Real estate investing lessons from the Great Recession applied to 2020

Real estate investing lessons from the Great Recession applied to 2020
by Brad Cartier, posted in Guides

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.

 

 

It’s tempting to lump every recession together as having the same cause and effect. However, there are some big differences between the recession of 2008 and the one we’re entering today.

In this chapter, we’ll explain what really caused the Great Recession of 2008 and how to apply the lessons learned 12 years ago to holding investment real estate in today’s downturn.

Why was the recession of 2008 so bad?

The Institute for Research on Labor and Employment (IRLE) at Berkeley University of California reports the Great Recession of 2008 was caused by predatory lending and securities fraud:

  • Fraudulent activity leading up to the crash of 2008 was widespread
  • Mortgage originators commonly deceived borrowers about loan terms and conditions
  • Banks gave risky “NINJA” and Jumbo loans knowing the loans would likely default
  • Loan quality in mortgage-backed securities (MBS) was frequently misrepresented in order to sidestep underwriting standards and make the securities easier to market as “investments” and derivatives

Great Recession of 2008 – 2009

When the mortgage industry in the U.S. collapsed in 2008, the country and the rest of the world when into shock:

  • Government-backed companies Fannie Mae and Freddie Mac failed and were taken over
  • The stock market crashed in 2008, with the Dow Jones Industrial Average plunging by over 50% and not recovering until five years later
  • Lehman Brothers filed for bankruptcy in September of 2008, resulting in a market panic and a rush into safer investments
  • Despite government efforts such as the Homeowner Stability Initiative and the Homeowner Affordable Refinance Program (HARP), banks selected only the best applicants while preferring to foreclose on over-leveraged loans instead

How what’s happening today is different

The Great Recession of 2008 was created by bad banking policy in the housing sector that rapidly infected all parts of the global economy. Today’s recession is caused by an infection of a different kind, with government policymakers in 2020 responding by focusing on safety rather than struggling to work through the fundamental economic imbalances of 12 years ago.

More savings

The personal saving rate in the U.S is currently at about 33%, helping to keep household debt today at about 76% of GDP. In 2008, thanks to banks’ loose lending standards, consumer debt skyrocketed to nearly 100% of gross domestic product.

Unemployment rates

Pew Research Center reports that while unemployment is higher than during the Great Recession, the economy today is affected in different ways. In 2008, job losses came mainly from the construction and manufacturing sectors. So far this year, job losses are coming primarily from the leisure, hospitality, and educational sectors which can more easily be replaced when the economy begins to recover.

Conservative lending

Just before the real estate market crashed in 2008, pretty much anybody could get a home loan. People without income, bad credit, or no money for a down payment easily qualified for “NINJA” loans (given to borrowers with no income, no job, and no credit) well above the home’s appraised value.

Lenders today are much more conservative. High-risk, pre-crash subprime loan products have been replaced with full-doc loans requiring a good credit score and a down payment of at least 3%, if not more.

Patrick Carlisle, Chief Market Analyst at Compass notes that

“Unlike the dotcom bubble popping, in which rents were hit much harder than home prices (due to soaring unemployment), in the 2008 downturn rents were hit less than home prices because the problem was predatory lending and home buyers and owners taking on loans they couldn’t afford in the first place.”

Carlisle continues that “predatory mortgage lending didn’t affect renters. In our current crisis, the problem is not overly indebted homeowners – in fact, mortgage debt service percentages are close to all-time lows because of interest rates. The problem will probably be soaring unemployment among a younger demographic of tenants paying very high rents. SF and the Bay Area generally have the highest rents in the nation. Unfortunately, for many high-end landlords, one of the ways they have been justifying very high rents are amenities that have lost their value with shelter in place: gyms, pools, party rooms, roof decks with barbeques, planned social events and so on.”

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Real estate is hyperlocal

You’re probably familiar with this quote from Robert Kiyosaki, author of Rich Dad Poor Dad: “The problem with real estate is that it’s local. You have to understand the local market.”

In fact, not only is real estate local, but the most successful investors also say that real estate is “hyperlocal.” Unlike any other asset class, real estate stays where it is and is held captive to the dynamics of the local community or area you’re investing in.

Basic economic principles that influence real estate market values include:

  • Anticipation of future potential profitability and advantages.
  • Change within and outside of the local market.
  • Conformity where median properties that are closest to the market norm are more valuable than the outliers that don’t “fit the mold”.
  • Contribution means features and updates are only valuable if the local market is willing to pay more for them.
  • Competition levels between investors to buy or sell and between owners trying to attract the same qualified tenants.
  • Highest and best use generates the greatest occupancy and income levels, which helps to explain why there is so much vacant retail space while rental property of any kind can be very hard to find.

Leading indicators to monitor and measure

To be fair, economic concepts are oftentimes unnecessarily complex. Fortunately, you don’t have to hold a PhD to predict in a common-sense way which direction the economy and local real estate markets may be moving in:

  • Interest rates are hovering at historical lows, meaning real estate can be financed inexpensively with demand likely growing as investors desperately search for yield.
  • Decay of urban areas with a high cost of living and low quality of life are seeing population losses as millennials flee to the suburbs and re-embrace affordable small-town living.
  • Population and job market growth are disproportionately strong in many smaller secondary and tertiary markets, where lower property prices and higher ROIs are a magnet for real estate investors.
  • Income levels trending downward increase the demand for well-managed housing with fair market rents.
  • Housing supply and demand imbalance continues to grow due to developers’ misplaced focus on “luxury property” that tenants today simply can not afford while workforce housing remains in short supply.

What we learned from 2008

Even in the best of times, savvy real estate investors hope for the best and plan for the worst. While the government seems intent on preventing a 2008-style housing crash, pragmatic property owners can do several things to prepare themselves for what may lie ahead:

  • Lock-in today’s low-interest rates by refinancing into long-term fixed-rate loans.
  • Keeping a conservative loan-to-value ratio (LTV) creates an equity cushion against short-term property price declines.
  • Line up a home equity line of credit (HELOC) for a property with high levels of accrued equity that you can turn into cash fast.
  • Hold off on discretionary personal spending to raise liquidity levels and have cash sitting on the sidelines for when the right investment opportunities come along.
  • Make tenants your #1 priority by communicating and staying flexible, because some cash flow is better than none and it’s their rent that pays your bills and builds your wealth over the long term.

Conclusion

Twelve years ago, systemic fraud by mortgage lenders caused the global economy to crash. Today, government mandates around the world have put the economy on hold intentionally, to minimize health risks with the eye on business recovery sooner rather than later.

While the Great Recession of 2008 created havoc for many property owners, some real estate investors were able to exponentially grow their wealth by planning ahead. Distressed sellers usually emerge during a recession, creating an opportunity for real estate investors to buy low and generate cash flow to help ride out the storm.

Patrick Carlisle had some parting words of wisdom for real estate investors looking to take action during recessionary times:

“I’ve seen several big recessions over the last 30 years. The biggest problem – the problem that most often leads to foreclosures or forced sales at low prices in recession after recession – is of investors being over-leveraged: Taking on too much debt which is dependent upon rents remaining high to service.”

“Trying to buy too many buildings instead of providing a strong financial basis for a smaller number. The investors that ride out the recession – and often take advantage of it to expand their portfolios – are well-capitalized, have solid financial foundations, with substantial reserves, and run well-managed properties. A drop in rental income, even significant, does not put them in an untenable economic situation.”