Maximize Profits in Any Stage of the Economic Cycle (Even a Recession)

Let’s discuss the basics of how the economy works, how we can know that we’re getting ready to enter one specific part of the cycle (a downturn, or recession), and how we should be modifying some of our strategies and tactics as real estate investors during this part of the cycle to reduce our risk and maximize our profits.

This is essentially an overview of my book Recession-Proof Real Estate Investing: How to Survive (and Thrive) During Any Phase of the Economic Cycle. But there’s a whole lot more that we as investors should understand in order to navigate the economic cycle. There are also a whole lot more strategies and tactics that we can be using to reduce risk and maximize profit during a recession or during any other phase of the economic cycle that we won’t necessarily cover here.

So, if you find this introduction valuable, I hope you’ll check out the book. It’s available in the BiggerPockets Bookstore in all formats.

With that said—let’s get started.

Market, Economy, and Cycle

These three words form the backbone of our discussion around recession-proofing your investment business.

We’ve all heard these words, but how do they relate to our real estate business?

Let’s find out.

What Is a Market?

To understand what a market is, we need to take one step back and talk about transactions.

We live in a transactional world. Every day, billions of times per day, financial transactions take place between buyers and sellers. Buyers give money in the form of cash or credit to sellers, who in return provide a specific good or a service.

For example, I might give cash to a restaurant for food. I might give cash to a car dealership for a new car. I might use credit in the form of a bank loan to purchase a house. These billions of transactions per day are based around many thousands of different good and services.

A market is simply the aggregate of all the transactions around one specific product or service.

The automobile market is simply the sum of all of the transactions that involve automobiles.
The gold market is all the transactions that involve buying and selling gold.
The real estate market is simply all the transactions that involve real estate.
And the stock market is made up of all the transactions that revolve around the buying and selling of public stocks.

And there are thousands of these markets. The corn market, the wheat market, the pork market, the oil market. The cell phone market, the personal computer market, the software market. The residential housing market, the commercial housing market, the self-storage market. There are literally markets for any other good or service you can imagine.

What Is an Economy?

All of these markets put together is what we call an economy.

To recap, the economy is made up of thousands of markets, which in turn are made up of billions of transactions. When we talk about the economy, we are simply talking about the sum all of those transactions within all those markets.

As you might expect, the number of transactions—and the size of transactions—that take place every day across all these markets isn’t always going to stay the same.

There will be months and years where there are more—and bigger—transactions. When we see more and bigger transactions, and there’s lot of cash and credit flowing through the markets, we typically refer to the economy as strong.

Then there are times when there are fewer—and smaller—transactions. During these periods, when there is less money flowing through the markets, we typically refer to the economy as weak.

There are a number of economic factors that tend to come together to make an economy strong; then, over time, those same factors that led to the strong economy will cause issues that weaken the economy and push it down. Eventually, those same factors will conspire to lead the economy to become strong again.

What Is a Cycle?

This pattern of strong economy leading to a weak economy leading back to a strong economy is called a cycle.

One period of economic strength and growth leading to a period of economic weakness and contraction and leading back into a period of economic strength and growth is referred to as a single economic cycle.

These economic cycles happen regularly. In fact, we’ve had 33 of these full cycles over the past 160 years.

Thirty-three full cycles in 160 years? Some quick math tells us that an average economic cycle lasts about five years.

We typically refer to the growth part of the cycle as an expansion. That eventually hits a peak and leads into a slowdown, which we refer to a contraction—which eventually hits a bottom and leads into the next expansion.

Today, we’re focused on this middle section: the contraction. This is also commonly referred to an economic downturn, or a recession.

Investing during this phase of the economic cycle can be tricky. But if you make good decisions and structure your business correctly, not only can your real estate business survive this period, it can thrive.

How to Identify an Economic Downturn

Before we talk about how to adjust our strategies and tactics during a recession, let’s talk about how we know we’re entering this phase of the economic cycle.

There are a number of qualitative and quantitative measures we can look at that will let us know that a recession is approaching—or has arrived.

By qualitative, we mean those indications that aren’t necessarily measurable, but they resonate with our feelings and our emotions. They can be just as valuable as quantitative measures, which are those based on actual data and statistics.

Some of the qualitative indications that we’re approaching or in a recession are as follows.

1. Desperation Selling

The first one I like to look for is desperation selling. Again, there are no numbers behind this. This is just something you’ll recognize when you see it. But as we move into the recession phase of the economic cycle, we start to see sellers getting desperate to sell.

They’re seeing that the economy’s changing. They’re recognizing that this could be the last opportunity that they have to lock in the equity that they built in their properties over the past several years. So, they’re looking to get out before their home values drop.

We start to see a lot of housing inventory hitting the market. We see sellers who are willing to chase prices down and do whatever it takes to get their houses sold. Sellers are starting to get scared—either because they are forced to sell, they’re in a bad financial situation, or they just recognize that this is the last opportunity that they’re going to have to capture some of the equity that they gained during the last expansion.

2. Lending Tightening

Next, we start to see lending getting tight. This may be gradual or it may be sudden.

From an investor standpoint, we may start to see portfolio and commercial loans getting tighter. A lot of portfolio and commercial lenders don’t want to lend to flippers anymore, so they’re slowing down.

Additionally, we may start to see a tightening in the conventional lending space as well. FHA, VA, conforming Fannie and Freddie loans—all of these start to require higher credit scores. They start to require larger down payments. And they start to get more serious about verifying income and verifying borrower assets.

So, it gets harder not just for you as an investor to buy properties using loans and leverage, but it’s also harder for your customers—your buyers—to buy those properties from you. And because we see this difficulty on both sides (difficulty from the buying standpoint and difficulty from the selling standpoint), it gets very challenging for those investors who make money by buying and selling properties to continue to profit in this part of the cycle.

Those are just a few of the qualitative indicators we see when we’re entering—or have entered—a recession.

Now, let’s jump into some of the quantitative things that we can look at to know that we’re in the recession part of the cycle.

3. Gross Domestic Product Falling

The first and the most obvious is a drop in Gross Domestic Product (or GDP). I say that’s the most obvious simply because that is the government’s formal definition of a recession. When the government sees two quarters of slowdown in GDP, that’s typically when they declare: “We are now in a recession.”

4. Housing Inventory Increasing

Next, housing inventory exceeds six months. Leading into a recession, we start to see housing inventory increase. Once housing inventory gets to about six months or above six months, we see a reversal from a seller’s market (a real estate market that’s beneficial to sellers) to a buyer’s market (a real estate market that gives buyers an advantage).

Depending on how bad the recession is, we might top off at six, seven, or eight months of housing inventory at the worst part of the recession. Or if we have a really bad recession, that number can hit 12, 14, even 18 months of inventory in some markets.

After 2008, there were several markets around the country that saw 14, 16, and 18 months. That’s a year and a half of housing inventory. In other words, it would take a year and a half to sell off all that inventory based on the average amount of transactions that are taking place.

5. Pre-Foreclosures/Foreclosures Spiking

Then, we start to see a spike in pre-foreclosures, something we often refer to as 30/60/90-day lates. The government measures when people are 30 days late on their mortgage, or when they’re 60 days late on their mortgage, or when they’re 90 days late on their mortgage. And as these three metrics start to rise, that’s an indication that people are having trouble paying their mortgage or choosing not to pay their mortgage.

When we see 30-, 60-, and 90-day lates spike, that’s generally an indication that we are either heading into the recession or we’re strongly in the midst of a recession.

To go along with that, we will see an increase in foreclosures. Depending on what state you live in and their foreclosure laws, those 30-, 60-, and 90-day late-payers may translate into foreclosures either sooner or later.

In some states, after 30 days or 60 days of missing your mortgage payments, it’s easy for a lender to declare foreclosure and start the foreclosure process. In other states, it takes a little bit longer to start and get through the foreclosure process. So, while the 30-, 60-, and 90-day lates don’t necessarily translate directly into the number of foreclosures, they are a good indication of how many foreclosures we’re likely to see in the future.

6. Home Prices Falling

In some markets, we may see a modest drop in house prices. In other markets—and in some recessions—we may see a major drop in house prices.

We don’t always see home prices drop precipitously during a recession, though. In fact, during some recessions, we see prices level off or even increase. But it’s not uncommon to see a drop in values in many markets.

7. Appraisals Coming in Low

Banks are starting to be more diligent about how they’re valuing properties. They recognize that prices may be dropping. So if your home was worth $100,000 yesterday, the bank will start to get concerned that your home’s going to be worth $95,000 tomorrow or $90,000 next month. And to account for the fact that your home price may drop throughout the recession phase, banks will often devalue their appraisals.

8. New Construction Pausing

Next, we often see an oversupply of new construction. This is what a lot of you probably saw if you were paying attention after 2008—especially in markets that saw strong growth in 2005, 2006, and 2007.

Developers recognize that they’re not going to be able to finish out their subdivisions or their new construction before we hit the downturn. So, they may simply stop construction. In some cases, they’ll hand the property back to the bank. In other cases, they’ll try and sell it off or try to hold onto it throughout the recession.

Finally, during many recessions and in many markets (and again, this isn’t going to necessarily apply to all markets and all recessions), we’re going to see a decrease in market rents and we’re going to see a decrease in occupancy—especially in the A-class and B-class properties that were focused on high-earning tenants who may lose their jobs or see a reduction in hours or wages. Many of these renters will downgrade their housing, moving from A-class to B-class, or B-class to C-class, to save money.

These are the measures that we often use to determine that we are either heading into a recession or that we’re in the midst of a recession. This is important to know. But what a lot of us are probably wondering is: how do we make money during this time?

How to Invest in Recession Times

In the world of estate investing, we often talk about strategies vs. tactics. Strategies are the high-level niches that are most common in this business, such as:

Flipping Houses
Buy and Hold
Wholesaling
Notes
Multifamily
Lending
Commercial
Self-Storage

Tactics are the implementation of those strategies—the day-to-day decisions we make to ensure that the strategies we’re using will allow us to reduce risk and optimize profits.

Wholesaling

For example, a common investing strategy is wholesaling. A lot of people think that wholesaling doesn’t work well during a recession. And to a large degree, they are correct.

But just because the strategy, in general, doesn’t work tremendously well, doesn’t mean that there aren’t tactics within the wholesaling strategy that do work. Specifically, one common tactic that works well for wholesalers during a recession is selling to landlords, as opposed to investors or retail buyers.

During good economic times, wholesalers typically focus on house flippers as their primary customer. That’s because it’s house flippers who are buying the most distressed properties when the economy is strong.

But when the economy starts to turn, house flippers tend to sit on the sidelines or adjust their strategies to something other than house flipping, making it very difficult for wholesalers to continue making money selling to flippers.

In addition, when the market turns, there are typically a lot of buy and hold investors—residential landlords, for example—who have been sitting on the sidelines for months or years waiting for more affordable properties to come along. They often have cash and are eager to pick up cheap properties. And because they aren’t planning to resell the property anytime soon, they don’t care if the market is dropping and they aren’t buying at the bottom.

Good wholesalers will focus on finding properties that suit these buy and hold investors and will work to build a buyer’s list of these landlords. During the 2008-2011 downturn, I know several wholesalers who made a killing by modifying their tactics to focus on buy and hold properties and investors, and they were able to weather the economic storm while most other wholesalers had to shut down their businesses.

This is just one example of how wholesalers can modify their tactics during a downturn to reduce risk and optimize profits. There are many more…

Fix and Flipping

Let’s turn our attention to house flippers for a minute. While flipping houses during a downturn isn’t the best strategy to pursue, there ARE ways to ensure that you are making the highest profits possible with the least risk if that’s the strategy you choose to pursue.

A couple tactics that work well for flippers during a downturn include:

First, buy in great school districts. Data indicate that prices tend to fall less in good school districts, meaning you’ll have the largest pool of buyers and the most opportunity to capture the highest resale price;
Second, focus on properties at the median price point in your area. If the average house in your area sells for $300,000, you shouldn’t be trying to flip a $700,000 house or a $50,000 house. Data indicate that houses well above or below the median price point tend to slow faster and more drastically during a downturn. This is because buyers in these price points are more at risk of losing their jobs and find it more difficult to get financing.

There are a lot more tactics that house flippers should be considering when continuing to flip during a downtown, but let’s turn our attention now to buy and hold investors.

Buy and Hold

What can residential landlords do during a downturn to reduce risk and preserve profits? Here are a couple tips:

First, focus on C-class properties. During a recession, we often see rents and occupancy rates drop in A-class and even B-class properties. This is because renters are losing their jobs and seeing reduced hours and wages. They are looking for smaller and less expensive housing and will often move down in housing class. But everyone needs a place to live, and because C-class housing will give the best bang for the buck for renters, it tends to hold up the best. In fact, in many areas around the country back in 2008, C-class housing outperformed the market—rents continued to climb and occupancy rates increased.
Second, consider college housing. A little-known secret is that during a recession, college enrollment increases! This is because a lot of people can’t find steady work, and decide that now is a good time to go back to school and add some additional credentials and skills. Landlords in college towns often find that finding and keeping tenants is a lot easier—and more profitable—than in other locations.

There are a lot more tactics that buy and hold investors should be considering when buy and holding during a downtown, but let’s turn our attention now to commercial investors.

Commercial

If you like commercial, there are some tactics that you can employ during a recession that will tremendously improve your chances of success. A couple of them include:

Self-storage. During a downturn, people tend to downsize their houses, but they don’t downsize their stuff. So, we typically see increased demand for self-storage during a downturn.
Also, medical centers. If you’re a commercial investor looking to buy commercial space, consider medical offices. Medical services tend to be very recession-resistant, so you can be confident that your tenants will continue to pay their rent and renew their leases.

These are just a few of the tactics that wholesalers, flippers, landlords, and commercial investors can use during an economic downturn to reduce risk and increase profits. But there are a whole lot more.

And, if your preferred investing strategy is note buying, lending, multifamily, or anything else, there are lots of tactics that you can employ, as well.

If you want to learn more about these tactics, about the strategies and tactics that work in other parts of the economic cycle and about how the economy and cycles work, in general, I hope you’ll check out Recession-Proof Real Estate Investing: How to Survive (and Thrive) During Any Phase of the Economic Cycle, my latest BiggerPockets book.

Now, go recession-proof your business today!

Questions? Comments?

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.