The 18 year property cycle and how to profit

Surfing the property wave

This post is all about how to use the 18 year property cycle to build your portfolio over the long term. The property cycle is one of the most misused ideas in property investment. Many people have heard of it. But lots of the discussions around it are either overly simplistic or overly definitive. Many pundits use the cycle predictively to express grand views about the future direction of the market. This often includes giving very precise predictions about when the market will peak and crash. In my view, this is just not possible for markets as complex as the housing market or economic systems in general.

In this post, I’m going to try to set the record straight. I’ll give you my views on the 18 year proposed cycle and what’s possible as far as predicting the future goes. Firstly, we’ll run through the basics of the 18 year property cycle, what it is, and why it happens. Then, we’ll look at some rules you can follow to take advantage of the cycle. We’ll talk about how you can position yourself at various points in the cycle to increase your chances of success. The best you can hope for is to tip the odds in your favour. That’s because no-one knows how the future will play out. However, being able to spot the trends and avoid expensive mistakes can give you an great advantage.

What is the 18 year property cycle?

The 18 year property cycle is a sequence of recurring events, a pattern if you will, that plays out across property markets. Like other investment types, property tends to follow a fairly predictable cycle. The cycle itself has four different phases. I’m going to walk you through each of these phases with commentary on what typically happens at each stage.

The recovery phase of the 18 year property cycle

Let’s start out with the recovery phase. At the beginning of this phase, prices have just fallen in a recent market crash. Prices have in fact fallen to a level where yields are strong and cash flows are good. This is because prices have fallen more than rents. For contrarian investors with cash to spare, this is a fantastic time to be buying property.

At this point in the cycle, there will be few active buyers in the market. The average investor will have been badly burned in the crash and still licking their wounds. They may have sold at the bottom of the market and crystallised large losses. The media will be downbeat, even though the worst of the recession appears to be over and property prices have stabilised. As rents and cash flows start to increase and brave investors lend support to prices, the recovery phase starts to develop. More and more buyers acquire the confidence to re-enter the market. Property prices start to rise. This happens in the prime locations first. Early price growth happens mainly in the big cities and city centre hotspots. Then it starts to ripple out.

The boom phase of the 18 year property cycle

With the recovery gathering pace, the market will move into the explosive boom phase. At the start of the boom, it will now be clear that prices are increasing. More investors will be returning to the market. The banks will have repaired their balance sheets, and they are keen to lend again. This will provide a boost to the market, as cheap-and-easy financing increases.

House prices start to increase at a faster pace. Prime cities and city centre locations will switch into another gear. Unloved secondary locations will start to see their first price rises. Better times and an improved economic backdrop will make providers of capital more optimistic. Banks will start to forget the lessons of the last crash, as financing becomes easier still. Now, we’re well into the boom phase. Yields have fallen and higher property prices have made cash flows less strong, except perhaps in secondary locations. Savvy investors are struggling to make property deals work. They can’t find value anywhere, so they stop striking deals. They might even sell a property or two to lock-in their gains, but no-one will pay attention. The public, encouraged by the recent price rises, begin to speculate on property. Property shows are once again all over the airwaves.

The mania phase of the 18 year property cycle

At a certain point, logic appears to leave the market and groupthink takes over. We’re now entering the mania phase. Banks have relaxed lending criteria as far as they can go. Credit standards are what can only be described as lax. The higher prices go, the more everyone believes that they will continue to do so. The vast amount of money pouring into the market keeps prices going up and up. We’re now into the last couple of years of the explosive boom phase. This is often called the “winner’s curse”. If you’re person who buys at the peak, then you’re the one who takes the hit in the crash. And the next crash is just around the corner.

The crash or slump phase of the 18 year property cycle

Just before the crash, the market is driven purely by sentiment, not fundamentals. At some point, confidence starts to dip a little. The banks begin to look at their ballooning loan books and worry about whether these loans will be repaid. Financing suddenly dries up, almost overnight it seems. And confidence evaporates completely, taking the market with it.

Property prices plummet. Individuals and investors who are over-leveraged will go bankrupt. This triggers a wave of repossessions and forced sales which add to the downward pressure on prices. The media stokes the fire with bad news headlines. And speculators who bought at the peak and are in negative cash flow positions sell up, crystallising their losses.

After a year or two of falling prices and bad economic data, we start to see the first green shoots of recovery. Unemployment peaks and rents stop falling. Brave investors start to look at deals again. To their surprise, some of these deals start to look attractive. If only they could raise the capital to invest. The odd bank agrees to start lending again, albeit the financing terms are tougher. Investors are asked to put more money down on deals. The recovery phase gets underway, and the cycle starts again.

The length of a typical cycle

In the narrative above, I’ve described how elements such as investor psychology, attitudes to risk and availability of financing feed into the property cycle. These are elements most financial cycles have in common, including the property cycle. But the 18 year property cycle incorporates one other element that other financial cycles don’t share, and that’s long lead times.

The impact of long lead times

In the property market, there can be significant lead times before buildings come on to the market to meet additional demand. Developers need to carry out economic feasibility studies. They need to find and purchase a new piece of land or a development site. The building has to be designed, planning permissions have to be granted, and financing has to be secured. And all this needs to take place before developers can put a spade in the ground. All in all, the property development process can take years. For a major project, the process can take more than a decade from start to finish.

Long lead times in the development process are then a major driver on the supply side. This influences the length of a typical property cycle. Property cycles can in practice last anywhere between 15 and 25 years from peak to peak or from crash to crash. The cycle can also interact with other cycles in the wider economy. The important thing to remember is that property prices generally increase in line with inflation over the long term. But the cycle means these price increases don’t happen in a straight line. Prices will increase faster in the boom phase, and they will fall or stagnate in the crash or slump phase. But the overall trend is generally upwards and in line with inflation.

Spotting where we are in the cycle

We can get some clues on where we are in the cycle by looking at the things going on around us. For example, in the recovery, we’ll have recently experienced a fall in prices and property will be out-of-favour. Plenty of people will be in negative equity, and the press headlines will be downbeat. Financing will be hard to get, and building projects started in the boom will be left unfinished. The odd brave developer might take on one of these projects as a repossession, and as activity starts to pick up, prices start to rise a little.

In the boom phase, lenders will be lending, and builders will now be building. People will have forgotten the pain of the last crash and property will attract headlines as prices soar. Lots of new building projects will be started and cranes will fill the skyline. In the final years of a boom, the media will be blurting out all kinds of nonsense. Financing will be cheap, and massive vanity projects like huge skyscrapers will be announced. Prices will make no sense. It will feel like a bubble, because it is one. Then comes the crash or slump. No description is needed. You’ll know when you’re in a crash.

How to use the 18 year property cycle

To finish off this post, I’m going to look at how you can use the property cycle to grow your portfolio. I’m going to give you my five golden rules of portfolio building. Some of these are straightforward. However, one of the hardest things to do over the long term is to keep your investment focus crystal clear and to keep your head when others around you are losing theirs. I hope you will keep these golden rules in mind over the years.

Golden rule # 1 – Only invest in properties that provide cash flow

This really is the most important rule of property investing. If a property doesn’t provide you with a monthly cash, preferably one with a good margin for safety, then you shouldn’t be doing the deal in the first place.

When it comes to the property cycle, the best time to be buying from a cash flow perspective is in the recovery phase and at the start of the boom. Later on in the cycle, yields will have fallen, and cash flow will be hard to find. That doesn’t mean you shouldn’t be investing at all later in the cycle, but it does mean you’ll likely have a much harder time striking good deals.

If you follow this rule diligently, it’ll mean being more aggressive and ramping up your investing activities when cash flows are at their strongest in the early part of the cycle. It’ll also mean refraining from bad deals later in the cycle.

Golden rule # 2 – Use the ripple effect to your advantage

Predicting which areas and which properties will experience good capital growth in the future is a difficult thing to do. The best tool in the property investor’s tool kit is to try to take advantage of the ripple effect.

As we saw above, different towns and cities experience growth at different points in the cycle. Let’s take the 2007-2008 global financial crisis for instance. After falling to a low in 2009, property prices rebounded in London. First, we saw growth in the prime areas of central London, then price increases rippled out to the surrounding areas. It took several years before prices in Leeds started to rise. Between 2014 and 2018, however, prime properties in the city centre of Leeds experienced strong growth, but properties on the outskirts of town have yet to experience major growth.

Let’s try to generalise this rule. Early in the cycle, properties in prime cities and prime locations will likely experience the first bout of capital growth. This growth will start to make properties slightly further out look comparatively cheaper, and so price growth will ripple out. To take advantage of the ripple effect, you need to buy in the right location at the right time. You’ll need to study how prices are increasing in different area at various points in the cycle and try to buy in ahead of the trend.

Golden rule # 3 – Manage your leverage carefully

If you’ve bought well during the recovery phase and used the ripple effect to your advantage, you may well have experienced strong capital growth by the later part of the cycle. At this point, you might be tempted to remortgage one or more of your properties and pull out some of your capital to expand your portfolio. If you do decide to do this, make sure you model the impact on cash flows (see Golden rule # 1). The increase in borrowings will increase your finance costs and reduce your cash flow. So, only do this if the property has experienced an increase in market rent and cash flows.

Some investors, I’m one of them, like to keep an unencumbered property or two in their portfolio. Having properties with no mortgage means you’ll have a stronger monthly cash flow to ride out any dip in market rents or an increase in interest rates. You’ll also have a strategic asset you can sell or mortgage, if you suddenly need to find a chunk of cash quickly. Being over-leveraged is the biggest risk for property investors, so make sure that you manage this risk carefully

Golden rule # 4 – Avoid the winner’s curse

The last couple of years of the boom period are the winner’s curse. Avoid it like the plague. In short, don’t buy any new investment properties and don’t refinance. Use this time to get ready for the crash that’s coming.

Golden rule # 5 – Build a tactical cash buffer before the slump

We’ve all heard the Warren Buffett quote “we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful”. Well, Golden Rule # 4 covers the first part, but what about the second bit of this mantra?

To take advantage of a crash or slump, you’ll need to build up your resources during the boom phase to take advantage of the crash. You should aim to build as big a cash buffer as you can in the years before the slump. If you’ve stopped doing deals and your cash flows are strong, then this should be achievable. Likewise, if you’ve kept one or more properties unencumbered, there may be creative things you can do to secure new borrowings.

Finally, managing your emotions will also be key here. You’ll feel like you’re missing out on the end of the boom phase and that you could be putting that cash to much better use, but don’t. Stay disciplined, and you’ll be thankful. Controlling your emotions and sticking to your principles is actually the hardest part about investing for many people, so don’t overlook this point. Investing with a partner and making decisions together can help here, as can coming up with a set of financial metrics or decision-making rules that define when you will and won’t invest.