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Here’s Why I’m So Freaking Bullish on Real Estate

Here’s Why I’m So Freaking Bullish on Real Estate

7 min read
Phil McAlister

Phil is the founder of The Macro Meets Re...

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Real estate has some special and important characteristics that make it more attractive than any investing alternative right now.

Stocks are horrendously overvalued, and running a business requires all sorts of risks and headaches like fickle consumers, employee issues, and competition out the wazoo.

Real estate is very broad, and allows you to choose specific assets, markets, submarkets, tenants, leverage points, partners, asset classes, and strategies. These variables allow you to fine-tune a strategy that can work in all sorts of economic conditions.

There are demographic tailwinds at work combining with government policies and supply issues that all support a bullish thesis on residential real estate. Industrial, manufactured homes, senior housing, and self-storage also have some of these features at play to varying degrees.

I believe the last recession has left an incorrect impression on many people who believe that real estate will get crushed with the next recession. Here I’ll show that many forms of real estate tend to do quite well during a recession, and if you do it right, a recession might actually present exciting buying opportunities.

Disclaimers

  1. I think it is fair in some respects to call this another housing bubble, in the sense that prices are getting out of control. The implication is that it will violently pop, and soon. I hope to demonstrate is a tough call to make.
  2. I think the stock market is in a bubble of epic proportions and actually may pop violently in the near future. Stocks can crash without an economic recession, but if it pops it may cause a psychological ripple effect in the economy.
  3. I think a recession is definitely possible, but I don’t necessarily think it will crush real estate investors who are smart.

The largest segment of the U.S. population is just now getting to the age where they’ll start to look to buy homes. On top of that, the government just started sending out monthly checks of up to $300 per child, per month. A family with three kids will be getting $750 to $900 every month for the rest of the year. I believe this credit will get renewed in January, or potentially indefinitely as a backdoor method to move toward UBI.

A lot of that money is going to go towards housing. And builders literally can’t build houses at prices that are affordable to the typical buyer.

What happens when demand is high and supply can’t catch up? If you answered “prices go up,” move to the front of the class.

Looking forward, we may see renewed first-time homebuyer credits, student loan forgiveness, and infrastructure projects on the political front. These will all spur more housing demand by directly pumping funds into the hand of borrowers, or in the case of infrastructure, by bidding up the cost of materials and labor in the construction industry.



What about a recession?

It turns out real estate usually does pretty well in a crappy economy. Not necessarily in the midst of severe recessions, but in economies where growth is meager, and inflation is low.

The reason? Interest rates stay low in that environment as there are lots of bank deposits and a lack of good places to invest, so capital flows into the areas that go steady even without high growth. People will always need places to live and keep their stuff, so capital flows out of higher growth, exciting investments and into real estate.

Let’s take it to the charts. Here’s real GDP per capita in each recovery period since 1950.

per capita gdp

You’ll notice that if we exclude two very brief recovery periods sandwiched between the double-dip recessions in the mid-1950s and early 1980s, our economic growth over the past 20 years has been less than stellar and well below all of the other recoveries.

The root causes here are manifold, but chief among them are reckless Federal Reserve policy and high government spending and deficits, which serve to crowd out private investment and allocate resources to less productive areas of the economy.

And how did residential real estate do during that period?

Pretty freakin’ well, all things considered.

fred 1 2

Now let’s look at how prices did during recessions.

median home price

Generally speaking, housing prices don’t get hurt too badly during a recession. The 2008 recession was different because the root cause of the problem was housing, and housing took the brunt of the correction.

What is different this time?

We all know that now there aren’t many 100% LTV no-doc “liar loan” mortgages out there. The vast majority of mortgages, especially as the pandemic ramped up, were given to very creditworthy buyers.

Lastly, as crazy as it seems, housing may be more affordable than you think.

The first time I saw this chart, I had to do a double take, rub my eyes, slap myself, and then look again.

mortgage payment

Here’s how I got to the data.

I pulled quarterly median sales price, 30-year mortgage rates, and disposable personal income data. I assumed a 20% down payment on the house value over time and applied the interest rate at the time to come up with a payment on the median home. Then divide that by disposable personal income and voila!

Due to extremely low interest rates and decent growth in disposable income, housing (at least from a cash flow perspective) is more affordable than it’s ever been.

That’s not to say that the down payment isn’t incredibly onerous at these levels, or that people don’t have other bills to deal with that they didn’t have before like student loans, auto loans, and more money going toward cell phones and other tech.

This is also quite artificial given Fed policy on interest rates, and it could come crashing down if interest rates rise significantly for a prolonged period.

Nonetheless, the fact that the mortgage payment on the median home now accounts for only half of what it did at the peak of the last bubble is extremely telling information!

When I put all of this together–multiple factors boosting demand, restricted supply, general real estate performance during recessions—I start to feel pretty bullish, and I don’t fear recessions.


How to become v5

How it might go wrong

You’ve got to know what can go wrong and how to avoid it if you’re going to navigate these choppy waters.

The two major factors that can really hurt us here are 1) a sustained spike in interest rates and 2) a severe enough recession that lasts long enough to make our properties insolvent in the eyes of the bank, and therefore unable to refinance or recapitalize.

Interest rates

I could see a spike on the 10-year Treasury. Maybe even back toward 3%, but I don’t see it lasting. Remember, we’ve got this crappy economic situation.

As good as current statistics are for housing, they’re equally bad for the broader economy. And the more debt an economy has, the less likely it is able to grow rapidly.

You get high interest rates when the economy is strong and there are a lot of viable investment options—when banks need to compete hard for deposits and there are lots of opportunities to lend money. We’ve got gobs of debt, a declining working-age population, and the banks have tons of deposits and few high-quality lending opportunities.

fred 2
fred 3
fred 4

I think interest rates will likely have cyclical increases but generally remain in the long-term downward trend we’ve seen for decades. Yes, if the politicians really screw it up, interest rates will probably shoot higher. But I can’t bet on that as my base case.

Economic/refinance risk

The way we avoid this problem is by structuring our deals properly. In a nutshell, this means moderating the leverage, focusing on long-term fixed-rate debt, and making sure to have plenty of capital reserved for capital expenditures or short-term disruptions to cash flow.

Here’s an example for you. Let’s assume you pay a 5% cap for a deal with a 60% loan, fixed at 3% interest for 10 years. Assume 3% rent growth and 2% expense growth and you plan on holding long term. Here’s what that would look like.

Year12345678910
Rent$ 2,000,000$ 2,060,000$ 2,121,800$ 2,185,454$ 2,251,018$ 2,318,548$ 2,388,105$ 2,459,748$ 2,533,540$ 2,609,546
Expenses$ 1,000,000$ 1,020,000$ 1,040,400$ 1,061,208$ 1,082,432$ 1,104,081$ 1,126,162$ 1,148,686$ 1,171,659$ 1,195,093
Net operating income $ 1,000,000 $ 1,040,000 $ 1,081,400 $ 1,124,246 $ 1,168,585 $ 1,214,467 $ 1,261,942 $ 1,311,062 $ 1,361,881 $ 1,414,454
Debt service$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110
Cash flow $ 392,890 $ 432,890 $ 474,290 $ 517,136 $ 561,476 $ 607,358 $ 654,832 $ 703,952 $ 754,771 $ 807,344
Debt service coverage ratio1.651.711.781.851.922.002.082.162.242.33
Cash-on-cash4.91%5.41%5.93%6.46%7.02%7.59%8.19%8.80%9.43%10.09%

Now let’s look at what happens if a gnarly recession causes 5% rent declines for three straight years before resuming 3% rent growth (much worse than what happened in 2008).

Year12345678910
Rent$ 2,000,000$ 1,900,000$ 1,805,000$ 1,714,750$ 1,766,193$ 1,819,178$ 1,873,754$ 1,929,966$ 1,987,865$ 2,047,501
Expenses$ 1,000,000$ 1,020,000$ 1,040,400$ 1,061,208$ 1,082,432$ 1,104,081$ 1,126,162$ 1,148,686$ 1,171,659$ 1,195,093
Net operating income $ 1,000,000 $ 880,000 $ 764,600 $ 653,542 $ 683,760 $ 715,097 $ 747,591 $ 781,281 $ 816,206 $ 852,409
Debt service$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110$ 607,110
Cash flow $ 392,890 $ 272,890 $ 157,490 $ 46,432 $ 76,651 $ 107,988 $ 140,481 $ 174,171 $ 209,096 $ 245,299
Debt service coverage ratio1.651.451.261.081.131.181.231.291.341.40
Cash-on-cash4.91%3.41%1.97%0.58%0.96%1.35%1.76%2.18%2.61%3.07%

Here, even at rock bottom you’re covering the debt with a bit of cushion. Life goes on. You’re not happy, but you’re cash flowing. But look what happens if you were a wise guy and you decided to use 70% leverage.

Loan-to-valueMinimum debt service coverage ratio
50%1.29
55.00%1.17
60.00%1.08
65.00%0.99
70.00%0.92
75.00%0.86
80.00%0.81
85.00%0.76

At 70% LTV, you’re not covering your debt. Now you’ve got to raise fresh capital, sell into a weak market, or give the keys back to the bank. Boom. Face ripped off.

Same is true if you used variable debt or took a short loan term. You can get caught up and become a forced seller. But with long term fixed-rate debt at a moderate LTV, if you bought a good deal in a good spot with good fundamentals, you can come out on the other side just fine.

In that case, other people’s pain is your gain. You can be the buyer when their fire sale occurs because the bank is going to foreclose.

I’m really bullish on real estate because supply/demand dynamics favor further gains; because the crappy economy will benefit real estate on a relative basis and attract a lot of capital; because interest rates are likely to remain low barring a real freakout about inflation; and because good real estate investors can structure and underwrite deals unique to a given property, market, situation, and investor base to mitigate some of the greatest risks that would occur if we get a recession.

Yes, there are risks. There are black swans that no one can see coming except those guys on the internet that scream about it every straight day for 10 years until they’re finally “right.” But that’s what investing is. Taking appropriate risks to generate strong returns. If you’re not comfortable with that, stick with Treasury bills.

For me, I’m comfortable taking smart risks that are managed through a strong investment process, from research to valuation to structuring to management.