This is a chapter taken from the upcoming comprehensive guide titled, Market Cycles: How Investors Can Survive (+ Thrive) in a Turbulent Economy. If you would like to sign up for early bird access to this comprehensive guide, please sign up here.
Economies and real estate markets historically go through cycles. It’s easy to be an investing success when the economy and housing market are firing on all cylinders. But down markets have unique characteristics that require savvy investors to think a little bit differently about their strategy and operations.
This chapter focuses on several key resources investors can leverage to weather the storm and seize the opportunities in the next down market.
Back to the Future: How today is different from 2008
The Global Financial Crisis of 2008 (GFC) took the world by storm, caused in large part by the housing bubble and subprime mortgages. This time around, a global pandemic and economic shutdowns are causing many real estate investors to ask if the housing market is going to crash again.
While it’s quite likely that we’re entering a period of recession, there are some big differences between the real estate market today compared to 2008:
- Household incomes and debt levels have only slightly increased between 2008 and 2020, helping to keep real estate prices from inflating as rapidly as they did right before the GFC hit.
- According to the Federal Reserve Bank of St. Louis, median sales prices of houses have increased over the last 12 years, but since Q4 2017 prices have been more or less stable, a sign that the market was already beginning to cool well before the virus.
- While subprime mortgages were made by almost every major bank back in 2008, the vast majority of mortgages today are being made by lenders requiring good credit scores and more conservative LTV (loan to value) ratios.
Update your tool chest: Better tenant management tools
The number and quality of technology tools available to manage your real estate investments and tenants has significantly grown over the last 10 years. In fact, many of the best ‘proptech’ tools available today are absolutely free:
- Stessa: Cloud-based dashboard solution for rental property financial management is 100% free with optional premium services such as mortgage financing.
- DocuSign: The ESIGN Act makes electronic signatures legally binding in every state and DocuSign is the exclusive eSignature provider for the NAR (National Association of Realtors).
- Google: Use all the free Google tools such as Gmail for email automation and sorting, documents creating with Google Docs, spreadsheets for financial analysis with Google Sheets, and Google Forms for rental application tracking and submission.
Tools like these allow investors to begin the important process of digitizing their businesses and automating recurring tasks. But there is so much more out there such as communication tools like Slack and project management software like Trello. Now is the time to optimize your logistics and operations with these free digital tools.
Your recession team: Focus on financing
Take one or two investor-friendly lenders to lunch in each market you invest in. Letting your bank put a name to your face is a great way to fast-track your loan application when a great deal comes across your desk.
Focusing on smaller local community banks and credit unions can create the best relationships much more so than large national banks. If you haven’t already, consider refinancing some existing properties to make the most of today’s low interest rates.
Refinancing will provide you with some liquidity that could be used either as a financial buffer during a down market in case of extended vacancy, or allow you to be opportunistic if distressed properties become available.
Turnover: Get your marketing in order
Savvy real estate investors know that the current state of the economy will affect vacancy levels and market rents. Understanding how to market during a recession helps to keep your tenant turnover low and cash flowing:
- Know your market like the back of your hand by constantly monitoring asking rents using sources such as Rent Estimates (more on this later).
- Advertise your property with a full court marketing press that includes online and offline channels. These include local Facebook groups, Craigslist, apartment listing sites like Apartments.com, the MLS, and local directories.
- Finding good tenants can be hard during a recession, so staying flexible on items such as roommates and pet owners can help keep turnover and rental property vacancy during a recession low.
- Communicate early and often with tenants so they know you’re a diligent and fair landlord. A positive and communicative relationship with tenants will reduce turnover in the long run and keep tenants happy.
Pricing is critical: Know your market rents inside and out
During recessionary times people still need a roof over their heads, but they may be more sensitive to price. This is because of economic uncertainty and potential job losses.
Over-priced rental property could be hardest hit as tenants are more likely to downgrade or shop around given the financial stress. This is why it’s important to peg your rents to the market in order to avoid tenant turnover.
Patrick Carlisle, Chief Market Analyst at Compass notes that “In very expensive housing markets such as San Francisco’s, if unemployment jumps dramatically for newly unemployed tenants paying market or close to market rents, they often relocate very quickly en masse.”
Carlisle continues that “it’s hard to justify $3500-$4000 for a 1-bedroom apartment if your high-paying, high-tech start-up job disappears. So, vacancy soars. This is what occurred after the dotcom bubble popped: SF rents dropped 25% in a relatively short period.”
Indeed, the current COVID-19 pandemic is hitting expensive markets such as San Francisco very hard. According to Zumper, in June of 2020 San Francisco saw a year-over-year rent drop of 9%. According to Crystel Chen of Zumper, “San Francisco rent is down over 9% year-over-year, which is the largest decline ever…Similarly, the 3 next most expensive markets, New York City, Boston, and San Jose, all had negative year-over-year changes for their respective one-bedroom rents as well.”
Carlisle gives us further advice to landlords during recessionary periods, “Landlords might proactively reduce rents to keep tenants in place as opposed to waiting for move-out notices, and the high costs of vacancy and re-rental. Even tenants not moving out of the area might well relocate to other apartments offering significantly lower rent rates as the market adjusts.”
“Landlords must keep a close eye on whether market rents for vacant apartments are dropping significantly. Tenants don’t want to move, but if they see apartments for rent next door at much lower rents, they’ll move.”
Smaller can be better: Power of secondary and tertiary markets
Over the last few years, cap rate compression – where returns are pushed down due to rising property prices – has been occurring in many major metro areas such as Los Angeles, Chicago, and New York City.
In some of these cities, it’s not unusual to see cap rates of 2-4%, which means asset prices are very high compared to the income generated. This is why we are seeing a growing interest in secondary and tertiary markets.
According to a recent Redfin report, interest in small and rural towns in America has skyrocketed, and the great move to remote work is only going to exacerbate this demographic trend. According to Tim Ellis, Senior Data Journalist at Redfin, “It looks like the housing market in rural areas and small towns will weather the storm through coronavirus shutdowns better than the big cities. We may also see an increase in home sales in these less densely populated areas in the long term as well, as homebuyers look to get away from the cities or just purchase a second home that they can retreat to when times in the city get rough.”
People and businesses are moving to smaller cities where the cost of living is much lower, job opportunities are better given the rise in remote work, and the quality of life is greater. Investors looking for higher yields and lower prices can find better investments in middle-market cities with strong anchor employers and positive migration.
Liquidity: Cash is king during down markets
The more liquid you are during a recession the better. Having access to immediate funds sitting on the sideline – also known as ‘dry powder’ in the real estate investing business – allows investors to maintain a capital reserve should they experience extended vacancy or rent reductions. Further, it will allow you to capitalize on any distressed opportunities that arise from the down market.
Refinancing is a great way to do this to free up some capital. The money you pull out from a refinance is tax-free, and in today’s interest rate environment, you may even be saving yourself some money in the long run by locking in a record low rate.
A HELOC (home equity line of credit) is another good way to have access to funds when and if you need it. Lines of credit on properties with large amounts of appreciation let you turn equity into investable cash fast.
OPM: Money is looking for you
Families in the top 50% of our nation’s income bracket have retirement plan balances ranging from about $250,000 to upwards of $650,000, based on the most recent data from the Federal Reserve.
Most of that money is in the stock market, and recessions typically hurt the stock market. Many of these people would like to invest in real estate because it has a low correlation to stocks, but aren’t quite sure how to do it.
Fortunately, you do know how to invest in real estate and would be happy to show them how.
Start by putting a small JV or partnership together with friends and family. Then, tout your investment success by networking at your local investment club to find people looking for alternative ways to invest.
Optimize your assets: Diversify your portfolio with a 1031 exchange
Most investments perform well with solid cash flow, long-term appreciation, and mortgage paydown. Other ‘outlier’ properties overperform, usually with surprisingly large amounts of equity, while others may barely break even.
Now is the perfect time to rebalance your investment portfolio by turning accrued appreciation into cash to reinvest and dumping the underperformers.
The IRS allows real estate investors who use a Section 1031 tax-deferred exchange to defer the payment of capital gains tax by selling an investment property and buying another. Portfolio diversification using a 1031 is a great way to take advantage of potential deals by having more investment capital to increase the total cash flow in your rental property portfolio.
- The 2008 credit bubble is very different from our current economic situation.
- Improve your tenant management with proptech tools like Stessa, DocuSign, Trello, Slack, and Google.
- Focusing on financing with local investor-friendly lenders and brokers during a recession can help fast-track your loan application.
- Conducting a full-court marketing press helps keep vacancy due to tenant turnover low.
- Missing middle and workforce rentals in secondary and tertiary markets can offer lower prices and higher yields than property in major metro areas.
- Rebalance and diversify your portfolio by using a 1031 exchange to cash-out of under-performing properties.
- Seek to network with those who want to passively invest in real estate.