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Between Errors of Optimism and Pessimism – Observations on the Real Estate Cycle in the United States and China

September 15, 2011 | About:
The latest White Paper from GMO by Edward Chancellor

Part One: An Analysis of the Real Estate Cycle

“Prosperity ends in a crisis. The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born, not an infant, but a giant.” A.C. Pigou, Industrial Fluctuations, 1927

Many Americans seem convinced that their housing market will remain in the doldrums indefinitely. Conversely, the rapid recovery of China’s economy from the global financial crisis has led many to believe that real estate in the Middle Kingdom is a one-way bet. In fact, property is the most cyclical of assets. Housing booms crater, while depressed real estate markets eventually recover. Part one of this paper aims to describe a typical real estate cycle through its various stages. In particular, I try to identify the characteristic features of the cyclical peaks and troughs.Part Two applies this understanding of the real estate cycle to the world’s two most important property markets, namely those of China and the United States.

Rudiments of the Cycle

Over the long run, income and household formation determine the facts of the real estate market. Home prices rise in line with household incomes. The level of construction reflects the underlying demand for homes from newly formed

households. The real estate cycle describes undulations around a relatively stable long-term trend. In the upwards phase of the cycle both valuations and new construction rise above their historic trend. The opposite is the case during the downturn. Mean reversion is the most salient feature of the real estate market: the excesses of the cycle, both at the peak and at the trough, are self-correcting. This doesn’t mean the real estate cycle is necessarily easy to read. The various phases between the boom and the bust

are not clearly defined. Most people can’t tell whether they are in the seventh or the ninth inning of the property game.

Even the cognoscenti of the real estate cycle can’t agree on its length. Homer Hoyt, whose classic text

One Hundred Years of Land Values in Chicago

(1933) is essential reading for anyone interested in this subject, identifed an 18-year cycle for American real estate prior to the Second World War. Other researchers have described a multitude of overlapping cycles of varying length, consisting of minor or short cycles (3 to 5 years), long cycles (9 to 10 years),and long waves (from 30 to 70 years).

GMO White Paper Edward Chancellor

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

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