Phoenix Development Cycles: Knowing When to Buy

The Phoenix area has been one of the nations strongest regions for growth for some 60 years. Virtually all economists agree the growth is going to continue for many decades.

A look back demonstrates that it doesn’t come at a steady rate. Instead, growth comes in waves, surging ahead for some years, then slowing way down for a time before ramping back up again.

More importantly, the growth follows national economic trends: When the national economy is robust, migration into the Phoenix area picks up. When the national economy enters a recession, growth slows down substantially (though it rarely stops completely).

Here are graphs showing those development cycles in terms of Phoenix area population growth and employment change. Note the vertical purple bands that indicate years of national recession:

Net Population Change

Net Employment Change

Those cycles have a dramatic effect on the development of real estate. Housing demand increases substantially during growth phases, raising prices. Developers exploit that demand by pulling permits for new housing construction.

It takes time to prepare land for development, and even to pull permits for houses or other building. Developers are necessarily predicting the short to mid-term future when they begin a new project and they are basing their projections on the historical data they have at the time. Any construction project you see that is currently underway is likely the result of decisions and commitments that were made many months ago in the case of a single-family home, and many years ago in the case of a complete subdivision or commercial project.

The greater Phoenix development industry rarely stops at the right time, and overbuilding is the inevitable result. Builders move forward entitling new subdivisions and pulling permits for construction based on strong sales activity and robust demand. But at some point in the cycle they find that by the time those homes are built, that demand has receded. They’ve overbuilt the market.

Compounding the problem, the downturn typically comes during a period in which the national economy is also slowing. Growth to the Phoenix area slows, and housing demand decreases further.

A soft market is the result. Vacant new builds become available in lots of new subdivisions with developers offering creative incentives to buyers. New permit requests drop substantially. We remain in a buyer’s market until enough people move to the valley to absorb this extra housing and create enough demand to start the cycle over again.

Here’s a graphic that illustrates the development cycle:

Development Cycle

So how does that inform our land investing?

We want to maximize our land investment returns as measured against the amount of risk we take.

1. We buy when demand is increasing (which is why we are buying right now, and expect to be for the next several years). We don’t have to buy at the bottom of the market (in fact, our most successful projects have rarely been bought at those bottoms), but we only buy when we have reason to believe that our real estate will have greater demand in the not-too-distant future.

There are plenty of indicators to show when market demand is dropping to such a degree that it foretells the end of a growth cycle. We currently don’t see any of those indicators.

In fact, take a look at these facts from the massive housing bust of 2007-2010:

• Housing demand peaked in August of 2005 (demonstrated by the ratio of homes sold to homes on the market, as well as the average days on market for active listings)
• Housing prices continued to increase for a full year until August of 2006
• The dramatic fall in housing values didn’t start for another year until the Fall of 2007!

There were two full years of strong warning signals telling savvy investors bad news was around the corner. Based on those indicators, we elected to exit all of our land projects in the years prior to the crash of 2008.

2. We only buy for cash. As recognizable as these development cycles are, we also recognize that their inflection points will never be completely predictable and that missing a market downturn is a possibility. By eliminating debt from the equation, we remove the possibility of being forced into a distressed sale by the combined forces of a soft market and the demands of a lender.

3. We don’t develop. Missing a market inflection is painful for a development project, even if there’s no debt involved. Land development has its own set of risks and rewards and there are many people who are quite successful doing it. But virtually all of the bad land investment stories we know about are related either to the use of debt in holding land assets or to poorly timed development projects. Arizona Land Partners doesn’t use debt, and we don’t do traditional development projects. Those two simple decisions reduce our risks dramatically.

The cyclic nature of Phoenix development is the engine that creates the radical returns that land investments have so often brought. Understanding the inevitable downturns and the indicators that foretell them is a big part of our past success. Knowing when to buy is as important as knowing what to buy. We think we’ve got a handle on both.