Friday, August 26, 2005


Real Estate Market: the Quintessential Business Cycle

The United States, Canada and all other modern industrial economies experience significant swings in economic activity. In some years most industries are booming and unemployment is low; in other years most industries are operating well below capacity and unemployment is high. Periods of economic expansion are typically called booms; periods of economic decline are called recessions or depressions. The combination of booms and recessions, the ebb and flow of economic activity, is called the business cycle. But of all the industries contained in the economic basket of goods, the real estate market is the one that serves as an indicator and prognosticator of times to come.
Real estate is partcularly susceptible to the ups and downs of the economy simply because it is a big ticket industry. The purchase of a single-family dwelling, the sale of a condo, the lease of industrial or office space - all these are transactions involving big dollars. One of the key insights of business cycles is that many economic indicators move together. During a boom, or expansion, not only does output rise, but also employment rises and unemployment falls. New construction and prices typically rise during a boom as well. Conversely, during a downturn, or depression, not only does the output of goods and services decline, but employment falls and unemployment rises as well. New construction also declines but - and real estate is the exception to the rule - prices may very well continue to rise in real estate even during downturns, though usually more slowly than during booms.
In many ways the term business cycle is misleading. "Cycle" seems to imply that there is some regularity in the timing and duration of upswings and downswings in economic activity. This could not be more farther from the truth, especially in the real estate industry. Booms and recessions occur at irregular intervals and last for varying lengths of time. For example, economic activity hit low points in 1975, 1980, and 1982. The 1982 trough was then followed by eight years of uninterrupted expansion. For describing the swings in economic activity, therefore, most modern economists prefer the term 'economic fluctuations'. Just as there is no regularity in the timing of business cycles, there is no reason why cycles have to occur at all. The prevailing view among economists is that there is a level of economic activity, often referred to as full employment, at which the economy theoretically could stay forever. Full employment refers to a level of production at which all the inputs to the production process are being used, but not so intensively that they wear out, break down, or insist on higher wages and more vacations. If nothing disturbs the economy, the full-employment level of output, which naturally tends to grow as the population increases and new technologies are discovered, can be maintained forever. There is no reason why a time of full employment has to give way to either a full-fledged boom or a recession.
Business cycles do occur, however, because there are disturbances to the economy of one sort or another. The quintessential cause of recessions and booms in real estate is monetary policy. The central banks - either the Bank of Canada or the Federal Reserve Bank in the U.S. - determine the size and growth rate of the money stock and, thus, the level of interest rates in the economy. Interest rates, in turn, are a crucial determinant of how much firms and consumers want to spend. A firm faced with high interest rates may decide to postpone building a new factory because the cost of borrowing is so high. Conversely, a consumer may be lured into buying a new home if interest rates are low and mortgage payments are, therefore, more affordable. Thus, by raising or lowering interest rates, the central banks are able to generate recessions or booms. This is the reason why keeping a close eye on interest rates is so crucial in the real estate market.
Luigi Frascati

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