How To Prepare For The Next Real Estate Downturn

In 2005, everyone was buying houses. It was common knowledge you were stupid to wait. House prices flourished and loans flowed like drinks at an open bar. Lots of people made money-until they didn’t. In 2009 the music had stopped and people were frantically looking for someone to pass the hot potato to. By 2010, those “smart” people were the ones looking stupid. Foreclosures dominated the market place and the great real estate boom of ‘05 looked more like a ghost town as the real estate downturn hit full effect.

Fast forward to 2018 and it’s starting to look a little familiar. In Northern CA, we frequently see homes sell significantly over asking price, regardless of appraisals or the condition of the home. Demand is outpacing supply, and prices are rising again. In hot rental markets across the country, we continually see local investors totally puzzled by how much out of state folks are willing to pay for traditionally modest priced homes.

So what do you do? Is now the time to buy, or should we be waiting for the next crash? Are we in 2005 at the peak of the market, or are we in 2010, with plenty of room to run?

If you want to make the best decision, you have to consider all the facts. Before I make a black or white suggestion, let’s take a second to consider several market factors, strategies, and possibilities. There just may be a way to invest now, and still be primed to take advantage if the market crashes later.

Are we in a bubble?

When we refer to a “bubble”, we are typically referring to an unrealistic, unsustainable value in an asset class that can’t be reasonably expected to continue. In 2005, home values weren’t based on affordability, they were based on horrible loans that allowed people to borrow much more than they could afford over the long term. When those loans reset, nobody could pay them, and the market was flooded with foreclosures. Supply increased while demand dropped and the market went south.

In today’s market, we see a much different scenario. I work as a real estate agent in the SF bay area, and I’ve yet to see any funky, clearly foolish loans from any of the buyer’s I’ve worked with. Rates are generally fixed over 30 years, do not adjust, and are absolutely reasonable based on the buyer’s income. It’s obvious that home prices are up, what’s not often talked about is how wages are up too. Let’s not forget that there have been 13 years of wage increases since 2006. That’s a pretty healthy number. Prices may be higher, but they’ve increased in proportion to wages as well. The danger of a massive wave of loan defaults hitting the market all at once isn’t all that high.

So are we in a bubble? In some areas, possibly. But remember, as long as people can afford their payments, it would take some external event to cause a housing problem. Things like an overall recession, hit to the job market, etc. If that happens, many asset classes are going to take a hit, not just real estate values. The point is, don’t be lazy and assume just because home prices seem high that automatically means we are in a bubble or seeing a repeat of 2005. There are lots of other variables to consider.

What happens if I invest too early and the market crashes?

This seems to be every investors worst fear. It’s a bit of a catch-22. If you invest too early and the market crashes after, you missed the “opportunity of a lifetime”. If you wait for the market to crash, you could spend years not making any financial progress. Then, when it does crash, all you hear is how real estate will never recover and you end up too scared to pull the trigger. Either way, no matter the current market, it's hard to take the plunge and jump in.

This question also assumes real estate markets are the same everywhere. A “crash” in one area doesn’t always mean there will be a crash in another. Some markets are driven by specific economic factors that aren’t affected by the rest of the country. Example? Texas. In 2009-2010, when many of the rest of the country (CA, AZ, NV, FL, to name a few) were all getting hammered, Texas went by relatively unscathed. The same goes for parts of the midwest that tend to operate independently of coastal markets.

So what’s the solution? Should you buy now, or buy later? Finding a way to have your cake and eat it too isn’t as hard as you may think. The trick is understanding why it is your actually afraid to buy now and miss out later. It can be summed up in two words-Opportunity Cost.

Opportunity cost is an economic term that refers to the price you pay to miss out on one option when you commit to another. In this case, buying house A can be a problem if you miss out on house B. If house B ends up being better (as in, you bought it after the market crashed and paid less), your opportunity cost would be the money you lost that you could have made if you’d waited for house B.

This fear of the unknown holds a lot of investors back. So how do you beat it? With the secret wise investors have been using for years. The BRRRR method.

What is the BRRRR method?

BRRRR is an acronym that stands for Buy, Rehab, Rent, Refinance, Repeat. It is the order of which you conduct the various stages in the investment cycle when you buy a rental property. When you BRRRR correctly, you can end up buying an investment property with zero money down. This often ends up resulting in a cash flowing property that’s been fully rehabbed and sometimes puts more cash in your pocket than you put in. When you recover 100% or more of your capital, opportunity cost ceases to be a factor to consider. It stops being about "House A, or House B?" and instead becomes "House A, then House B".

How is this possible? When you buy a house traditionally, you put a hefty down payment down, then include money for closing costs and the rehab. The total of that money you put down makes up your investment basis that is used to calculate your ROI. With the traditional model, there is always a heavy opportunity cost. If you put 35k down, pay 5k for closing costs, and have a 10k rehab, that’s 50k of your money you cannot invest anywhere else.

In this case, if the market crashes, you don’t have that 50k to invest in the down market, so your opportunity cost is high. This is the reasoning behind the “fear of missing out” that keeps investors from getting started investing in real estate. So how do you overcome this? My solution is to remove the opportunity cost. If you can buy a property and recover the capital you used to buy it, what stops you from buying the next one too?

BRRRR’ing successfully is the way I accomplish this. In a hypothetical BRRRR deal, you would buy a fixer upper property for 60k that needs 40k of rehab work. Throw in the same 5k for closing costs and you end up with a total of 105k, all in.

At a Loan-to-Value ratio of 75%, if the property appraises for 135k once it’s rehabbed and rented out, you can refinance and recover $101,250 of the money you put in. This means you only left $3,750 in the property, significantly less than the 50k you would have invested in the traditional model. The beauty of this is even though I pulled out almost all of my capital, I still added enough equity to the deal that I'm not over-leveraged. In this example you'd have about 30k in equity still left in the property, a healthy cushion.

It’s not too difficult to save another $3,750. Significantly easier than $50,000. This means you’ll have all that money to put into the next house when the market crashes. If you do this effectively, you can pull out even more money than you put in (by buying great deals and rehabbing prudently), growing your capital and the ability to invest in future properties. Voila! No more opportunity cost.

How do I know which market to invest in?

While no one has a crystal ball and can tell where the market will crash and when, there are some pretty standard metrics you can use to hedge your bet against a crash.

Diversified Economy-You want to avoid any area that is dependent on one employer or economic driver. Detroit is a great example. When the auto industry failed, so did all the home values. With no one able to find work, all the rentals went vacant (and so did everything else). Other examples would be North Dakota (oil dependent), an area known only for tourism, or a coastal village in Alaska that is completely dependent on fishing.

C-class or better neighborhoods- Real estate investors tend to evaluate neighborhoods like school grades. A-class properties are the best spots in town, B-class are where the upper middle class lives, C-class are your average neighborhoods with lots of renters, and D class properties are problematic with high crime and high vacancy rates.

You want to avoid anything less than a C-class neighborhood. By investing in nicer neighborhoods in economically diverse markets, you avoid the worst of the negative factors when a market turns and can ride out the storm. For more information on how a property is classified, ask a local top producing real estate agent or property manager.

Cash Flowing Properties- If your property cash flows (brings in more income than it costs to own), it doesn’t really matter what happens to the value. If prices drop, that doesn’t impact you unless you sell. Experienced investors buy properties that produce income and only experience price appreciation as icing on the cake.

Look for properties in areas that meet the “1%” rule. If a property will rent for 1% of the purchase price every month (a $100,000 that rents for around $1,000 a month), it is very likely to cash flow positively. If you focus on buying in areas like this, and avoid bad neighborhoods and non-diversified economies, it won’t matter what the market does. Your investment will be safe.

If you’d like more information about these concepts, check out my book “Long Distance Real Estate Investing: How to Buy, Rehab, and Manage out of State Rental Property” where I spell out my system for choosing markets, building a team, and rehabbing properties. We can never know the future, but if you follow the advice in this post you're much more likely to grow your wealth over time. Don’t wait to buy real estate, buy real estate and wait!

 

How To Prepare For The Next Real Estate Downturn curated from Forbes - Real Estate