Potential Real Estate Downturn Preparation
Real estate investing is a cyclical business. Markets go up and markets go down. For example, a recent press account indicated that the San Diego, CA RE market experienced a 13% annual percentage increase in property values in 2020. That is good news for those who happen to own properties in that locale; not so much for those just entering that market. We have had several major real estate downturns since WW 2, we will eventually experience another one.
4 Warning signs of a Potential Downturn Bubble Forming
1. Rapidly rising housing prices
2. Decreasing inventory
3. Unbridled optimism that the market has no place to go but up
4. Rising interest rates
Real estate investing (REI) is no different than any other business in that the laws of supply and demand apply just as they do with automobiles, canned goods or bicycles. When any commodity experiences rapid increases in price, this tends to diminish the number of buyers because they are effectively priced out of the market. Real estate has for decades relied upon first time buyers coming into the lower end of the market; this allows the previous lower end owners to move up to middle size properties, and middle market buyers to move up to higher end real estate. This of course relies, in part, on a rising homeownership rate
Unfortunately, the homeownership rate has been generally dropping over the past couple of decades. Comparing say the year 2004 to the latest year (2020), according the US Census statistics:
- In 2004 the homeownership rate was 69.0%
- In 2020 the homeownership rate was 65.8%
- Net effect: the homeownership rate dropped by 3.2% (69.0%-65.8%) 2004-2020
In other words, the normal upward-mobility pattern in housing, that has been prevalent since World War II, appears to be slowing down or even reversing.
Reasons why this has happened are, for one thing, wages have been virtually flat for many years. This means the average American adult has less money to spend and/or save. For example, it was reported recently in the popular press that more than 70% of American adults do not have $1000 in cash savings to take care of an emergency. Also, there are reportedly less first-time buyers coming into the marketplace because of changing population demographics. Tens of thousands of people have moved out of the Northeast (New York, New Jersey and some other states in the region) and moved to the sun belt. This is due to poor business climate and higher taxes from the states they were leaving and an enhanced attitude towards business and lower taxes in the states they are moving to. Lots of companies have also decamped the Northeast as well.
Further, many lower-end jobs are disappearing due to automation. For instance, it has been estimated that hundreds of thousands of taxicab and trucker jobs may be eliminated over the next 10 years by driverless systems. Further, Covid-19 caused millions of homeowners to fall into debt. Also, in many US markets, the inventory of unsold homes has dropped to near-historic lows: three-six week supply vs. 3-6 month supply. Yet, despite all these obvious warning signs, some real estate investors continue to take on more risk; many are seeking out marginally higher yields in selected markets in the Mid-west, south and many rural areas.
Crash Warning?
So, is a real estate crash eminent soon? Probably not, but that doesn’t mean that this decade-long run-up in prices is going to go on forever either. The beginning of the end of this upward cycle could come in a year or two or go another year beyond that. Nobody really knows.
One big caution sign: Since real estate is so interest-rate sensitive, if the Federal Reserve starts to aggressively raise interest rates, that could start a downward spiral in the market sooner than expected.
So, if you DO start to see a looming downturn, what action should you take?
1. Buy and hold investments. Don’t panic and sell off your holdings. The worst thing you can do is buy high and sell low. That is what hurt so many real estate investors in 2008-2010. Emotions got the best of them and they rushed to sell, following the herd of other sellers. Unless you have a compelling reason to sell, don’t. If your places are rented out and producing positive cash flow, then keep them. Selling out at fire sale prices is not a long term, winning strategy. By selling into a downturn, you are locking in a loss. Better to hold onto the properties and wait out the market.
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A smart move is to dedicate some of that positive cash flow and save it. That way when the market turns (down) you will have some buffer to get you past any problems that might arise (temporary loss of a tenant or unexpectedly high repair bills, etc.). Having extra cash stashed away also allows you to take advantage of new investment opportunities that inevitably arise when OTHERS are panicking and selling. That is when you can potentially pick up bargains. Make sure your actions are logic- and not emotion-driven, and that it is all part of a well-thought-out, long-term plan.
2. Flippers and fixers.
a. If interest rates rise, you can offset the problem of increased debt service costs by switching from loans to equity or joint venture arrangements. Once the deal is done and you sell off the property, profits can be split in proportion to how much investment (money, sweat equity, etc.) each partner contributed.
b. Make certain you have exit strategy funds lined up BEFORE you put the property under contract and/or purchase it. This can be a cash buyer investor, retail buyer, another (co-)wholesaler. The important point is you do not want to get caught holding a property you cannot afford to keep.
What We Do: Quickly provide private capital funding to real estate investors. Contact info: Tod Snodgrass, emdfunding1@gmail.com, 310-408-7015
- Tod Snodgrass
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