This blog is meant purely for educational discussion of finance. It contains only general information about financial matters. It is not financial advice and should not be treated as such.
The U.S. economy has been growing for 11 years, making the current expansion the longest in its history. So, when is the expansion going to end?
This is the question on everyone’s mind. Although we can’t predict when the recession is going to start, we can assess the market risk intellectually using statistics and then prepare for it strategically.
With that, let’s discuss the current status of the housing market and how to minimize risk and not lose money.
The Housing Market
Median Historical Housing Price
Figure 1. Median Single Family Home Price in America 1953-2019
Based on the graph above, our inflation-adjusted home price in the beginning of this year just reached the pre-recession high. One might think that we’re in a bubble, and it’s time to sell. On the contrary, I think home values still have room for growth, since they typically increase in the long-term, and we just spent the last decade recovering!
“Median housing price just reached pre-recession high” is a scary fact, but let’s look at this from a different perspective. Our current S&P 500 stock price is 3150; the previous peak was 1550 in 2007. It’s double what it used to be!
Even though the S&P 500 price doesn’t account for inflation, the difference is still much greater than that of housing. If the current housing market were in a bubble, then the stock market is in a way worse situation. Not to mention the Nasdaq Composite is currently triple of the previous peak.
Are We Overbuilding?
The short answer is NO! We’re actually not building enough. Here’s why!
Figure 2. Housing Units Completed Analysis (1970-2018)
The number of housing units we built in 2018 was 1,185,000, compared to 1,979,000 in 2006. We are currently building at 60 percent of the pre-recession rate—not to mention that we now have a higher population.
By adjusting for the population size, the number of housing units completed in 2018 was only 0.36 percent of the population, compared to 0.66 percent in 2006—a drastic decline in the building rate per capita.
The economy has been doing well and our interest rate is at a record low, so why are we building at a slower pace?
Although our interest rates are at a historical low, the more conservative underwriting by banks, such as debt coverage (DCR) and loan to value ratio (LTV), combined with our cautious mindsets, have limited the pace of growth.
Since housing prices have more room for growth, and we haven’t saturated the housing market by overbuilding, I’d argue that housing in the U.S. is still at a healthy state. However, this doesn’t mean that we won’t have a recession. There are still other factors that can cause our economy to decline, which will inevitably impact real estate.
How Can Real Estate Investors Reduce Risk
Warren Buffett’s No.1 rule: “Never lose money.”
Here are some very important tips that you should follow, especially at this stage of economy.
Local Absorption Rate
Although we concluded that U.S. housing in general is not overbuilt, that doesn’t mean this is the case in every city. Some cities are more overheated than others, so try applying the two methods I presented earlier (in Figure 1 and Figure 2) to the cities that you’re interested in.
In additional to that, you should look at the local absorption rate for both single family and multifamily. If you notice that local housing is overbuilt, then start underwriting more conservatively by using more stress tests.
For single family, it’s a red flag if you see absorption rate lower than 15 percent. That means less than 15 percent of the single family supply was sold in the last 30 days.
For example, in a market where there are 100,000 houses available for sale, only about 15,000 houses were sold in the last month. This is a 15 percent absorption rate
When the rate is lower than 15 percent, the local supply is much higher than the local demand. This is now a buyer’s market, which means the selling price is usually below the listed price. The local housing economy is starting to cool off.
The metric for multifamily is a bit different, because you are not selling commercial properties on a daily basis. Instead of looking at how fast the commercial properties are selling, you want to understand how fast the rental units are being leased out.
For multifamily, use the absorption period, which is defined as the amount of time it takes to lease out the current vacant supply. If the absorption period is more than three years, then it’s a sign of oversupply.
For example, Los Angeles currently has 21,000 lease-up vacancies, and the average annual absorption is 10,000 units, which means the absorption period is about two years.
Reducing rent is another sign of oversupply. When the apartments are not leasing out fast enough, rents will naturally decrease to retain or attract tenants. Declining rent is not a good sign for the housing economy.
Buy for Cash Flow
One of the common ways to lose money in real estate is selling the property while the market is down. Obviously, nobody wants to sell at a loss, but there aren’t many other choices when a house is losing money or when the property needs to be refinanced.
To reduce the risk of this from happening, you want to make sure that your property’s debt coverage ratio (NOI divided by debt service) is still above 1.4 after several different stress tests. The stress test could be lower economic occupancy, higher interest rate, or lower rental growth.
You also want to avoid using cash flow for renovations. If you’re renovating a house or an apartment complex, make sure you raise equity for this, and add an additional 15 percent contingency into your budget.
To avoid having to refinance your property, talk to your loan officer, and try to secure a permanent loan as soon as you can.
So… Should You Keep Investing?
The best strategy is to make good investments consistently overtime. It’s very difficult to predict the next recession or to quickly adjust your real estate portfolio.
The bottom line is: even though the next recession will hurt your property’s value, it’ll eventually recover. Stress test and make sure you have enough cash flow to cover the expenses and loan payment—even during a market downturn!
This blog is meant purely for educational discussion of finance. It contains only general information about financial matters. It is not financial advice, and should not be treated as such.
What do you think about the current state of the economy? Are you still investing or sitting on the sideline?
Please share your thoughts below!
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.