How to Survive the Next Real Estate Crash

Cycles…?

There are many economic cycles working their cogs currently in the world today. A cycle in general is a series of patterns or movements that result from actions, events, or outpacing sustainable growth. In an economic context, cycles are usually specific to certain asset classes or industries: the business cycle, the market cycle, the real estate cycle [link billy’s article], debt cycles, and more.

A common frustration among, well, basically everyone is this: you can’t really predict with 100% certainty a cycle’s phases or characteristics. Although there are definitely indicators such as the proven (since the 1970s) inverted yield curve and different types of market valuations, even those can’t give you the magic answers everyone wants to know: when exactly the market will correct and how bad it will be.

Why is this? There are simply too many variables involved. Every action has a reaction. Multiply that by the amount of people in the country, or the world, earning a living. Multiply it by the amount of lenders handing out massive mortgages on a macro level. Multiply it by massive global companies taking on huge debt, laying off thousands of employees, or suddenly being taxed more or less through legislation.

There are ways that you, as a real estate investor (or just a homeowner!), can mitigate your risk and slug it out in any type of market correction or crash. But before getting started, it will be helpful to:

Accept that economic powers are way over your head and mine. As a student of business, entrepreneurship, real estate, and personal finance – I definitely agree that familiarization with economics and the market is important in life. However, the sooner you realize that not even Presidents of substantial Private Equity firms or Chief Executive Officers of Fortune 500 Companies can truly predict and prevent any of this, you’ll sleep better at night.

Instead, let’s take a sustainable approach to how we prevent risk and manage risk when it comes (and it will). Because…

• By only preventing risk and playing conservative, you are limiting your ability to act and therefore limiting your chance at failure or success. Failure allows us to learn at a faster pace than success. And reward doesn’t come without risk anyway, right?
• By only reacting to risk, you are likely failing, not realizing it, and unfortunately not learning from it. You are leaving yourself open to too much leverage and unnecessarily risky investments and actions that is almost guaranteed to ruin your coffers, credit, and credibility.

Purchase in markets with diverse growth. If you can, you will want to ensure your home purchase or real estate investment is in or around an area that is consistently experiencing growth. But more importantly, that market must be experiencing diverse growth. You can find this information easily online using the Census Bureau, city websites, or even Wikipedia (But make sure you verify this info!).

For example, St. Louis in Missouri has been consistently seeing negative growth since 1950. In 1950, the population was almost 860,000. But that number has dwindled every 10 years until it was recently estimated that 303,000 people call St. Louis home. However, St. Louis is the home of 10 major Fortune 500 companies which is a rather large amount. There are also a number of other large private companies. Employment in St. Louis is spread between healthcare, retail (WalMart), education, biotechnology, and finance. If the city was experiencing more growth, this would be a great place in general to invest!

Population growth means more people looking for housing, whether it be rentals or purchases. Further, a diverse workforce ensures that the market isn’t reliant on one industry. Many oil towns and mining towns have been devastated when that one company goes under or leaves. With a diverse pool of employers, even if a qualified employee loses his or her job, they can quite easily find another.

Make sure you look toward growing & diverse places to buy!

Purchase properties with positive cash flow. What’s cash flow? Cash flow is the total amount of money going into your pocket. In the real estate world, we look use the term to mean net cash flow. Or in other words, the cash that is left over after all of your expenses (mortgage, insurance, taxes, savings for maintenance, capital expenditures, and vacancies) are paid.

A general rule to follow is to use the 1% rule. This means that you should only buy a property if the rent that you can collect from that property in your specific market is at least 1% of the amount of the purchase price. For example, a $100,000 home should bring in at least $1,000 a month in rent. Although many investors will conduct more advanced and deliberate analysis and underwriting, this is a good general qualifier to get started with.

Why do we do this? First, if you can almost guarantee that you can collect $1,000 a month on that property in rent, you’ll usually have positive cash flow left over after paying all the bills. You can use a mortgage calculator in addition with a rental property expenses calculator to preview your expenses. This will give you cash that you can put away for your emergency rainy day fund or for further investments.

But secondly, making sure you buy with positive cash flow will allow you room for slight depreciation and lowering of rents in a downturn. Even if rents go down and your $1,000 a month rental lowers with the market, you have a better chance of still breaking even and getting your expenses paid for by rent. And when the real estate market bounces back (which it always will!), your rent will further increase for you to realize your more positive cash flow.

Buy under-valued properties. An under-valued property is one that you can purchase for under what it will appraise for based on condition and comparable properties. Doing this will save you money up front but it always cost a little bit somewhere. That price comes with knowing that you might have to update your property or fix something, which you can do slowly over time to save costs.

When you buy under-valued properties, you ensure that you start right away with a little more equity than normal. This, like positive cash flow, adds in giving you a little wiggle room during a drop of prices in a downturn. It might even guarantee that you don’t go underwater which is when the market price of your property is less than what you owe on the mortgage (ouch!).

You can buy under-valued properties, like one that might just need a bit in upgrades, and let it ride. Under-valued properties also provide value-add opportunities. We already know that when you purchase a property under-value, you give yourself a little bit of equity as soon as you close. But if you added value by updating items, your house will likely appraise for even more than its original appraised value when the market bounces back. This forced equity, in addition to the natural equity that you purchased with, is powerful for real estate investors!

This might be going a bit far…

Don’t use adjustable rate mortgages. This is huge, and might only apply to novice investors or homeowners. Banks offer adjustable rate mortgages as well as fixed mortgages. An adjustable rate mortgage is just that: the interest rate may adjust, or change, with market conditions. A bank might one day offer you a stellar interest rate on an adjustable rate loan, but you’re almost guaranteeing that rate to skyrocket once the market sees a downturn.

Instead, always shop around and get the lowest rate you can with a fixed rate loan. Even if a bank can give you a slightly better interest rate with an adjustable rate loan at first, a fixed rate is 99% of the time better for long-term stability and security. And remember, the difference in a low interest rate on both types of loans at first is minimal: it may be $10, $25, or $50 difference in payments a month. But adjustable rates can skyrocket at any time, and the delta will widen in the opposite direction and you might find yourself paying $100, $200, or even more on just interest when it does.

Don’t sell! Many homeowners and real estate investors resort to immediately selling during a recession or when their specific market starts depreciating. This is almost always a bad decision. Sure, everyone’s personal finance situation is different: if you lost a job, are being threatened by piles of debt or bankruptcy, or need to downsize, selling might help.

But for the majority of us, selling is a mistake. The market always bounces back. If you sell during a downturn, you are automatically leaving money on the table by limiting your ability to bounce back with the market and realize your original value and profits.

Remember, the fair market value of a property only means something if you are buying or selling. If you don’t buy or sell your house, then what does it really matter if your house is depreciating? Sure, rents might drop a little. But if you sell a property that is still making money or breaking even (using the principles we discussed above!), you are ensuring that you lose money.

Lastly, always have an emergency fund. Remember your “personal finance 101” class? Yeah, I didn’t get one in school either. However, a common and fundamental principle in sound personal finance is always ensuring you have a rainy-day fund somewhere.

The amount differs for everyone. If you have a stable job with little chance of being fired, that emergency fund might be pretty minimal. But even if you have a high-paying job in which the industry can fire you pretty easily, it’s worthwhile to save up six months of expenses and have that on standby. Ensure this fund is either in a cash savings account or some other “liquid” vehicle. You’ll want to be able to access it immediately because, you know, life happens.

In summary, relax. Practice the principles of sound investing, don’t give up or sell, and know that millions of us are going to get through it. Also realize that real estate is very sub-market driven. For example, some midwestern and southern areas of the United States don’t often experience the same proportion of depreciation that coastal cities might. In 2009, the Texas market was relatively fine.

Unemployment and even homelessness may rise during a downturn. But the vast majority of people caught during a recession still need a place to live. A lot of them will sell their house for some quick cash or just out of fear, but they will still need a place to rent. In some areas, rents might not even drop during a recession!

Do you have any tips or practices that have allowed you to safely invest and survive during a downturn? Please share them!