Four lessons all property investors must understand about property cycles

Our real estate markets have surprised many on the upside this year– especially the Melbourne and Sydney property markets

But now this upward phase of the property cycle has lasted more than four years and with prices being so high, what lies ahead, especially as our banks keep tightening the screws on lending?

As I delved back into my memory to see what lessons I could learn from past property cycles, I realised I’ve probably learned more from the many mistakes I’ve made than from the things I got right.

Now there’s a powerful lesson in itself!

Here are four key lessons I wish I’d learned earlier in my investment journey.

1. Firstly, the economy and our property markets move in cycles

And the main cause behind these cycles is that we’re human and tend to share the general optimism or pessimism of others.

It’s a common fallacy that Australian property cycles last for seven to 10 years. They vary in length and are affected by a myriad of social and economic factors and then, at times, the government lengthens or shortens the cycle by changing economic policies or interest rates.

For example, the current property cycle is being prolonged by a period of historically low interest rates.

Yet it’s my observation that investment markets often “overshoot”. That is, they move by more than changes in the fundamental influences would seem to require – on the upside as well as the downside.

Take the Perth property market, which experienced significant growth (overshooting its fundamentals) during the recent mining boom. And now home prices have fallen 20% from their market peak in Perth and are likely to fall further.

2. The market is usually wrong about the stage of the cycle

“Crowd psychology” influences people’s investment decisions, often to their detriment.

Investors tend to be most optimistic near the peak of the cycle, at a time when they should be the most cautious, and they’re the most pessimistic when all the doom and gloom is in the media near the bottom of the cycle, when there is the least downside.

Market sentiment is one of the key drivers of property cycles and one of the reasons why our markets overreact, overshooting the mark during booms and getting too depressed during slumps. Remember that each property boom sets us up for the next downturn, just as each downturn sets the scene for the next upswing.

3. There is not one property market

While many people generalise about “the property market” there are many sub-markets around Australia.

The fact is, each state is at a different stage of its own property cycle and within each state the markets are segmented by geography, price points and type of property.

For example, the top end of the market will perform differently to the new home buyer’s market, the investor segment, and the median priced established property sector.

And while there is an oversupply of CBD high-rise, off-the-plan apartments in Brisbane and Melbourne, there are more buyers looking for homes than there are properties on the market in the middle ring suburbs.

4. We need to allow for “the X factor”

When most Australians hear about “the X factor” they think about a talent show on TV.

However, “the X factor” is also talked about in the less glittery world of economic forecasting.

Economists refer to “the X factor’ when an unforeseen event or situation blows all their carefully laid forecasts away.

More recently, Nassim Nicholas Taleb, a finance professor and author, popularised the term Black Swan events for these deviations from the expected.

I first came across this concept many years ago when distinguished economics commentator, Dr. Don Stammer, used to try and predict “the X Factor” for the forthcoming year in the January edition of BRW magazine.

Of course, by definition “the X factor” is unforeseen, so you can’t really predict it. But it was a little game he used to play and then review his prophecy 12 months later.

And it is a game I also took up many years ago and have had fun with over the years.

These X factors can be negative (the aftermath of the Global Financial Crisis of 2008) or positive (the China driven resources boom of 2010-12), and can be local or from abroad (the US subprime mortgage crisis of 2008).

One of the X factors for 2016 was how interest rates dropped to historic lows. It wasn’t that long ago that most economists were expecting a rise in rates by now.

These X factors affect the economy at large, which of course affects our property markets, but our property markets also have their own specific X factors – unforeseen events that affect the best laid plans and predictions like APRA’s unprecedented restriction of bank lending to investors.

So the lesson is while it’s important to take a long-term view of the economy and our property markets, you also need to allow for uncertainty and surprises by only holding first class assets diversified over a number of property markets and having patience.

Trying to predict the X-factor is futile: if it’s been predicted, it’s not the X-factor. But let’s have a look at a list of major past X-Factors from Dr. Stammer, who now writes for The Australian.

2015: Negative interest rates in Europe

2014: Collapse in oil prices during severe tensions in middle east

2013: Confusion on US central bank “taper” of bond purchases

2012: The extent of investors’ hunt for yield

2011: Continuing problems with European government debt

2010: European government debt crisis begins

2009: The resilience of our economy despite the GFC

2008: The near-meltdown in banking systems

2006: Big changes to superannuation

2004: Sustained hike in oil prices

2001: September 11 terrorist attacks

1997: Asian financial crisis

1991: Sustainable collapse of inflation

1990: Iraq invasion of Kuwait

1989: Collapse of communism

1988: Boom in world economy despite Black Monday

1987: Black Monday collapse in shares

1986: “Banana Republic” comment by Paul Keating

1985: Collapse of $A after MX missile crisis

1983: Free float of Australian dollar

Now it’s your turn to play the game and predict the coming year’s X-Factor.

Michael Yardney is a director of Metropole Property Strategists, which creates wealth for its clients through independent, unbiased property advice and advocacy. He is a best-selling author, one of Australia’s leading experts in wealth creation through property and writes the Property Update blog.