Part II

Key Message

Putting the Real Estate Cycle to Work in the Canadian Market

Never write about a place until you're away from it, because that gives you perspective.

—Ernest Hemingway

The Press Box View of Strategic Investing

The first eight chapters of this book focused on providing the theory behind the real estate cycle: what it is and how it works. Part II zeroes in on how strategic investors use their knowledge of the real estate cycle to increase profits.

As discussed, the real estate cycle's movement through the phases of boom, slump and recovery is predictable. But the cycle is no crystal ball. While each phase has an identifiable beginning, middle and end characterized by changes in key drivers, market influencers can prompt real-world interruptions in a cycle's progress that can confuse even the most strategic real estate investors. There are no magic formulas or computer-generated algorithms that predict how long temporary changes or specific phases or stages will last, especially when market influencers are interjected in the cycle. Nevertheless, strategic investors use information about how the cycle works to predict cycle changes so that their actions can capitalize on current market conditions or impending shifts.

Knowledge of how the real estate cycle works gives strategic investors what we call a press box view. Those sitting in the press box at a hockey game can see the entire ice surface and all the players. As a result, they see plays developing well before the puck ends up in the net. Meanwhile, those with front-row seats have restricted sight lines and only see part of the ice surface. They can see how plays end, but not how they develop.

So how does one make the most of this press box view of the real estate cycle? By following the four basic principles described here.

1. Track the long-term trends of the key drivers.

Tracking the long-term trends of the key drivers lets strategic investors see how each particular key driver has performed and is performing in the context of the cycle. This allows you to monitor the collective behaviour of the key drivers, which always contributes to a combined impact. Long-term trends are essential to the press box view. Point-in-time statistics, like those shared in headlines (“Sales are up 27 per cent” or “Housing starts down 15 per cent”) provide only a limited front-row perspective, not a complete view of the game.

Since real estate cycles typically take years to unfold, the key drivers should be consistently monitored. One way to accomplish this is by creating a dashboard of all the key drivers, and updating them as new data is made available, or become a member of the Real Estate Investment Network (www.reincanadamembership.com) as they continually analyze key drivers for their members.

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To access the Key Driver packages for Calgary and the Greater Toronto Area visit: www.realestatecycle.ca.

2. Normalize the data.

To effectively track the long-term trends of the key drivers, strategic investors must normalize the data so trends can be identified. Many key drivers that are reported monthly are subject to a high degree of volatility, which creates noise and makes it difficult to identify meaningful trends.

One way to normalize raw monthly data is to calculate the 12-month moving average. That provides data that identify meaningful trends.

3. Seek answers to your questions. And keep asking questions.

When the key drivers don't add up, strategic real estate investors ask themselves why. Investors who are new to the strategic approach of following the real estate cycle may assume the cycle is moving into a particular phase when it is actually not shifting.

The apparent shift is typically evidenced by the fact that key drivers are not aligning with the characteristics of the phase. For example, strategic real estate investors know that rental rates typically peak during the middle of the boom phase and then reach a trough toward the end of the slump phase. However, in markets where rent controls are in effect, this trend will exhibit characteristics out of sync with a free market.

Strategic investors who are tracking meaningful trends with all of the key drivers seek to understand what's happening when certain key drivers don't line up with the expected behaviour. They refuse to see an anomaly as the norm and they don't take this as a sign that the market is not following a cycle; they seek to understand by asking the right questions. Doing so will often lead to a greater understanding of the local nuances of the market. This helps them identify how key drivers may behave in the future.

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Strategic investors track a basket of key drivers. When individual drivers seem out of sync, they dig deeper to find out what's happening and often these efforts reveal vital clues.

4. Keep your eyes on the road—front and back.

Tracking the long-term trends of the collective key drivers in a normalized manner provides a great rear-view-mirror look at the cycle. But always use forward vision to dig deeper into what the key drivers are telling you.

That forward vision will help you identify and analyze emerging patterns. Strategic investors look at what's causing these patterns. They assess what these patterns are likely to mean to the future trend of that key driver.

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Hindsight and Foresight

In early 2006, co-author Greg Head led a group of U.S. real estate investors through an analysis of the Phoenix real estate cycle. Through the process, he asked the group some tough questions regarding what the key drivers were telling them about the overall U.S. real estate market. Greg was particularly interested in finance availability. On its own, that key driver appeared to point toward a continued boom in real estate. However, by pushing the group to dig deeper into other key drivers, he helped the group identify the emergence of some concerning patterns:

“What did these patterns mean to the future trend of the key driver of finance availability?” Greg asked the group of Phoenix investors. More importantly, what could this key driver tell them about what they were about to see in front of their market windshield?

The group arrived at its conclusions quickly—and they were contrary to the conclusions reached by many other real estate investors who were basing their conclusions on information that was biased by market influencers. With Greg's help, the more strategic real estate investors saw that sloppy U.S. lending practices were pushing the market toward a serious market adjustment. The group concluded that once these subprime mortgages began to reset at higher rates, the shift in affordability and financing availability would trigger a massive wave of foreclosures as millions of high-risk borrowers began defaulting on their increased payments.

As it turned out, these investors were right. What they did not know at the time was that the U.S. subprime mortgage situation would have such far-reaching impacts on the global economy. However, by following the methodology presented in this book, these investors had ample evidence that a significant slump was nearing and they took the requisite action.

Back in Canada, Greg was asking himself the very same questions about a booming real estate market. Here, more prudent lending practices were not contributing to an unsustainable real estate market, leaving much less chance of a significant financial meltdown.

That experience—and the fact that their predictions put them well head of the eventual market meltdown, gave these U.S. investors a chance to take full advantage of a critical window of opportunity in the real estate market. And make no mistake: that window was a windshield view of what was to come, backed by a clear rear-view-mirror view of market history.

 

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Strategic investors don't just track key drivers; they look at what individual drivers tell them and then assess that message alongside what other key drivers are telling them. This provides foresight based on hindsight and it's the best way to identify future trends that will impact the key drivers and overall real estate cycle.

What Lies Ahead:

Identifying Critical Transition Points

Strategic investors continually track and monitor the key driver trends on an ongoing basis. This helps them follow the real estate cycle and predict what's to come. Those predictions are based on the identification of what we like to call critical transition points.

Critical transition points are defined as the critical points in time, as evidenced by key drivers, when the cycle turns from boom phase to slump phase, slump phase to recovery phase, and recovery phase to boom phase. These transition points are critical because they provide insight into when the transitions are coming. This enables strategic investors to be proactive instead of reactive in their response to the realities of the cycle.

The following chapters will take a closer look at real estate cycles in two key Canadian markets to show how trends reflect markets in Toronto and Calgary. They will look at historically significant phases of the markets, and explore what current key drivers are telling us about the markets today.

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American philosopher George Santayana once wrote that “those who forget the past are condemned to repeat it.” The strategic real estate investor takes that advice seriously. He learns from the past and applies those lessons to the future. That hindsight is essential to his ability to recognize when booms turn to slumps, or slumps turn to recovery. Failure to recognize such important changes in the real estate cycle can equal massive financial losses or missed opportunities for the non-strategic investor.