Stop Worrying about a "Crash"

12 Replies

Debate about a coming crash seems to be the hottest topic in real estate recently. What is a crash anyway? A recession? A total meltdown like 2008?

No one can predict the future (except I can tell you with certainty that Mitch Trubisky will be an all-pro one day), and no one can time markets perfectly. The good news is, you don't have to. Maintaining a disciplined approach and understanding where you are in the cycle is all that matters. If you can do that, you can confidently move forward in real estate investing. There are many reasons to believe both the economic recovery and the real estate cycle are long in the tooth. But unless you want to sit on the sidelines and watch everyone else accumulate wealth, you need to continue to pursue deals. Here's a brief recap of where we are and how we got here:

  • The Fed and Central Banks around the globe injected an unprecedented amount of liquidity into financial markets, and drove interest rates artificially lower, much lower than the market clearing rate would have otherwise been.
  • Early on, the "smart" money came into real estate and found once-in-a-generation deals. This attracted more attention to the space, and as the dust continued to settle, more and more capital flowed in. 
  • As the recovery progressed, due to the artificially low interest rates and perceived government backstop, capital started chasing all assets from stocks to bonds to real estate to very aggressive heights. This triggered a cascading effect where all investors had to move further out on the risk curve to find yields that were acceptable. Higher prices means lower prospective returns. This is why we hear constant stories of people that can't find deals anymore.
  • Leverage increased throughout the economy as a result of artificially cheap credit. 
    • Global debt to GDP is now well past 2007 highs
    • Corporate balance sheets are loaded with debt
  • Many real estate sponsors, fund managers, hedge funds, PE shops, etc. have had to justify very optimistic investment outlooks in order to continue raising capital and doing deals.

Now the economy is entering it's tenth year of recovery, which ties for the longest expansion on record. We have a stock market that is, by the most reliable/correlated measures, the most overvalued in history. Stocks have had the longest streak without a 20% drop in all of history.

The takeaway here is not that a crash is imminent. The takeaway is that right now, there is an increased appetite for risk, chasing yields, and a low level of skepticism among investors. This is driving an environment where too much money is chasing too few deals. Real estate now is like a party in college where the guy/girl ratio is 10:1. It may seem for now like the sponsors raising money in syndication are doing great deals (some actually are) and making money, but as one really smart rich guy said "It's only when the tide goes out that you learn who's been swimming naked." Historically speaking, it has been prudent to be a little more cautious in environments like today. 

So what should you do? I dunno, I'm just a guy. But here are a few ideas.

  • Looking back at historical multifamily data, when the "crash" happened 10 years ago
    • Rents declined 1-2% a year for a couple years
    • Vacancy crept up a couple percentage points
    • Credit tightened up drastically
  • The people who got killed were those who didn't understand the full risk of what they were doing
    • Spec development in shaky markets
    • Over leveraging 
    • Using high cost, short term bridge debt

Overall, the single most risky thing you can do is be over-leveraged. Even if you're doing okay  with cash flow in a downturn, if you are over-leveraged and your loan matures when interest rates are higher and so are cap rates, this is how you end up giving the keys to the bank. If you aren't over-leveraged, even a pretty severe recession won't wipe you out if you're generating good cash flow. 

So will there be a recession? Absolutely. Will it be relatively soon? History would suggest yes, but not the data. Will it be a "crash?" Hard to tell, but the toxic financial instruments aren't as prevalent as before. Should you care? No.

Just be disciplined. Pass on the risky stuff. Look at long term debt at lower leverage points. focus on cash flow. Learn how to stress-test your deals. Invest in value-add deals (but not where you need an expensive bridge). Maybe politely decline the advice of the guru who taught you how to buy deals at 95% leverage with no money out of pocket. Ultimately, just go outwork the next guy and make good deals. Or just go watch TV and complain. I don't care. But I'm doing deals. 

@Phil McAlister

Boom!  You should just drop the mic and never post again!  Well said

Love the recap and insight into how we got here. I 100% agree that where people are going to get into trouble is with LTV. I have seen some Crowfunding deals that make me cringe when I see the going in LTV and rent growth assumptions driving their NOI and DSCR.

While we would all like to be like Warren Buffet sitting on $12 Billion in cash waiting for the impending correction, we still need to produce income generating opportunities for our investors.  For investors and syndicators alike make sure you are not putting yourself at risk with leverage to get into a project.  

Every real estate project is a good deal in 20 years, you just have to get there.  

Kris

Well said, @Phil McAlister .  Not much I can add to that--been saying nearly word-for-word for the last couple of years.  Three years ago people were saying that I couldn't keep doing deals, couldn't keep buying, couldn't keep generating the kind of returns we have.  But here we are.  Certainly we don't expect to produce the same kind of return as we would in an asset acquired in 2010, but that's not the point.  The point is that if we employ the right strategy in the right location and use conservative underwriting, stress test our numbers, have multiple exit strategies, and conservative leverage points we can keep doing this for quite a long time.  And do it safely and produce returns to boot.

The most recent adverse cycle was the worst one since the great depression.  So that's what people remember--and many use that memory to visualize what an adverse cycle looks like.  But I've seen many adverse cycles in the three decades I've been involved in real estate investments.  They don't always look like that.  Your description was far more accurate than what I see thrown around so often.  

I frequently see people post that they are waiting for a downturn to buy.  Ok, that's fine if that what makes you comfortable.  But if you are waiting for a drop in pricing you might not be seeing the forest through the trees.  If prices rise 3% for three years, and then there is a 10% downturn you are buying in three years what you could have bought today for the same price (because you probably won't buy exactly at the bottom--you'll miss it while you wait for it to drop further and it starts to rise).  Trouble is, financing will be harder to get then, which means a larger down payment, so your returns are lower.  If you use investors in your deals I can guarantee that the investors knocking on your door today will vanish until the downturn has fully reversed.

Wow, I had to give my vote to all three of you - @Phil McAlister , @Kris Benson , @Brian Burke - very well said.  Thank you for sharing!

I couldn't agree more that sitting on the sidelines will only produce "0" zero results. And to continue using Warren Buffett analogy, his buddy Charlie Munger once said that "... “Assiduity is the ability to sit on your *** and do nothing until a great opportunities presents itself”. One can sit and wait, but who can confirm that down-economy will only present great opportunities and who can confirm that there are no good opportunities now?! 

I think sticking to one's strategy and making sure it is the most conservative one will ensure one will manage through the next bubble!

On average over the last 45-years, the Denver real estate market has grown steadily at a 6% rate with the "cycles" lasting 17-years,

The 2008 crisis was a long time in the making. It all started with Jimmy Carter and his Community Reinvestment Act and the Bill Clinton's prohibition of red lining neighborhoods. No down payment, no-doc loans are not happening anymore. 

@Phil McAlister is right. Be smart. Buy value. Don't over leverage. Manage your investments tightly

Robert Kiyosaki has a saying, "there are three sides to a coin".

People argue that its a good time to buy or bad time to buy. For example "mfh” is overheated or commercial is getting killed by Amazon and e-commerce. I think these are mental justifications by tire kickers not to do anything.

Sophisticated investors live on the edge of the “coin”. They buy deals out our reach of amateurs due to the lack for network/knowledge. These opportunities are undervalued, with undermarket rents, with value add opportunity.

They are patient and don’t stray from standards that make them get crushed in a market correction. (Cashflow from other investments make this possible) They invest following the macro and micro trends and don’t gamble on gimmicks such as guessing where Amazon’s next HQ is going or where the hurricanes just crushed a market.

The trouble is as an outsider is figuring out which of these deals transcends the two side of coin and is on the edge. And starting out its going to be slim pickens due to lack of network but you have to push through this rough part. 

People need to understand that a adjustment/crash will likely be the result of something entirely different from past adjustments, highly likely a combination of unpredictable events combined.

Being aware it could happen is understandable however if you are "worried" you should not be an investor. You plan the best you can but never waste energy worrying about factors in life you have no control over.

I guess I am a bit of a contrarian. I keep my properties highly leveraged so my cash is not at risk in my real estate holdings. My cash is safely/creatively protected so that worse case the bank can take my properties if they wish but likely will not. In most cases Banks try to avoid owning real estate. Could I lose them....possibly, will I lose them...low risk do to majority of my tenants not relying on employment income and having high cash flow properties but time will tell if my gamble will pay dividends.

If all your eggs are in one basket (Real estate) you are at a higher risk regardless of whether you own them outright. If you are diversified as others point out, and as I am, only a major world cartography will wipe you out. However in that situation everyone will be in the same boat and it will not matter.

If you believe, as I do, that central banks printing money and holding rates too low for too long was really the root cause of the last crash, you could make the argument that the next recession will actually be worse. They've doubled down on their mistake for 10 straight years.

It may not center on real estate this time around. I think sovereign debt, corporate debt, and pension funds are artificially strong right now.

Crash shmash...

GDP is pushing 4%. Will that sustain? Nope. Will 3%+? Probably in 2019. 

What happens after? Who knows, but people need a place to live. Buy in Class A markets. Buy value add. Buy 50% below re-build, with value pegged on income. 

The formula hasn't changed in a few hundred years.

Good thread, guys.

@Phil McAlister I agree. Lots of worrying out there. That being said, I am still cautious and have changed up my underwriting and will stress test every deal to make sure we have ourselves covered. Real estate is very local and if you buy right and in good locations you can thrive during a recession. 

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