an example.
Let’s assume that there are ten homes on the market that were worth $500k last month. There are only two buyers. Any seller can easily get rid of his house if he chops the price by $20k to $480k. But no seller does this, because nominally $20k seems like a lot (even though in percentage terms, it’s only 4%). No one wants to “lose out” on $20k.
So the sellers hold on to their houses and hope that the market will improve. But the market doesn’t, because the bull market in real estate is over. So while prices are stable, activity (transactions) in the real estate market has already fallen. Activity leads prices.
Given enough time, sellers realize that prices might not quickly recover to previous highs. That’s when sellers start to slash prices, which causes the real estate market (in terms of price) to fall.
This is called “the stickiness of prices”. Sellers don’t adjust prices fast enough to meet the new supply/demand situation, which means that the market will have excess supply for quite some time before sellers realize that they’d better sell now before prices fall even more.
And like I said, this demonstrates human psychology. Any seller could have sold close to the top of the market, if only he had cut his price by a little bit and taken a small loss. Instead, sellers hang on to their houses, only to sell at an EVEN LOWER PRICE when they realize the mistake they made.
The opposite is true at the bottom of real estate bear markets
Prices are falling because people are foreclosing on their mortgages. However, cash-rich investors (e.g. long term savvy investors) recognize that real estate is “cheap”, so they start to buy. Their buying causes housing activity (transactions) to go up even though prices are still falling.
Eventually, the increase in housing demand stops the decline in prices. The bear market in real estate is over.
Real Estate today
Activity in the U.S. real estate market is clearly trending higher today.
Housing Starts, New Home Sales, and Building Permits are all trending higher. This suggests that the bull market in U.S. real estate is not over, regardless of how “expensive” you think valuations are. Valuations can’t be used to predict turning points in the real estate market. Activity can.
Inflation-adjusted real estate prices in the U.S. will probably continue to trend higher.
*The real estate market is more local. This looks at the U.S. real estate market as a whole.
The “activity leads real estate prices” concept probably applies to other countries as well. But since other countries don’t have as much economic/market data as the U.S., it’s hard to quantify this relationship for other countries.
But I can explain it anecdotally in Toronto (Canada) and Sydney (Australia).
In case you’re not aware, Toronto and Sydney experienced massive real estate bubbles before 2017.
Real estate activity fell last year in Toronto. Everywhere on my street were “For Sale” signs (something I haven’t seen in 10 years), but not a single “Sold” sign. Some of my family friends were real estate agents, and they told me that “prices hadn’t fallen, but the number of transactions tanked”.
Toronto real estate prices are falling this year (2018).
The same thing happened in Sydney. Real estate activity fell in 2017. There were “For Sale” signs everywhere, and the number of cranes in the city skyrocketed. Real estate prices are falling this year in Sydney for the first time in a long time.
For those in the Membership Program
I will show you how to quantify this leading-lagging relationship and turn it into a quantitative model. That way you will know EXACTLY when is the optimal time to buy and sell U.S. real estate.