Worried About a Stock Market Crash? Prepare for the Bear Without Fear

by | BiggerPockets.com

Here’s a reassuring statistic for you: In all but one stock market crash in the last 70 years, residential real estate went up in value, not down.

The notable exception, of course, was the Great Recession 10 years ago.

But just because that bear market remains top-of-mind for most of us, it doesn’t make it any less of a statistical anomaly. Historically, real estate is an excellent hedge against stock market collapses.

Let’s not get ahead of ourselves, though. Before we dive headfirst into bear markets and how real estate can help, I want to share a quick framework for matching short-term planning to your long-term goals, and rolling with the motions of the markets.

Expansion Cycles

When I invest, I think in terms of expansion cycles and consolidation cycles.

My long-term, high-level financial strategy is twofold: grow my passive income and grow my net worth. Toward that end, I love rental properties, and I love equities (diversified in ETFs and mutual funds) because they further both goals.

An expansion cycle could be a quarter, or six months, even a year. But it should be a short time horizon, a short-term plan to advance your long-term goals.

In an expansion cycle, I aggressively buy up rental properties and invest in equities. I’ll leverage my rental purchases as much as possible. I max out my retirement accounts with equities.

That all sounds fine and dandy, right? Why ever stop investing, if these investments help me reach my long-term financial goals?

Consolidations Cycles

If you constantly run, run, run and keep throwing money around, you don’t give yourself a chance to learn from your mistakes.

Every investor needs to periodically pause and take stock. What’s working the way you intended? What hasn’t gone according to plan?

How comfortable are you with the amount of debt you’re carrying?

And, of course, what’s going on in housing and equity markets?

In these pauses, investors can make defensive moves, such as paying down debt or stockpiling some cash. I call these phases consolidation cycles.

“Wait—Are You Saying I Should Try to Time the Market?”

No.

Last week, Scott Trench made a compelling case for why investors shouldn’t cringe on the sidelines simply because housing prices seem high. His logic holds true: Even when stocks or real estate is priced high by historical standards, it could continue rising for years to come. And when the next crash comes, who’s to say that the bottom will be lower than today’s prices?

Expert market analysts, whose entire educations and careers have been spent in this field, can’t predict how the market will move. Some tough love here: If they can’t predict market movements, you definitely can’t.

With that being said, market crashes can be a great time to buy. When everyone else pulls out, consider starting an expansion cycle.

But expansion and consolidation cycles are more about the rhythms of your personal finances and what’s happening in your life than they are about market conditions. When you start feeling overextended, it’s a good time to pull back and consolidate.

Related: The Irrefutable Advantage Real Estate Investors Have Over Stock Investors

If you have a major life change, such as a new job, marriage, or having children, consider pausing to consolidate. Review your investments. Sell any assets you’re not enthusiastic about. Pay down debts. Beef up your cash reserves.

Rentals as a Hedge Against Stock Market Crashes

Robert Shiller, co-creator of the ubiquitous Case-Shiller Home Price Index, has a word or two to say on the subject. To most people’s surprise, he notes that historically “there is surprisingly little relation” between equity prices and residential real estate values.

In fact, if you look at annualized returns since 1953, home values have actually risen more during bear markets than bull markets!

housing during bear and bull markets

Chart courtesy of Marketwatch

That means that if you’re worried about a stock market crash, a logical place to put your money is in real estate. Rental properties in particular make a great hedge because rents tend to be relatively stable over time and rarely drop significantly.

And if you don’t like the look of how equity returns (over 10%) compare to the home price gains (under 5%) in that chart, don’t start sweating just yet. Those equity returns include dividend income, but the home price index only covers appreciation, not rental income.

Over time, returns from residential real estate are made up of roughly 50% appreciation, 50% rental income. In fact, a recent collaborative study between U.C. Davis, the University of Bonn, and Germany’s central bank found that rental properties were the best investment of the last 145 years.

Leverage, Real Estate, and Good Debt

One of the great advantages of investing in real estate is the ability to leverage other people’s money to build your own net worth and passive income.

But an oft-overlooked perk of that leverage is that it opens a 100 percent safe, guaranteed place for you to put your money in a consolidation cycle: paying down your mortgages.

Imagine you borrow money at 6% to buy a rental property in one of your expansion cycles, and earn $300/month cash from that property. This is what Robert Kiyosaki famously calls “good debt”—debt that puts more money in your pocket each month, rather than costing you money.

No matter what comes down the pike, you can now earn a guaranteed 6% by paying down that debt. When you get spooked by what’s going on in the stock market, or in housing markets, you can still put your money to work for you, effectively earning a return. And when you pay off that rental property mortgage, you suddenly find yourself earning $800/month cash flow from the property, rather than $300.

In other words, the leverage on your real estate investments open up an entirely new set of defensive investments for you.

As you near retirement, it will grow ever more attractive to consolidate and play defense, rather than offense, with your investments.

Preparing for the Bear by Investing

Sound counterintuitive, to prepare for a market crash by investing rather than selling?

That’s the beauty of rental properties. They hedge against inflation, they hedge against stock market crashes, and they even hedge against housing market crashes with the stability of rents and the ability to ride out stormy weather in the market while still earning positive cash flow.

Related: Should You Put Your Money into Stocks or Real Estate?

Try out this framework of thinking in expansion versus consolidation cycles. When you’re expanding and investing, you’ll know you’re furthering your long-term financial goals.

And when you pause for a consolidation cycle, you’ll know you still have plenty of options to advance those long-term goals, even without buying new investments.

Equities perform well over the long term, as do rental properties. They just don’t always perform well at the same time—that’s why both are so useful for fitting short-term planning to your long-term goals.

How do you plan on investing your money over the next year? How do you decide where to put it? 

Let’s discuss. Comment below!

About Author

Brian Davis

Brian is a landlord and long-time rental industry expert, who offers a range of free landlord resources through his company, SparkRental. Grab a state-specific lease agreement or take our free mini-course on buying 2-4 unit rental properties while you’re at it.

Message me if you’d like me to write for you about real estate or personal finance!

19 Comments

  1. Jerry W.

    Brian,
    Really good article that not many folks have addressed on BP. It is easy to overspend and not follow through quickly enough or or not as thoroughly as you should. I found that I have 4 properties sitting on the sidelines not able to be rented because of work that needs done. That has a big negative effect on cash flow. The properties were all bought at good prices, but until they are rehabbed they drain cash flow in mortgage payments and utilities, taxes, insurance, etc. I now have 2 of the projects going forward slowly but surely. When I get at least 2 of them done I can consider buying more properties. It is easy to over reach, especially if you are slow going over your P&L for your business.

    • Brian Davis

      It’s so true Jerry, that it’s easy for landlords to get overextended. Owning and managing rental properties does require a cash reserve, and many landlords get so caught up in the excitement of buying that they fail to keep enough cash to cover those huge turnover and repair costs when they come along.
      Best of luck getting your 4 vacancies up to rental condition, I’ve been there myself and know how frustrating (and expensive) that can be!

  2. Lewis Christman

    good debt can become bad debt real quick. It makes sense to expand and contract and review your finances. As a financial planner the goal is to help you achieve your dreams AND let you sleep well at night. Sometimes it is 2 steps forward then pause or maybe 1 back to then take 2 more.

  3. Jeff Little

    I agree with most of what is said here, but I will also mention that the political climate should be considered when trying to decide how much expanding and how much consolidation should be done. 2016 was a very special election year from a historical perspective, as it was only the third time in history when Republicans gained decisive control over the House, the Senate, and the Presidency all at the same time (I am not counting a minor 2 year blip under Ike). The previous instances were:

    1921-1932 – Massive tax cuts on the wealthy in 1921 and much of the nation’s talent left industry and became real estate agents, stock brokers, and bucket-shop owners. Result was a downturn that equaled the entirety of the growth from 1921-1929 over the next 4 years.

    2001-2007 – Moderate tax cuts for the wealthy were stacked on top of the massive cuts of 1984. Inequality reached 1929 levels around 2007. Stories of Florida swampland millionaires, quiescent since the 1920s, began to circulate again. Result – we dodged a bullet. As bad as the crash of 2008 was, it could have easily been much worse because massive liquidation prevented many of the problems from the Great Depression.

    2017 – ? It looks like this time around things will probably not turn into Great Depression II because it is looking like the run will likely end in one of the next two elections. In the unlikely event, though, that Republicans do hold all three through the election of 2000, though, then we can expect major trouble on the horizon.

    If we do have another major financial crisis, it will almost certainly be preceded by a market run-up where people stop buying for cash flow and start buying for appreciation only. If and when this happens, “be fearful when others are greedy and greedy when others are fearful”.

  4. Anna Watkins

    Thanks for the idea construct of “expansion cycle” and “consolidation cycle.” That’s pretty much what I’ve been doing — going on a buying spree then resting, but I think of it as “letting the dust settle” before buying again. I am definitely in a consolidation cycle now, getting systems in place, refinancing out of adjustable mortgages into fixed-rate, and trying to hold back pursuing the excitement of property hunting (!). Financially, I need a holding pattern for a while to make best use of the acquisitions and debt added over the past couple of years. I can now use your terminology and sound like a real economic pro.

  5. John Murray

    Very good article Brian. Anybody that has been in the game awhile knows that dollar cost averaging is the way to invest in the stock market. Portfolio. passive and capital gains income will always out perform earned income. Multiple income streams is the goal, the individual has to figure out how to effectively obtain that goal. Just knowing this is half the battle, this is what should be taught in high school instead of trying to figure out who will be the King and Queen of the prom.

    • Brian Davis

      Absolutely John! I wish personal finance was a central part of the Common Core curriculum for the United States. I’m with you on dollar cost averaging, slow and steady wins the equities race, even as real estate investing inherently requires more stops and starts given the size and cost of the assets involved.

  6. John Murray

    You are a smart guy Brian. When the new tax Act was signed I immediately started taking profits and transferred to government securities. I knew the government would have to barrow money to make up for the tax short fall. The SALT states with upper middle class deduction limited at $10K will provide some of the short fall, the rest Uncle Sam will go begging. Learn by history!

  7. Russell Gronsky

    Brian, thank you for a great article. I enjoyed reading it very much. While I agree with the overall message, and many specific points of your article, there are two ideas you mention that I have a different approach with:

    1. Pausing to evaluate your positions when you have a major life change. I see evaluating one’s position as a continuous, real-time exercise one does consistently and constantly. I don’t see evaluating one’s position as a sequential phase to be done only when a specific gate or milestone is triggered.

    2. I wish you would have expanded more on your idea of consolidating debt. You said pay down debt during your contractions but there are two caveats: first is, should you pay down good debt, bad debt or all debt as much as possible? How do you prioritize which debt to pay down first? Second is, does it make sense to pay down debt if you can’t pay it all down during your contraction cycle? For example, if you have a mortgage note for $200,000, does it make sense to pay down that debt if you can only pay it down $20,000? While you may think yes, since it shortens the duration of the mortgage, you have dedicated a significant amount of disposable income to paying down debt BUT the very next month, you’ll get another bill for the exact same amount that it was the month before so you haven’t improved your current financial position at all. In fact, if you have a major life change, you probably want that disposable income for use in relation to the major event instead of shaving payments off the back of a note you may not reap the benefits of for another 10, 15 or 20 years.

    Now the flip side of the above example is the person in their 50s who wants to retire early. With most major events (marriage, kids) behind them, they may be more interested in paying off properties and putting the $20K towards a $200K note probably makes more sense to them. So what I’m ultimately getting at is, I don’t think it is as simple of a decision as, “I’m in a consolidation phase, I need to pay down debt”. It depends on what your age is, do you see major expenses in your immediate future, and would the smaller amount of cash flow be better used in a emergency fund you can readily access or put towards shortening the remainder of your loan.
    There are obviously other scenarios that can come up as well.

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