The global real estate market is built on a web of complexity that determines prices and hierarchical relationships of supply and demand. The activity of low-volume transactions, even at the local small-town level, helps determine the conditions and trends that affect the activity of larger investors making multibillion-dollar plays and vice versa. The ups and downs of other investment vehicles like equity and debt markets—as well as the conditions that underlie those changes—have a significant and often unforeseeable effect on real estate prices, both in the long and short term.
One of the most important things new investors can do is educate themselves on the indicators that show which direction the markets have been headed and their implications. It’s important to keep in mind that none of these indicators can accurately predict the future, but by keeping an eye on them, the new investor can make better choices, get a better idea of proper valuations and perhaps notice trends that will provide an advantage over competitors.
1. S&P 500
A leading indicator of economic trends, the S&P 500 tracks the prices of the 500 largest companies in the United States. Rising stock prices typically indicate a strong economy, suggesting a future demand for real estate (and so, rising real estate prices). Gains in the stock market boost confidence, at which point investors begin looking to diversify into real estate and other illiquid investment vehicles.
A dip in the S&P 500 indicates the opposite. A stock market crash could herald falling real estate prices and a future lack of demand. A dip might indicate it’s time to start pulling back and divesting riskier holdings until everything looks like it’s bottomed out. At that point, it’s time to go shopping. To someone who has maintained enough liquid cash, the bottom of the market is like a bargain-bin sale.
2. GDP Growth Rate
Typically, gross domestic product is used to measure the strength of the domestic economy, i.e., how much are we producing? Anyone who has taken a basic macroeconomics course probably remembers the formula, GDP = C + I + G + NX, in which “C” stands for “consumer spending,” “I” for “investment,” “G” for “government spending,” and “NX” for “net-exports.” GDP is a coincident indicator, meaning that it reflects the immediate state of production in the economy.
Historically, the base GDP growth rate for a developed economy like the United States is around 2.5 percent per year. A higher rate probably means an inflationary period is on the horizon. High inflation rates usually mean higher real estate prices, but a decline in purchasing power for consumers.
A GDP growth rate slowdown could indicate an economic recession and falling land prices, during which it may be hard to divest yourself of current holdings, or charge enough rent from tenants to keep up with mortgage rates.
In the best of all possible worlds, you would buy at the beginning of a GDP growth cycle and get out before a recession.
3. Housing Prices Index
The Housing Prices Index, just as the name implies, provides the investor with a survey of the overall condition of the housing market. It’s a lagging indicator, meaning that it detects changes in the economy that have already happened.
It’s important to remember the age-old axiom: “Buy low, sell high.” A decline in the index can be an indicator of a great opportunity for new real estate investors to get in on the ground floor. Once again, though, the trick is to divest oneself of one’s holdings before another decline, after riding the housing market to the top.
At the same time, if you find yourself with an abundance of positions after a decline or crash, it might be a good time to hold, so long as you have enough income to keep making mortgage payments. A crash in the Housing Prices Index might be a great time to refinance.
4. New Residential Construction Report
A leading indicator that covers new building permits, housing starts and housing completions, the New Residential Construction Report indicates the amount of construction of new homes in the coming years. A month-to-month increase indicates an economic expansion (usually good for future real estate prices), while a decline signals a contraction (bad for future real estate prices).
That being said, remember: Real estate is a game of supply and demand. An extremely high New Residential Construction Report could indicate an oversupply of housing in the future, leading to a decline in prices. Never use an indicator by itself to make investment decisions, but try to take a broad approach.
5. The Federal Funds Target Rate
Used by the Federal Open Market Committee to boost or reduce monetary supply in order to combat rapidly rising inflation and deflation, the Federal Funds Rate is probably the most closely monitored economic indicator, as the direction it moves affects so many factors that determine real estate prices.
Typically, to rein in monetary supply during periods of high inflation, the FOMC will increase the target rate. This most directly affects bond markets, as it indicates that future Treasury debt will compensate creditors higher rates for new issues. For existing bond holders, it indicates an imminent decline in bond prices, as their outstanding bonds have relatively lower values now that the Treasury is issuing higher-valued, near-risk-free debt.
At the same time, a rise in interest rates heralds a decline in stock prices. Higher interest rates make the cost of borrowing money more expensive, indicating a slowdown in a company’s abilities to use leverage to grow.
For the real estate market, a rise in interest rates makes it more difficult to purchase property, as banks will start raising mortgage rates. This usually indicates a decline in housing prices.
On the other hand, it could be boon for commercial real estate owners, as they can use it as an opportunity to renegotiate and raise rents.
It’s always important to maintain a diversified approach. Never put all your eggs in one basket. Examine each potential investment closely, and use these indicators as guidelines for understanding general trends in the economic factors that have an effect on real estate prices, rather than strict indicators of how a real estate portfolio will perform over any given period. Remember to buy low, sell high, maintain a significant cash position and always leave yourself enough wiggle room to get out of an investment if it goes south. It’s also a good idea to take a wider approach to diversification. Alongside your real estate portfolio, perhaps consider a portfolio of stocks and mutual funds, or a portfolio of lower-risk fixed-income investments like municipal bonds.