03/04/2020 01:39
Interest rates have been rising. Single family residence prices are softening. Does that mean we’re headed for a downturn?
Well, sure—at some point.
Recessions have been around forever—they’re an unavoidable part of the investing landscape. But you don’t need to fear them. You can prepare for, and even thrive, during a recession if you have the right tools and strategies.
This is the story of my first recession. As recessions go, it was a doozy.
Getting Started
Throughout the 2000s, I was pumping every dollar I earned into value-add multifamilies in up-and-coming neighborhoods in Los Angeles, like Koreatown and Hollywood. I loved it. I was a multifamily evangelist.
But by 2006, nothing seemed to make sense, and, like a lot of investors, I was anticipating a downturn.
That’s right—the correction didn’t come out of the blue. The warning signs were everywhere.
Reckless lending practices combined with the irrational exuberance of the market had most sensible investors cowering for what was to come.
I stopped buying in 2006, waiting for the inevitable correction. I’d be ready to jump in, lock in discounted “correction pricing” before values once again reverted to their upward, long-term trajectory.
Timing the Market
It came in early 2008. Prices slid 10%, then started to tick back upward. This was my chance, and I jumped in. I found a C+ class multifamily property with cashflow and value-add. The sellers were suing each other and were motivated to sell. It was a great deal.
And pretty sweet market timing on my part. Right?
Not exactly. It turned out that this 10% decline wasn’t the end of the correction, it was just the beginning. That tick back upwards in values? It was caused by investors like me, waiting on the sidelines to jump in after a correction. We all jumped in, and it caused an uptick.
But we were still at the top of the waterfall.
A Seductive Temptress
I’ve read that this is a common occurrence during recessions. There’s a portion of investors anticipating a downturn, who wait on the sidelines, ready to jump in once prices correct. After a 5-10% decline, the first wave of side-liners jumps in to lock in the discount. This wave of buyers results in a slight uptick in the market. The uptick is misinterpreted by the rest of the sideline investors as the correction being over, and they rush in so as not to miss it! But the reality is that the crash has just begun. And they all go over the waterfall.
They call it the seductive temptress of a market crash. It takes down the foolish investors, but seduces otherwise smart ones as well. Cruel—but kinda funny, right?
I was one of those idiots.
To make matters worse, I’d convinced some work colleagues to invest with me. We bought with confidence, feeling good about our price. But then Lehman Brothers collapsed—and along with it, our entire economy and real estate market. We entered the worst real estate crash in the last 50 years.
It was Armageddon.
My greatest dread was losing my colleagues’ money. (I would much rather lose my own money than to have people trust me, then blow it.)
A Resilient Asset Class
As real estate news got more and more grim—mass foreclosures, investors walking away from properties—something strange was happening at our C+ class building. Rents were actually inching upward.
Renters in higher-end properties were facing layoffs and salary cuts, causing them to move into more affordable, mid-tier units, like ours. And former homeowners were becoming renters. During the recession, demand for this asset class actually increased.
The recession was nerve-racking, but fortunately, we survived. I was able to deliver my work colleagues triple their money (crushing the stock market returns during the same period). I felt more relief than triumph.
9 Takeaways From the Great Recession
The experience taught me a lot about recession-resilient investing. I’d completely mistimed the market, but was saved by other factors—some that were part of my strategy, others accidental.
Here are strategies I now use to invest with confidence in any market:
1. Stick with B and C-class properties.
I have no problem buying A-class buildings at the beginning of a recovery—when I can buy them cheap. In late stages of a real estate boom, they’re overpriced and I avoid them like the plague. I also avoid turnkey. The high end of the market is the first to get slaughtered in a bad downturn. I aim squarely for mid-tier properties I can improve!
2. Multifamily is resilient.
Recessions tend to create renters, so multifamily tends to be resilient during downturns. From 2008-2012, 8 million single-family homes went into foreclosure. During the same time, multifamily default rates were less than 1%.
3. Buy as cheaply as possible.
The saying goes, “You make your money when you buy.” If you want to overpay, do so at the beginning of a market recovery. But not now. Prices are high, but deals still exist. Be patient. Make sure you’ve got that cushion that will allow you to absorb declines in value that could wreck other investors. Learn how to negotiate. Battle for the best price possible.
4. Cash flow is a must.
Late in a real estate cycle, positive cash flow is a must. I make sure the buildings I buy generate income from day one. An added benefit of this is that you get a better loan-to-value. Bonus! An adjunct to this is: Don’t over-leverage. Only borrow what the property’s cashflow will cover.
5. Buy in an up-and-coming neighborhood.
Even during a downturn, submarkets are evolving. Some evolve in response to the downturn—renters move out of pricier areas into nearby, more affordable neighborhoods and then make them cool! This lead to the birth of neighborhoods like Silver Lake, in LA, a neighborhood that is downright posh now. Catch neighborhoods on the rise.
6. Beware of oversupply.
Another saying goes, “Most real estate booms die from oversupply.” Keep this in mind. Supply and demand is a basic fundamental of investing. Overbuilding is a growing concern in several markets, especially at the high end of the market. Track your metro’s supply/demand stats, absorption rates, etc., so you don’t get caught.
7. Add value.
This is a must for me in any economy. If you can reduce expenses or increasing cashflow with strategic renovations, you are increasing the value regardless of the economy. So you don’t really need to worry about it. It’s another layer of cushion.
8. Have cash reserves.
This is basic common sense and key during any stage of a market cycle. The reality is your expense projections will usually be too low. Be prepared with reserves.
9. Don’t try to time it.
I tried to time the market and failed. Market cycles are predictable, but the timing of them is not. Our economy is too complex to know the event that will trigger the investor fear and cause a recession.