There’s a lot of factors that impact real estate prices, but they all ultimately depend on liquidity. Liquidity is just a way of saying there needs to be people that want to buy your home, and have enough money to buy it. The money used to come from income and savings, but in the late ’80s banks started extending more and more credit. To rip a page out of the Wu Tang Financial planning guide, we replaced cash with credit in CREAM. That’s why you should get familiar with the credit cycle, and how it impacts real estate markets.
Credit Cycles 101
Today we’re going to break the credit cycle down into four categories – recovery, expansion, downturn, and repair. The credit cycle doesn’t give a s**t about how much density you built, or whether or not you’re on a South facing lot. The cycle is based on availability of credit, and the expansion and contractions it makes. It’s actually such a force, post-Keynesian economists like Minsky believe it drives the business cycle. Since credit availability and income are major factors in home buying, it plays a pretty big role in the housing cycle.
Source: Better Dwelling.
Let’s start with the recovery phase, when damage from the previous cycle is being repaired. During this phase, credit and asset growth is relatively flat. Defaults and unemployment peak, and things start to feel normal. Interest rates are cut to “stimulate” the economy, and household debt starts growing. The impact is increased liquidity, which is bankster for “people can start buying s**t.” The increase in liquidity allows asset prices to grow, which makes it easier for banks to lend.
The credit expansion phase is exactly what it sounds like, it’s when credit expands – very quickly. Have you ever heard that a loan is easiest to get when you don’t need one? That’s what’s happening here, but with whole economies. Wages grow, unemployment falls, and credit defaults print new lows. The increased wealth from the employment boom meets low rates to create a lot of leverage – and fast. During this phase, debt rapidly expands, but it’s fine – the job market is booming [insert eyeroll]. Asset prices like stocks and real estate make very sharp climbs.
Sadly, all good times come to an end in a phase known as the downturn. This phase is a transitional phase, so it starts very differently from how it ends. In the beginning, credit growth trends lower and stabilize at a lower rate. Debt is still growing, but much less than it was just a year before. Defaults start to gently climb, and assets start to lose luster.
The slowing of credit growth adds up towards the end of this phase. The economy grew so quickly during the expansion, everyone forecasts huge growth. That growth can’t be met, which leads to a sudden halt in spending, and rise in unemployment. Credit starts to tighten as lenders carefully chose new borrowers. The end of the phase is usually marked by a recession, fast falling asset prices, and soaring defaults. Usually about a tenth of the population is severely impacted.
Fun Fact: The Bank of Canada just warned about 8% of the population will be impacted by rising interest rates.
Making It Better: The Repair
No, the doom doesn’t last forever. The economy just needs to fix the inefficiencies caused during expansion. A recession is a necessary correction of human and financial capital. During the repair phase, the reallocation begins. Households deleverage, meaning household debt decreases. Unemployment begins to drop, and credit defaults start to bottom. Interest rates are about as high as they can get, and may start getting cut. Asset prices start to make a gentle climb back higher.
Canadian Real Mortgage Credit Growth
The annual percent change in mortgage credit growth, adjusted for inflation. Real Canadian home prices are plot as annual change per quarter, for reference.
Source: Bank of Canada, US Federal Reserve Bank of Dallas, Better Dwelling Calculations.
Rinse and repeat, for as long as people will over and underestimate expectations. I’ll let you decide where in the cycle we are, but properly assessing risk is how you make and keep wealth. There can’t always be a right time to buy every asset, otherwise someone with a lot more money would beat you to that 400 sqft condo.
Now enjoy real estate agents and economists discussing the credit cycle for the next few months. Always glad to help.
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