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Recently I was reading an article in NuWire Investor by Colin Brechbill called The Real Estate Cycle: Where Are We Now? In the article, the author described real estate prices as a pattern, or as he wrote, a "real estate cycle" - in which real estate prices were virtually predictable based upon historical calculations. Brechbill wrote about a theory called "The Great 18-Year Real Estate Cycle":

Back in the 30's a real estate economist named Homer Hoyt discovered that real estate prices seemed to ebb and flow on an almost perfect 18 year schedule. Hoyt's theory was later used and refined by now famed economist Fred E. Foldvary to predict the real estate crash of 2008. I'll get into more depth about "The Great 18-Year Real Estate Cycle" shortly, but to me the important part isn't necessarily the 18 year time frame, it is understanding that real estate market operates in a fairly predictable cycle that can be seen and taken advantage of by smart investors.

As Brechbill described, "The Great 18-Year Real Estate Cycle" was originally discovered by economist Homer Hoyt. He noticed that the Chicago real estate market followed an almost perfect 18 year cycle dating back nearly 100 years. Here is a chart showing the cycle through 2007:

(click to enlarge)

As observed above, the "18 year cycle" theory looks great until that huge gap between 1925 and 1973. (Remember, though, that Hoyt discovered his theory in the 30's, and at that point the 18 year cycle was nearly flawless) As Brechbill explained:

If you were expecting a perfect cycle that allowed you to precisely time your investment and make a ton of money with no risk - sorry to disappoint. Perfect business cycles just doesn't exist - if they did the nature of capitalism would distort them. The important part isn't necessarily the time frame, though, the important part is that you understand the leading indicators signaling when the cycle is turning.

One of the most interesting observations with the chart above (used by Fred E. Foldvary - in his now famous report) was that the 2008 prediction was right in line with the 18 year cycle - which Foldvary uses as the basis for his report. Foldvary observed that Hoyt's 18-year cycle theory diverged so drastically between 1925 and 1973 and he points out that the cycle does not always function on a precise 18 year schedule, but - baring catastrophic events like a world war - for the most part the cycle should be right around 18 years.

The Answer is Nine

Now I really like Hoyt's 18 year theory; however, I have a better - and in my opinion more predictable - crystal ball strategy and instead of 18, the answer is 9.

A few years ago I was reading an editorial by Steve Steppe in Real Estate Capital Markets Report called The Answer is Nine (*). In that article, Steppe described a simple method of predicting markets:

In 1971, when I was still a young leasing broker for Coldwell Banker in Southern California, I signed up for my first investment training class. The class was being taught by a very bright Harvard MBA who ran the newly formed Investment Department at Coldwell Banker. Bob Ellis, starting the class by asking the question 'How many of you would like to make a lot of money selling properties you have been leasing?' Obviously everyone's hand went up.

At that point, Bob said that the answer to the final exam for the class would be 'nine'. Now, to say the least, it was unusual to be given the answer to a final exam before the class began. So we waited patiently for an explanation.

The next two weeks were spent on case studies of actual sales. And in every case we studied, the cap rates always either were over or under 'nine.' So much for being given the answer to the final exam up front.

As we soon learned, however, the answer to all of these cases really was 'nine'. For example, whenever we researched and analyzed a property that sold for a reported seven percent cap rate and brought the rents to current market, the actual cap rate at current market rents would be 'nine.' If transactions were completed at 10 percent to 11 percent cap rates, we always found it invariably was due to over-market leases that would adjust down or, at best, remain at the same rent when they were renewed. And, whenever we made those adjustments, the answer was always 'nine.'

Even today when I read this quarter-century-old article by Steppe, I find wisdom in his words and his strategy that returns will eventually move back to higher historic cap rates, perhaps not 9 percent, but higher than today's 6 or 7 percent. As Steppe argued, returns on commercial real estate may dip during cycles but will always rebound to the historic average. Accordingly, when interest rates rise, there is a strong possibility of a substantial downward adjustment in pricing over the intermediate term.

However structural changes in the commercial real estate business have permanently lowered investor risks, justifying lower returns. The efficiency of information, the specialization of capital, the domination by institutions instead of entrepreneurs - all these things have produced lower risks. If you have lower risks, you should not expect to get the same returns you got a decade ago and we may never go back to a 9 percent world.

Unlocking the Secret Code of Dividends

Ben Graham once wrote (in The Intelligent Investor):

There was then [during the Great Depression] a psychological advantage in owning business interests that had no quoted market. For example, people who owned first mortgages on real estate that continued to pay interest were able to tell themselves that their investments had kept their full value, there being no market quotations to indicate otherwise. On the other hand, many listed corporation bonds of even better quality and greater underlying strength suffered severe shrinkages in their market quotations, thus making their owners believe they were growing distinctly poorer. In reality the owners were better off with the listed securities, despite the low prices of these. For if they had wanted to, or were compelled to, they could at least have sold the issues - possibly to exchange them for even better bargains. Or they could just as logically have ignored the market's action as temporary and basically meaningless. But it is self-deception to tell yourself that you have suffered no shrinkage in value merely because your securities have no quoted market at all.

In other words, despite the fact that the quoted price of a REIT may fluctuate on a daily basis, the economic reality of direct real estate investing is no different. In essence, it is as if the owner of a REIT simply didn't pick up the paper and examine the price offered to him by Mr. Market. Taking it one step further, this perceived disadvantage is actually one of the perks of owning REITs. Unlike direct real estate holdings, REITs are liquid assets that can be sold fairly quickly to raise cash or take advantage of other investment opportunities.

As Warren Buffett explained,

In the business world, the rearview mirror is always clearer than the windshield

Likewise, several exceptional real estate investment trusts (REITs) have defied the "18 year cycle" while producing risk-adjusted returns consistent with the Harvard educated instructor's "answer is 9" strategy. Accordingly, these world-class income REITs are distinguished by their sound risk control fundamentals that have demonstrated exceptionally powerful dividend consistency. These REITs include Federal Realty (NYSE:FRT), Washington REIT (NYSE:WRE), HCP, Inc. (NYSE:HCP), National Retail Properties (NYSE:NNN), Realty Income (NYSE:O), Tanger Factory Outlets (NYSE:SKT), Universal Health Realty (NYSE:UHT), Essex Property Trust (NYSE:ESS), Urstadt Biddle (NYSE:UBA), Taubman Centers (NYSE:TCO), and Monmouth REIT (NYSE:MNR). Dividend snapshot as follows:

(click to enlarge)

(*) I could not locate the URL and the original source is referenced as follows: Steppe, Stephen M. "The Answer is Nine," Institutional Real Estate Letter 7, September 1995, 2.

Source: In The Real Estate World, The Rearview Mirror Is Always Clearer Than The Windshield