Are We at the Top of the Real Estate Market Cycle? 6 Things for Investors to Consider
I’ve heard this question in some form or another at least a dozen times over the past few months. It’s a reasonable question considering the run we’ve been on since the bottoming out in 2009. However, from an investor’s perspective, is it the right question to be asking?
Too often, whether it is in the stock market or real estate market, people try to time the very bottom or the very top of the cycle. As investors, we need to be aware of where we are in the cycle on both a macro level and on a local level. This fundamental understanding will allow us to make the necessary changes to our business model in order to adapt to the current market climate. The most important question we need to answer for ourselves is whether our investment strategy can withstand or even thrive in the event of a flattening or bear market.
6 Points to Consider:
1) Let’s get this out of the way, we’re definitely not at the bottom of the market. According to the latest quarterly report from the National Association of Realtors, nearly two-thirds of United States housing markets are at all-time highs. The largest driver of this is that inventory is very low which contributes to an upward pressure on prices. The main concern; however, is how rising interest rates will affect the housing market and whether or not it will drive the currently high demand down.
2) It’s important that investors take a critical look at the success they have had over the past few years while the market has continued on an upward trajectory. If the market’s natural appreciation had stayed flat would they have made money, lost money or broken even? Many investors and homeowners alike have enjoyed massive gains in certain markets purely based on appreciation. This is a great thing if you’re a homeowner but if you’re an active investor then you need to consider how your business will need to change or adapt in the event of a flattening or downturn.
3) Risk Mitigation & Stress Testing: Absolutely, NO ONE knows where any market is going at any given time. If you haven’t set yourself up to weather a storm, you are in trouble. Regardless of where we are in the cycle, you need to stress test each investment you make. If you evaluate your investments in an excel spreadsheet, consider adding a “market drop” component to the final profit calculation. If you’re a developer, what happens if your, already conservative, (hopefully) sell out estimates drop by 10% or 15%? Are you still making money? Factoring in this disaster scenario into your spreadsheet will help you calculate a purchase price that will allow you to profit if the market dips 10-15% during your hold period.
4) Don’t buy for short-term appreciation. In hot markets, rookie investors will buy assets under the assumption that the appreciation pattern they have been witnessing will continue indefinitely. Inexperienced brokers often feed this notion as they push to get deals done for clients. How many times have you heard some variant of “I don’t see it going down,” or “its appreciated 10% last year, it's probably going to go up more next year?” The most dangerous part of this attitude is a lot of times they haven’t been wrong… YET. If you “overpaid” for a property last year in markets like Boston, Denver, Austin, or San Francisco, you’ve probably been fortunate enough to have still enjoyed a boost in value from market appreciation. If all of your profit margin is tied to appreciation, then your deals will fall apart as soon as the appreciation stops.
5) Buy for Cashflow. If you buy an asset that cash-flows from day one at your purchase price while taking your leverage into consideration, you are in a much better position to weather a downturn. Consider purchasing stabilized assets with longer-term value-add components that can be switched on or off according to market conditions. The major key to this strategy is structuring your debt for a longer term than you think you might actually need. This will allow for flexibility and prevent a forced sale at an inopportune time in the cycle.
6) Target more resilient asset classes. If you have been building ultra-luxury condos or Class A office buildings, it may not be the most profitable strategy in a bear market. Those types of assets will be the first to de-value if the market takes a turn. Consider buying more resilient asset classes such as Class B&C multi-family apartments in stable markets or single-tenant retail structured with long-term leases by nationally recognized tenants such as a Walgreens or CVS. The beauty of real estate is there are many different asset classes that perform differently in different parts of the cycle.
While it’s important to know roughly where we are in the cycle, it is nearly impossible to know for sure. As you invest in real estate whether actively or passively its important to understand how the different business models, markets and asset classes will perform during different market cycles. As always, make sure you diversify your investments and don’t put all of your proverbial eggs in one basket.