Minimizing risk during an economic downturn.

18 Replies

Show 250 with Grant Cardone was very informative and I thought he had a great point when he advised to purchase property in the middle range of the market with rental rates falling between $800 to $1200 to minimize your risk.

After his interview, I started to wonder what more could be done to minimize risk during a downturn and was hoping someone would be able to provide feedback on the following:

During the last downturn, which type of properties continued to have success with rents (less vacancies, monthly rents not fluctuating too much, etc)? Were there any advantages to owning one type of property than the other? House, Duplex, Apartment? Did SFRs continue to have success or were there more success with duplexes and apartments? I don't have experience yet, but to me, it seems like people would not overlook renting an sfr during a downturn as long as the monthly rent cost is within the middle/affordable range? A duplex or aparment would not have a desirability advantage over a sfr would they?

Now that I think about it, I guess the sfr would have a desirability DISadvantage since it would usually not be able to compete with the rental pricing for duplexes or apartments..?

We have single family rental houses, duplexes, and an 8-plex.  All did fine during the downturn. High demand for affordable housing, which worked well for us since we operate in the low-income to mid-income range.  

The biggest advantage of the economic downturn was the greater availability of tradesmen (or tradeswomen) at better rates. Building materials were at a better price too. This was the time to do renovations, rehabs, etc. Also, more owners were getting out of holding real estate (by necessity or by choice), so it was a great time to buy.

Have enough cash on hand to last during the downturn. Plan on having positive cash for a few years if the loan conditions changed. Don’t become House poor where expenses are higher than the income.

I like the idea of middle rents, if the PITI is $600 per month, make sure rents are between 800-1200. Something that gives cushion. Save cash for buying opportunities too. Hopefully piti would be less.

A vacancy in a SFH is far more serious than one on a multi unit. A loss of 100% of income clearly more impact than 25% loss in income.

Risk wise I would say the highest risk would be owning SFH rental properties at any time but definatly during a down turn.

@Ben M. I think location plays a bigger role than type of housing.  There is a rental market at every social-economic level if your in the right location. I have single family, duplexes and apartments ranging from $500-$2500. I never had to lower rent on an existing tenant during the recession.  (We did lower expected rents on some empty units to get them occupied.)  

I would agree with @Jack Bobeck about having reserves.  While I had adequate reserves to maintain our homes and pay off my second mortgages, I didn’t have adequate cash to invest at that time, which would have been great! 

Locationwise, I’m south of Seattle in Olympia (state capital) and we have a strong job market in multiple industries as well as government offices.  Being in a high demand location mitigates risk of downturns. 

Also, own more than 1, whether it’s a duplex, tri, or multiple houses. As @Thomas S. was alluding to, spreading your risk across multiple units always helps during turnover, vacancy or market adjustments. 

I believe this largely depends on where you are and you need to stay aware of the climate in the market. For example, say you are in a town where the "migration rate" is relatively low, but there are mass amounts of new developments coming up, you should be cautious. This could cause not only the home values to drop, but rents as well. If most people are moving to rent homes instead of buy where are they going to chose? The home that is 40 years old, or the brand new development where rent is the same? Typically in a market where the supply of homes is not abundant you should expect rents to rise in an economic downturn. More people who no long own, or are no longer looking to own, will still need to live somewhere and most homes are not on the market. This would create much higher competition allowing us, as investors, to not only be more selective in the tenants we choose, but also be able to raise rents to meet demand. I do however 100% agree with Grant Cordone about the price range of rentals you want to invest in. The median income in the United States is $51272 per year (this number does vary by location) according to an article that USA Today published. This would put most Americans right in the market for the $800-1200 dollar rent range. Following Grant's advice could keep your properties in high demand even in a terrible economic slump. 

Here is the link to the article I was referring to, in case anyone is wondering.

https://www.usatoday.com/story/money/personalfinance/2017/03/28/whats-the-average-income-in-the-united-states-now/99574116/

Besides having reserves, make sure you have properties people want to live in. A 3 bedroom house is better than a 2 bedroom house, just as a 4 bedroom is better than a 3 bedroom. Kids these days do not want to share a room with a sibling, they want their own privacy. Gone are the days of the 2 kids home living in a 2/1, as now both parents/partners are likely to work.

The cost to have a 3rd bedroom is negligent over 30 years, but can really affect what you can charge. Having had 2 bedroom units, I would never go to a 2 bedroom again. The problems and issues are similar with 2 vs 3 or even 4, so why take less rent? 

Hey Ben, in the 2008 financial crisis multifamily did really well because of the moderate leverage as well as ample cash flow to cover debt. Also, while home prices were losing over half of their value, rents only dropped slightly and even went up in some markets!

Leverage can make you or break you. There are some that preach to leverage to the hilt. I like to be a bit more conservative. If you have vacancies can you cover the expenses? All I am currently doing is SFR but I seriously doubt that I would end up with 100% vacancy with 13 units. Even if I have 3 or 4, most are debt free and the income will cover debt service. So my caution would be not to over-leverage! Also, WHEN we have the downturn, if not over-leveraged you can reduce rents to compete.

@Ben M. location is the most important factor. Several markets saw massive population loss during the last down turn, so regardless of rent price, there were not enough people in the market. My city saw population increase as people moved from other markets looking for work. We saw rents increase during the last down turn.

I do agree with Grant that having properties in the mid-range is best. The luxury market is the first to collapse in a down turn, as is any vacation market (Florida and Vegas). Low end is best to avoid at all times to just to avoid tenant problems.

@Thomas S. I disagree that having multifamily reduces risk from vacancy. If anything single family homes have lower vacancy over time. Even if we assume vacancy rate is equal in single family home as it is in multifamily, the financial effect over time is worse on multifamily. Assuming a 4-plex, maybe only 25% of your unit will be vacant at one time, but you have four times as much vacancy versus one home. The net dollars may be the same, but you are filling four units instead of one, so cost is higher. I think the bigger issue is scale, regardless of single family or multi-family. If you have enough units, a single vacancy has little effect. 

Originally posted by @John Thedford :

Leverage can make you or break you. There are some that preach to leverage to the hilt. I like to be a bit more conservative. If you have vacancies can you cover the expenses? All I am currently doing is SFR but I seriously doubt that I would end up with 100% vacancy with 13 units. Even if I have 3 or 4, most are debt free and the income will cover debt service. So my caution would be not to over-leverage! Also, WHEN we have the downturn, if not over-leveraged you can reduce rents to compete.

100% agree.  We did not own rental properties in 2008, but were 100% debt free, including our residence.  Never lost a night of sleep, even when my husband's agency announced 10% across the board wage cuts.  We got a great deal at recession prices in what would become our retirement house, also got a great deal on a hungry contractor who did remodeling at great prices.  We bought our apartment building in 2013 when the economy was starting to rebound.

I never hear this talked about in the debt/no debt discussions on this board, but years ago my mother gave some advice.  She had  grown up during the Great Depression and knew about hard times.   Her advice was to take your risks (leverage)  when you are young -- that way you have time to rebound if  you fail.   Your debt to equity ratio should decrease as you age.  That way you will not end up old and poor.  Old and rich is much better than old and poor.

Ben,

Good question.  You certainly want to start w/the market / submarket and be in the strongest ones that history proves falls the least and recovers the fastest.  Additionally, value add opportunities where even after renovations you are still under market compared to new construction in the area will insulate you further as new construction typically gets hit the hardest (most expensive). Folks have to live somewhere concept and if your rents are competitive it's too painful and costly for folks to move out of established areas for marginal savings.  You want to be conservative with your numbers, adequate reserves to weather downturns.  Non tangibles like improving tenant retention / morale through hosting resident gatherings and keeping the property looking sharp go a long way as turnover is costly.  

Dallas is a great example, weathered the downturn very well in 2008/2009.  It would be worthwhile if you are in syndications to ask for the sensitivity analysis to see how the property holds up against changes to rent and occupancy.  We had just acquired a property in one submarket there where we have 3rd party data from REIS showing avg occupancy at its worst was 85% in 2009 .  Our analysis shows that we  B/E break even at 75% and making 6% at 85%.  It's nice to know w/data how you can do during economic shocks.

Originally posted by @Rob Beardsley :

Hey Ben, in the 2008 financial crisis multifamily did really well because of the moderate leverage as well as ample cash flow to cover debt. Also, while home prices were losing over half of their value, rents only dropped slightly and even went up in some markets!

I think the problem with assuming the strategy from the last war is about the same as the French assuming they were safe behind the Maginot line.

What I mean by that, is the years leading up to 2008, there was a massive bubble, people were buying every SFH that was built. Remember there were lines at new subdivisions for the right to buy homes before they were built, and then people were flipping those unbuilt homes the minute they wee completed for tens of thousands if not hundreds of thousands of profit. It was unsustainable, especially with a bunch of no doc loans.

Now fast forward a decade, and the last I looked (granted a little while ago), we were at home building rates from the 50's or 60's when the US population was half of what it is today, and I believe we arent even keeping up the houses being torn down. So I disagree with is premise on their being a glut of SFH's as the baby boomers die. (at least in cities where the population isn't declining.)

Millennials have fought the last battle as well, where I grew up in an era of 15-20% inflation, homes always went way up in value, we learned to buy.  Todays millennials lived thru a housing bubble, and super low interest rates, with relatively low rental costs. They learned not to buy.

IF we get very high inflation, I think you will see a lot of people wishing they owned their own home.

As far as apartments, multi family units, everyone sings the praises of how that is where the money is made, and I am sure in general they are correct, but my sense is there are a lot of cranes building Class A apartments and a lot of value add syndications rehabbing older units. 

I think there is a real probability that high end apartments are getting overbuilt, and many of these deals are being penciled at really low cap rates, and that it could get ugly if a lot of these groups end up needing to refinance balloon payments in a downturn.  Especially if we finally see a return to 5-7% nominal rates, ie rates a little closer to historic averages.

I do think properties in the $1,200 price are obviously less susceptible to a downturn, but I think we may see millennials moving to SFH's as they start families in this next recession, vs when they were single and just moved to apartments.

In short I think we need to seriously consider the next war may be a quick strike, rates going higher recession vs a prolonged trench warfare of over priced homes.

Personally we are thinking about slowing down, maybe being a little more selective, holding firm until we find higher returns etc.

Originally posted by @David Thompson :

Ben,

Good question.  You certainly want to start w/the market / submarket and be in the strongest ones that history proves falls the least and recovers the fastest.  Additionally, value add opportunities where even after renovations you are still under market compared to new construction in the area will insulate you further as new construction typically gets hit the hardest (most expensive). Folks have to live somewhere concept and if your rents are competitive it's too painful and costly for folks to move out of established areas for marginal savings.  You want to be conservative with your numbers, adequate reserves to weather downturns.  Non tangibles like improving tenant retention / morale through hosting resident gatherings and keeping the property looking sharp go a long way as turnover is costly.  

Dallas is a great example, weathered the downturn very well in 2008/2009.  It would be worthwhile if you are in syndications to ask for the sensitivity analysis to see how the property holds up against changes to rent and occupancy.  We had just acquired a property in one submarket there where we have 3rd party data from REIS showing avg occupancy at its worst was 85% in 2009 .  Our analysis shows that we  B/E break even at 75% and making 6% at 85%.  It's nice to know w/data how you can do during economic shocks.

 Interesting information, thank you for sharing. One question, if you don't mind me asking, do you have refinancing risk after 5 years?  or do you have a fully amortizing loan? In case the market turns down in the next 2-3 years.

@Bart H. I agree with all of that especially the idea that properties renting in the low $1,000s are safer while class A is overbuilt. However, I think you are underestimating the cultural shift in America. The Millennials started a trend of wanting to live in big cities in apartments. I don't think this will change for the next 20 years. 

Another valid point is interest rate risk. Interest rate risk is one of the major macro concerns in almost all yield investments. However, I don't see how the FED could raise rates substantially any time soon. Even if the FED were to raise rates 100 basis points, I don't see that affecting cap rates much in terms of decompression. 

@Bart H. I am less familiar with balloon payments and refinancing risks. Can you explain this to me?

Thanks

@Bart H. ..in the market now you can obtain 10 year fixed loans at very good rates (say low 4%) and pay interest only for a period of time (say 2-3yrs though we just scored 5yrs on our latest deal). This supports better cash flow to investors during the renovation ramp / rent adjustment period (typically 2yrs). Amortization is over 30 years. Instead of refinancing a good underlying fixed loan and pulling money out for investors, it's better to look at using a supplemental loan after the renovations are complete and you have achieved your rent projections (increasing its FMV). The supplemental loan is on top of the underlying fixed loan. This enables funds to be pulled out to the investor increasing CoC and IRR for the investor at end of yr 2. This also reduces investor risk because we are now paying back more of their equity earlier in the program (typically we target a 5 year hold).

How does this not become riskier you might ask? Well, the LTV starts at say 75% may go down to 65% as the value of the property has increased thru your value add strategy. Hence, the supplemental loan gets us back to 75% where we started which was safe debt in the first place. This allows us to keep the bulk of the debt at a very low rate and provides us with 8 more years after renovations to look for a better market exit.

I think folks get the impression that in a downturn we won't make money, be forced to sell, etc?  Well, we won't sell is the goal.  We hold on and if positioned well, we continue to payout distributions to our investors and weather the storm looking for a better exit.  Sensitivity analysis will show you how low occupancy and rental rates can drop to B/E.  Surprisingly for many, its pretty far say 75% occupancy and reduced rents 10% for B/E.  Get 3rd party data to show worst case avg occupancy of apts in past 15 years in the submarkets you are in.  It's usually not much worse than 85% because again, folks have to live somewhere.  At 85%, most of the deals that are conservatively underwritten are producing 4-6% cash on cash.  

Keep in mind the 2008 downturn was pretty darn severe and the laws that were in place unfortunately prevented a lot of mortgage loans to be re-worked as they were part of large collateralized mortgage packages sold to investors via Wall Street.  Those laws have been changed to prevent as much damage next go round.  Even so, during this period MF mortgage delinquencies were still in the 1% range versus 4-5% for residential. Overbuilding / oversupply is something you always need to watch but new construction is where that will hit first and do the most damage.  We saw this in 2014 in Houston w/oil falling from $100 barrel to $50 barrel  w/B/C value add properties there performing admirably while class A occupancy fell hard.

Hi @David Thompson ,  I realize you may be more commercial than residential but do you know of a company similar to REIS that provides similar data for residential markets?

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