Hello BPers,
As we all spend time analyzing deals and determining “flip” or “buy and hold” I was wondering if anybody here currently runs their numbers anticipating another major market correction.
I am not sure if another housing crash comparable to the last one is possible. In any instance, it seems reasonable to think when a correction does occur, which ever market is hit, there will be issues that trickle down. Some issues would be tenants keeping up with rent and new homeowners buying recently rehabbed homes at the current market prices. These would specifically be problems for Flippers and Buy/Hold Investors
For example, to prepare do you run the numbers for potential rental property based on percentage decrease in rent amount? For Flip properties do you buy if numbers total to 60% instead of 70% of the ARV?
Previous to this past weeks market gloom and more so presently I have been pondering the best way to approach this method. Or on the other side of things, is it necessary to make such preparations? Any insight or past experiences would be much appreciated.
@Yashar E. As @Omar Khan and others have pointed out, you need to be aware of two different kinds of corrections that could affect real estate, and prepare for both.
There is a correction in the real estate market, which would cause cap rates to go up and sale prices to go down. This could happen because inflation rises, the lending environment changes, real estate becomes overbuilt, or just because the bull market runs out of steam after so many years.
Then, there is a correction in the general economy - i.e., a recession.
Many investors conflate the two because, the last time the real estate market collapsed, it coincided with a general collapse of the economy. But it's important to keep them separate in your mind.
For example, in the late 1980s, the economy was booming but the real estate market collapsed because of overbuilding and the S&L banking crisis.
Many people, like Grant Cardone, have pushed the view that rental real estate does well in a downturn, because after the Great Recession, rental real estate - especially multifamily - did really well. Many people lost their homes and had to rent, and many others wanted to buy but no longer qualified for mortgages. Many people - including me - took comfort from this and drew the conclusion that rental properties do well in recessions in general. We all felt that, in a recession, businesses disappear, but people have to live somewhere.
However, I have come to revise this view, looking at vacancy statistics in the markets where I invest.
What I noticed was that, when the recession hit, vacancy spiked. It spiked big. Unemployment went to around 11% nationally. Areas with high concentrations of working class people were hit even harder, because manufacturing and the service economy bore the brunt of the recession.
AFTER that, when the foreclosure crisis really got going, people started moving into rental homes. But it's important to remember that the people who lost jobs were not necessarily the ones who moved to rentals - because without a job, you don't qualify for most rentals.
The people who moved to rentals were the ones who had jobs, but either could no longer qualify for mortgages or could no longer afford their mortgages after their payments re-set and the interest-only period was over. They had counted on selling or refinancing when this happened, but the recession stopped it.
In the next recession, vacancy will spike, as it always does, and it will hit workforce housing the hardest.
HOWEVER, this time around, landlords will not have a housing crisis to bail them out.
Since the Great Recession, lending standards have grown much stricter. The home ownership rate has plummeted. There is not a huge cohort of marginal home owners waiting to lose their homes in the next recession and then move into rental housing. (Of course, there will always be people who lose their homes, but this time around it will be more like the traditional way people lose their homes - they lose their jobs and cannot pay their mortgages, not that they have jobs and their mortgages re-set to a level they cannot afford.) On top of that, there has been massive construction of rental housing in the last decade, and many cities are hitting oversupply.
There is going to be pain for landlords in the next recession.
So, bringing this back to where we started, in my view, this is what you need to watch out for.
1. Real estate market correction: If you have a solid rental property that is cash-flowing, and we have a real estate market correction without a general recession, then you will be fine. The decline in value will be on paper only, and if you have long-term fixed debt, you can just ride it out. What you need to be concerned about is whether the market correction hits just before you need to refinance, because you may be forced to refinance at a lower valuation, which means that you will have to put additional equity into the deal to pay the first loan.
And, of course, if you are a buyer with dry powder when the correction happens, you are a happy person.
2. Economic correction (recession): This is the scary proposition, especially for people buying now at the top of the market. If a recession hits, you will lose tenants, unless you are renting to the kind of people who don't lose as many jobs in a recession (i.e., white collar professionals in recession-proof industries). If you are renting primarily to working class people, your vacancy is going up to be sure.
If you purchased the asset at a low price and have a small nut for debt service, you will be able to ride out the dip in occupancy.
But what happens if you bought at the top of the market, at a high valuation, with a huge debt service nut to pay? Then you are putting yourself in danger of having to fund the mortgage payment yourself if there is a recession.
(Many people buying in comparatively high cap rate markets, like Rust Belt cities with declining populations, are going to have some very scary times ahead when the recession hits. The reason these markets have higher cap rates is not because they are overlooked, but because they are passed over intentionally by most investors because of the risk they pose.)
The way to protect yourself right now is not just cash flow. It's buying the best, most well-located properties, close to the best schools and the best jobs. It's buying with the right tenant mix of stronger white-collar tenants, or blue-collar tenants in recession-proof industries like education and healthcare and government.
It also means stress-testing your deals so that you have a very comfortable cushion of vacancy that you can run through and still make your debt service. You need to find the historically highest level of vacancy in your market and make sure that your asset can withstand that level of vacancy at the price you are paying/debt you are taking on.
You need to be buying at a 1.5x DSCR at the very least, to make sure that when vacancy spikes on you, you can still meet the 1.25x DSCR that you need to stay afloat, when you consider the routine capex needs that a typical apartment complex is going to need.
If you are buying an SFR, you need to determine how many months you can go without a tenant, because if your only tenant loses his/her job in a recession, you now have 100% vacancy. How many months of this can you survive?
Right now, we are at the tail end of a real estate buying frenzy. People who are not careful right now are going to find themselves in a world of pain when the next recession hits.
@Yashar E. You can run your analysis through scenario and sensitivity analysis. In the former, usually investors create 3 scenarios - bad, baseline, good - and run different scenarios to understand their downside, liquidity, default and other risks. This can help clarify how the asset should perform under various conditions as well helping an investor devise a game plan in case things go south.
With sensitivity analysis, you are only adjusting one variable and seeing how it affects the overall picture. For instance, you might want to understand how a change in vacancy will affect your NOI (and hence, value of the property). Again, this can (A) help you devise a game plan, (B) give you ideas on how to manage your asset better and (C) helps you understand where you have the greatest exposure to help mitigate its effects.
Plus, rents dropping = values dropping (as pointed out by @Caleb Heimsoth). Might be a good time to buy :)
I think the answer is- a balance. A balance between keeping a crash potential in mind and that should drive you to buy as smart as possible, but then not going to the far extreme and putting so much thought and planning into something that doesn't exist, and if it were to suddenly exist, pretending we have any way of knowing exact numbers on that.
I think the best place to start on the balance for that is to just be sure you are buying in solid growth markets with a lot of industry. That way if one industry tanks in a crash, an entire city isn't at risk because other industries can keep it afloat. For instance, I don't trust Vegas as far as I can throw. There is a lot of aerospace out there, but all of those folks typically own their own houses and don't rent. So the renters are likely somehow connected to the entertainment industry, as that's the only real big industry out there. And what is the first industry to go in a crash? Entertainment. So to me, that is a risky market for exactly the concerns you express.
I wrote this not too long ago- maybe it can help-
https://www.biggerpockets.com/renewsblog/survive-a...
There's no bulletproof solution, but there are a lot of risk mitigations that can be put into place.
Also don't forget, if it's just the value of the property that slips, that's fine as long as you aren't trying to sell it.
mental preparation is most important. If you don't think it can happen or consider it, you won't build it into your strategy. So thinking about it, and then making decisions with it in mind is a big step just by itself.
I do buy and hold, and I have inexpensive properties ($900rent) so downturns only worry me in terms of income. I don't care so much about equity.
I keep 75% or better LTV in my homes, they all have low rates, and because my properties are inexpensive if I need to lower rents to hobble through a recession I believe I can. I don't plan to be profitable during a downturn, I just need to survive through it
the last is cash or equivalent. I find that people act as if a downturn means a total investment exit strategy, which is not likely to be necessary. Market downturns are normal, painful, and temporary. So I don't need the perfect strategy to beat a recession or permanent change in the market, again, I just need to be able to weather a storm. For this I have good decent sized chunks of cash, I don't tie my cash up long when purchasing, and I have HELOC and business credit cards with great terms ready to deploy if needed.
for flips and retail buyers, yeah buying at the top of the market adds some risk because you lose flexibility to sell and the spread for low-rent market scenario is more painful, especially if you're stretching cash.
Hey @Caleb Heimsoth maybe I worded it wrong but my thought process was that the possibility of a market crashing would harm incomes for various people thus, it would be difficult for them to keep up with rent. Although to your point, then you would just find another tenant..
@Omar Khan great point on sensitivity analysis. I am going to see if I can incorporate that into my spreadsheet. Thanks!
@Ali Boone I just briefly skimmed over your blog post and it touched on a lot of key points and also explained a bit more what Caleb mentioned. I am going to go back and read over again!
Also thank you @Alexander Felice input is nice from the seasoned vets.
Buy for cash-flow and you'll never have to worry about market downturn. Appreciation is a bonus.
If you have an exit strategy, that helps too.
I've been hearing this comment more and more often on BP and I disagree. Whereas buying for cash flow is a conservative strategy (and we follow it as well), it does not mean one can stop worrying about market downturns.
For e.g. if there your tenants get laid off or your sub-market suffers from employment issues, your rental income will go down, your NOI and hence, property value will go down.
In the case of a lender-driven downturn, especially in a particular sub-market, where the credit markets freeze up (even for a short period of time), again your property will suffer (regardless of how great of a cash flow machine it is). E.g. operators who had 5 year balloon payments on their commercial loans (loan started in 2004) ending in 2009 were forced to liquidate a part or all of their portfolio because they couldn't re-finance. It didn't matter how great their asset was. Operators who got 10 year terms in 2004 rode out the market downturn and came out on the other side looking pretty.
As @Ali Boone has mentioned, things have to be done in balance. But one can't get just not worry. That is not being a good steward of capital .
@Yashar E. As @Omar Khan and others have pointed out, you need to be aware of two different kinds of corrections that could affect real estate, and prepare for both.
There is a correction in the real estate market, which would cause cap rates to go up and sale prices to go down. This could happen because inflation rises, the lending environment changes, real estate becomes overbuilt, or just because the bull market runs out of steam after so many years.
Then, there is a correction in the general economy - i.e., a recession.
Many investors conflate the two because, the last time the real estate market collapsed, it coincided with a general collapse of the economy. But it's important to keep them separate in your mind.
For example, in the late 1980s, the economy was booming but the real estate market collapsed because of overbuilding and the S&L banking crisis.
Many people, like Grant Cardone, have pushed the view that rental real estate does well in a downturn, because after the Great Recession, rental real estate - especially multifamily - did really well. Many people lost their homes and had to rent, and many others wanted to buy but no longer qualified for mortgages. Many people - including me - took comfort from this and drew the conclusion that rental properties do well in recessions in general. We all felt that, in a recession, businesses disappear, but people have to live somewhere.
However, I have come to revise this view, looking at vacancy statistics in the markets where I invest.
What I noticed was that, when the recession hit, vacancy spiked. It spiked big. Unemployment went to around 11% nationally. Areas with high concentrations of working class people were hit even harder, because manufacturing and the service economy bore the brunt of the recession.
AFTER that, when the foreclosure crisis really got going, people started moving into rental homes. But it's important to remember that the people who lost jobs were not necessarily the ones who moved to rentals - because without a job, you don't qualify for most rentals.
The people who moved to rentals were the ones who had jobs, but either could no longer qualify for mortgages or could no longer afford their mortgages after their payments re-set and the interest-only period was over. They had counted on selling or refinancing when this happened, but the recession stopped it.
In the next recession, vacancy will spike, as it always does, and it will hit workforce housing the hardest.
HOWEVER, this time around, landlords will not have a housing crisis to bail them out.
Since the Great Recession, lending standards have grown much stricter. The home ownership rate has plummeted. There is not a huge cohort of marginal home owners waiting to lose their homes in the next recession and then move into rental housing. (Of course, there will always be people who lose their homes, but this time around it will be more like the traditional way people lose their homes - they lose their jobs and cannot pay their mortgages, not that they have jobs and their mortgages re-set to a level they cannot afford.) On top of that, there has been massive construction of rental housing in the last decade, and many cities are hitting oversupply.
There is going to be pain for landlords in the next recession.
So, bringing this back to where we started, in my view, this is what you need to watch out for.
1. Real estate market correction: If you have a solid rental property that is cash-flowing, and we have a real estate market correction without a general recession, then you will be fine. The decline in value will be on paper only, and if you have long-term fixed debt, you can just ride it out. What you need to be concerned about is whether the market correction hits just before you need to refinance, because you may be forced to refinance at a lower valuation, which means that you will have to put additional equity into the deal to pay the first loan.
And, of course, if you are a buyer with dry powder when the correction happens, you are a happy person.
2. Economic correction (recession): This is the scary proposition, especially for people buying now at the top of the market. If a recession hits, you will lose tenants, unless you are renting to the kind of people who don't lose as many jobs in a recession (i.e., white collar professionals in recession-proof industries). If you are renting primarily to working class people, your vacancy is going up to be sure.
If you purchased the asset at a low price and have a small nut for debt service, you will be able to ride out the dip in occupancy.
But what happens if you bought at the top of the market, at a high valuation, with a huge debt service nut to pay? Then you are putting yourself in danger of having to fund the mortgage payment yourself if there is a recession.
(Many people buying in comparatively high cap rate markets, like Rust Belt cities with declining populations, are going to have some very scary times ahead when the recession hits. The reason these markets have higher cap rates is not because they are overlooked, but because they are passed over intentionally by most investors because of the risk they pose.)
The way to protect yourself right now is not just cash flow. It's buying the best, most well-located properties, close to the best schools and the best jobs. It's buying with the right tenant mix of stronger white-collar tenants, or blue-collar tenants in recession-proof industries like education and healthcare and government.
It also means stress-testing your deals so that you have a very comfortable cushion of vacancy that you can run through and still make your debt service. You need to find the historically highest level of vacancy in your market and make sure that your asset can withstand that level of vacancy at the price you are paying/debt you are taking on.
You need to be buying at a 1.5x DSCR at the very least, to make sure that when vacancy spikes on you, you can still meet the 1.25x DSCR that you need to stay afloat, when you consider the routine capex needs that a typical apartment complex is going to need.
If you are buying an SFR, you need to determine how many months you can go without a tenant, because if your only tenant loses his/her job in a recession, you now have 100% vacancy. How many months of this can you survive?
Right now, we are at the tail end of a real estate buying frenzy. People who are not careful right now are going to find themselves in a world of pain when the next recession hits.
Thank you for your detailed explanation! Your summary greatly clarified my understanding of the current situation. As you noted, both economic and housing correction is on the horizon. With the current global fiscal tightening stands and historical high valuations, our risk for correction is probably higher than ever.
So should I wait until the market corrects? As with most investors, I was looking at rust belt markets with cash flow, specifically turnkey models (purchase at retail price). In my view, diverting my investments to midwest market was my method to hide out from the market correction, or at least partially. After reading your post, I am stuck again in “analysis paralysis” mode, specifically that investors that purposely overlooking midwest market even with higher cap rates. As conservative investor, any suggestions on the overall strategy? As a non-accredited newbie investor, I don’t see much passive options for real estate.
I am sure there isn’t a concrete answer for this but please let me know if you can clarify or suggest any reading materials on this topic. Thank you!
Thank you for your detailed explanation! Your summary greatly clarified my understanding of the current situation. As you noted, both economic and housing correction is on the horizon. With the current global fiscal tightening stands and historical high valuations, our risk for correction is probably higher than ever.
So should I wait until the market corrects? As with most investors, I was looking at rust belt markets with cash flow, specifically turnkey models (purchase at retail price). In my view, diverting my investments to midwest market was my method to hide out from the market correction, or at least partially. After reading your post, I am stuck again in “analysis paralysis” mode, specifically that investors that purposely overlooking midwest market even with higher cap rates. As conservative investor, any suggestions on the overall strategy? As a non-accredited newbie investor, I don’t see much passive options for real estate.
I am sure there isn’t a concrete answer for this but please let me know if you can clarify or suggest any reading materials on this topic. Thank you!
I don't know if it makes you feel any better, but I have been on the sidelines waiting for the correction for a couple of years.
The time to buy in Rust Belt cities with no population growth was at the very bottom of the market, when the risk was lowest. That way, at least you could ride up the asset bubble in pricing. The problem is that most people investing in these markets - particularly if they are outsiders, because the locals know what they are doing - think they are getting good cap rates because they are comparing them to cities with better fundamentals that naturally have lower cap rates (because their fundamentals are better and therefore they are less risky). These outsiders are not comparing the cap rates of these Rust Belt cities to the same cities at a different point in the cycle. Somehow, they think that cap rates have compressed in more dynamic cities but have remained static in Rust Belt cities. This is a major analytical error. Cap rates have compressed everywhere. You have to compare a city to itself, not to other cities.
Conservative strategy is to wait, especially with the financial markets getting roiled now and interest rates rising.
@Jonathan Twombly That was an amazing explanation and break down. I am keep this for my notes and I am sure this will help a lot of people analyze their own situations. One of many things I didn't even think on was refinancing after any type of recession. At this point considering the times we are at one thing I need to change immediately is narrowing in on the right locations as you had suggested, coupled with doing a little research on past vacancy levels. May sound silly but how would I find those numbers on past vacancies?
@Yashar E. I'm glad this helps. This is a good question, because it's not always easy to find this information.
You can find some historical data in REIS reports if you are looking at a specific property or market, but I think they only go back 5 years, so we're now at the point where the Great Recession is dropping off the reports, which is a shame.
You can try asking brokers or property managers. Perhaps they have kept old reports themselves. This would be valuable information.
I admit that I have been struggling myself to find free information on historical vacancy in some markets. But I would still try doing the simple first - try simply searching on Google for "historical vacancy rates in _____". You never know what you are going to come up with.
But at the end of the day, this may be information you need to pay for, from REIS or CoStar or someone else who was tracking the data. The good thing is that you only need to pay once for historical data, since it won't change. If you are looking at a market and it costs you $150-$200 for a report like this, which you can use forever, it's probably worthwhile to pay for it.