Markets, including the U.S. housing economy, aren’t always rational. No matter how many booms and busts markets endure, there is always a temptation to think “this time, it’s different. This time, the value of my property may continue to increase another quarter or another year.”
As we know in our rational minds however, this is not the case. Booms and busts are both temporary, and the wise housing professionals will accept this reality and develop a long-term strategy that works within it. However, doing this is often easier said than done if macroeconomic forces are not by design factored in to long-term financial modeling.
For real estate in particular, the stakes are high. In boom times, portfolios tend to expand as models predict increased demand from tenants. When inevitable busts hit, it’s the owners of this property that are left holding the bag as tenants downsize (often aggressively). Some of the hottest emerging concepts in real estate might actually create more vulnerability to the boom-bust cycle.
Co-living and community-driven spaces are impacting the multifamily industry, with new types of wants and demands to meet. For example, the growth in co-living generates new demand for remodelers and interior reconstruction firms, but also poses challenges to other industries such as homebuilding.
The sharing economy model of co-living and community-driven residential might make these properties the canary in the coal mine when the next downturn hits, but every real estate investor is exposed to the same forces. Such is the nature of the risk involved in any investment—but as we know risk is not to be avoided, but rather managed.
The problem is that these macroeconomic risks are at a scale that is often not factored into the discrete financial models that drive decision-making on individual deals. Instead, that most dreaded factor in investing–emotion–tends to sneak in and inform the big picture decision-making of even seasoned real estate veterans.
Better modeling: an end to booms and busts?
The research on what drives booms and busts in real estate is large and often contradictory in its findings, but all seem to agree: beliefs about the market have a significant effect. One 2015 study on residential housing markets found that agents’ individual views on long-run fundamentals and how they shift over time might actually produce booms and busts. In this context, adoption of a more rational, data-driven approach to the big picture could in theory actually reduce the magnitude of booms and busts triggered by gut beliefs.
Another extensive study by the European Central Bank of booms and busts in housing markets developed a model it found to be “quite successful in identifying booms and busts early on,” and also identified policy factors like interest rates and global money supplies as significant. With effective models such as these as a baseline, augmented by technologies like AI, further potential exists on a market level to even out booms and busts through policy and business strategy.
Activate the rational mind
The core problem with booms and busts for real estate investors is not necessarily that they happen, but that they often go unaddressed in individual financial models. With little data shared between individual models, it’s easy to see why this is the case. Thus it falls to the gut to answer questions like “do we have the financial wherewithal to weather a major downturn?”—and the gut is prone to irrationality.
Developing a more rational analysis of how macroeconomic trends might affect real estate investments may not replace gut instinct for shaping strategy, but it’s an invaluable data point most investors currently don’t have access to.
Because there are new cloud based technologies which support financial analysis and underwriting capabilities, creating visually informative outputs from different models are available for meta analysis. Today, such meta-analysis may not be able to predict booms and busts, but they can offer a more concrete picture of an investor’s readiness to weather them. The future though, paints a potentially very different picture.
Future predictions aside, there’s no doubt that better availability of data about residential real estate deals will be increasingly valuable as the ability to analyze it develops. Investors that can address that challenge today will be primed for whatever analytics technology brings tomorrow.