Preparing for a Down Real Estate Market

While raising capital for our last investment fund, potential investors asked us a lot of questions in getting to know us better and to learn how we do business. The most frequently asked question was: How do we deal with a down real estate market? This is a great question because it focuses on the downside risk of non-performing notes. In a nutshell, we deal with a depreciating real estate market by:

1. 1. Anticipating Future Market Trends
2. 2. Buying the Right Type of Product
3. 3. Speed of Execution

Never Lose Money

According to Warren Buffett, “Rule No. 1 [of investing]: Never lose money. Rule No. 2: Never forget rule No. 1.” All investors should be concerned about getting a good return on investment but getting return of your investment is even more important.

We choose to invest in defaulted mortgages or notes that are backed by real estate, which are hard assets. They are not virtual, we’re not buying shares of companies that can go down to zero. We buy notes with real estate that will always have some value.

In a normal or flat market, we buy non performing notes at a discount. If the market continues on its course and doesn’t go up or down very much, we’ll make money. If the market goes up, we benefit from the wave of appreciation and see even better returns.

How do we defend against a down market?

The Down Market

In my last post, I talked about how bids are affected differently when there’s equity versus when the property is underwater (when the loan balance exceeds the property value). The condition of the real estate market directly affects the values of the loans we buy when the underlying property is underwater. When the market goes down, the value of the note goes down.

When there’s equity it’s a different story. As long as there’s enough equity (we like 80-85% LTV), the value of the note remains stable in a down market since your bid will be based off of UPB instead of the property value. A down market might temporarily suppress the equity cushion but that’s it.

Anticipating Future Market Trends

The first defense against a down market is to anticipate market trends. This is not an exact science. We look at the latest key economic indicators, how the economy is doing as a whole, we pay attention to national real estate trends. We also look at the local level and talk to our real estate agents, fellow investors, title officers, and the traders that we buy and sell notes with and get their views, experiences, and feelings on the market and where they think it’s going.

National real estate trends will tell you only so much. At the end of the day, local real estate markets are what counts to each note and each market is different. We try to be aware of as much of the local real estate markets that we can and do the extra research when we evaluate notes for purchase. For a quick example, the San Francisco Bay Area appears to have hit a peak and is coming down from extraordinary highs while areas near Nashville, TN are completely hot.

We do our best to anticipate future trends but we don’t have a crystal ball to be 100% accurate. Even if we did, there is only so much we can do because the nature of buying non performing notes is that there is a lag time from when you buy the loan to when you can actually liquidate it. Some notes take two to three years or even longer until you can liquidate because the borrowers’ actions are outside of your control and what they do and don’t do affect your timelines.

Buying the Right Type of Product

The best tool we have by far to limit the downside risk of a down market is to buy the right kind of product. In our view that means:

1. 1. Notes with underlying collateral value between $70,000 and $300,000.
2. 2. Notes with collateral in urban and suburban areas
3. 3. Collateral that is “A” and “B” quality

Collateral Value Between $70,000 and $300,000

We like this range because we believe that this type of property has the most demand across the board. Investors and owner occupants alike will be interested in houses at this price level. This is a sweet spot for most markets nationwide, not too big and not too small. Relatively easy to get financing with the largest amount of buyers. There will always be demand for this price point even in a down market.

If the market got really bad, we could always turn an REO into a rental and collect rents until the market recovered. Million dollar homes don’t provide the same bang for the buck and typically fall a lot more in value.

Remember, all real estate markets are different and $300,000 in Savannah, Georgia, is a lot different than $300,000 in Los Angeles. This is a general rule of thumb for us and sometimes we’ll go higher or lower in value if it makes sense to do so.

Urban and Suburban Areas only

Again, this is in line with our desire to buy notes with desirable collateral. Urban and suburban areas have lots of buyers who will be interested in buying our REOs or the foreclosure sales. If the property is in a remote or rural area, then it’s not for us. Those areas tend to get hit harder and properties stay on the market longer in a down turn.

Best and Better Quality Houses

Another factor that contributes to demand is the quality of the properties. In a downturn, retail real estate buyers turn their attention to the better quality homes because they are more affordable. They don’t have to settle for something that’s lower quality, requires more work, or is in a less desirable location. In general, we like to buy the notes with properties that are good and high quality. If we anticipate a down market, we’ll be even more discerning.

Speed of Execution

Finally, the last defense against a down market is our speed of execution. We pride ourselves on being a small operation that is not encumbered with the bureaucratic dysfunction and inefficiencies of the big banks. We give the attention that each of our notes needs to maximize profits. Our compensation is directly tied to how well each note does so we are extremely vigilant at making sure that we complete the numerous, complicated tasks we need to foreclose as quickly as possible.

The faster we can process a foreclosure or renovate an REO, the faster we can liquidate. The faster we liquidate, the less likely a down turn will hurt us since we will have less time exposure and can be more responsive to changes in the market.