Investors and economists often talk about cycles … business cycles, credit cycles, even news and legislative cycles.
Cycles are the ebb and flow of causes and effects sloshing around in the economic sea we all swim in. They’re big picture stuff.
For nose-to-the-grindstone Main Street real estate investors, cycles are barely interesting, seemingly irrelevant, and mostly boring.
But a danger for Main Streeters is not seeing something dangerous developing on the horizon. Another danger is getting lost in the lag.
The lag is the gap between when a “cause” happens and when the “effect” shows up.
For example, in a typical supply-and-demand cycle, a shortage of homes could cause prices to spike. The effect of the supply-demand imbalance is higher prices, which in turn becomes a new cause.
Rising prices causes builders to increase production … and existing property owners to put their homes on the market … thereby increasing supply.
As supply grows, price escalation slows. If supply overshoots demand, prices might actually fall. If you’re structured for only rising prices, you might have a problem.
Of course, there are other factors affecting pricing such as interest rates, wage growth, taxes, labor and material costs, availability of developable land, and on and on.
But our point is … an amateur investor often doesn’t see the cause for price escalation (or anything else) until the effect happens.
Once prices rise, they jump in to ride the wave … believing prices will go up tomorrow because they went up yesterday … and their speculation only adds to the demand and fuels the fire.
At least for a while …
What’s often overlooked is the production pipeline … until the supply shows up and softens pricing. Near-sighted investors often get lost in the lag. They’re not sure where they are in the cycle.
It’s what happened to “GO Zone” investors after Katrina and Bakken investors during the shale boom.
Folks bought in during a boom, not considering the “production lag” … and didn’t structure for a slowdown. When it happened, they didn’t have a Plan B.
It’s a simple example … and before 2008, that was about as deep as our analysis ran.
But the pain of 2008 opened our eyes … and 10 years later they’re still as wide open as we can keep them … because we know there are cycles as sure as the sun comes up.
That knowledge isn’t bad. In fact, it’s good. Because when you see the bigger picture, you also see more opportunity.
So we study history for lessons … current events for clues … and we talk with experts for different perspectives.
It sounds complicated … and maybe it is a little … but it’s like the old kids’ game, Mousetrap.
There’s a lot of fancy machinery hanging over our heads …and it’s just a series of causes and effects. “A” triggers “B” triggers “C” and so on … until it’s in our faces.
But even at the street level with our nose on the cheese, if we watch the machinery, we can see events unfold and still have time to react appropriately.
So let’s go past a simple supply-and-demand example.
Back in 1999, Uncle Sam decided to “help” wannabe homebuyers get Fannie Mae loans … so the government lowered lending standards and pushed more funds into housing. It seemed like a nice thing to do.
But at the time, observers cautioned it could lead to financial problems at Fannie Mae … even to the point of failure. It took nine years (lag) … but that’s exactly what happened. Fannie Mae eventually failed and needed a bailout.
But before things crashed, it BOOMED … and people made fortunes. We remember those days well. It was AWESOME … until it wasn’t.
Folks were profitably playing in the housing jumphouse from the time the easy money air pump switched on until the circuit blew. Lags can be a lot of fun.
Because few understood why the party started and why it might end … most thought the good times would roll forever. So they were only structured for sunshine.
People who urged caution at the height of fun … like Peter Schiff and Robert Kiyosaki … were derided as party-poopers.
Of course, they both did well through the crisis because even in the boom they were aware of the lag and the possibility of a downturn … and were structured accordingly. Smart.
Now, let’s go beyond supply, demand, and mortgages … and look even further up the machinery …
In late 2000, Congress passed the Commodity Futures Modernization Act of 2000.
Doesn’t sound like it has anything to do with real estate … BUT …
This was the birthplace of unregulated derivatives … like those infamous credit default swaps no one in real estate ever heard of …
… until they destroyed Bear Stearns and Lehman Brothers in 2008, while bringing AIG to the brink of bankruptcy, and nearly crashing the financial system.
This mess got ALL over real estate investors in a big and painful way … even though there was an 8 year lag before it showed up.
Remember, for those 8 years a lot of the money created through derivatives made its way into mortgages and real estate … adding LOTS of air to the jumphouse.
Back then, real estate investors were riding high … just like today’s stock market investors.
And those who only measured the air pressure in the jumphouse … ignoring other gauges … didn’t see the circuits over-heating … until the system failed.
Then the air abruptly stopped, the inflated markets quickly deflated, and the equity-building party turned into a balance-sheet-destroying disaster.
And it happened FAST.
Which bring us to today …
The Atlanta Fed recently raised their GDP forecast for the booming U.S. economy.
Stock indexes are at all-time highs. Unemployment is low. The new Fed chair says, “The economy is strong.”
Some say these are the effects of tax cuts and a big spending bill.
Makes sense … because when you measure productivity by spending, when you spend, the numbers move. Spending, or “fiscal stimulus” is an easy way to goose the economy.
But some are concerned this is a temporary flash fed by debt and deficits.
Others say it’s fiscal stimulus done right … kindling a permanent fire of economic growth and activity.
Could be. After all, Trump’s a real estate guy, so he understands using debt to build or acquire long-term productive assets.
Real estate investors know better than most that not all debt and spending are the same.
Of course, government, geo-politics, and a national economy are a much different game than New York City real estate development.
And there are certainly some cracks showing in all these strong economic numbers …
A strong U.S. dollar is giving emerging markets fits. Home buying, building, appreciation, and mortgages are all slowing.
We’re not here to prognosticate about what might happen. Lots of smart people are already doing that, with a wide variety of opinions.
We just keep listening.
Our point today is … there’s a lag between cause and effect smart investors are wise to consider.
When lots of things are changing very fast, as they are right now, some are tempted to sit out and see what happens. Probably not smart.
After all, the air in the jumphouse could last a while. No one likes to miss out on all the fun.
But others put on sunglasses, toss the umbrella, and go out and dance in the sunshine … without watching the horizon. Also not smart.
Dark clouds could be forming in the distance which might quickly turn sunshine into storm.
The best investors we’ve met take a balanced approach … staying alert and nimble while enjoying the sunshine, but not getting lost in the lag.
Changes in economic seasons aren’t the problem. It’s not seeing them coming and being properly prepared.
Until next time … good investing!
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