The Science of Finding Deals - Part 6: How to Profit In Any Market

As part of boiling down finding deals into a science, you got to KNOW your market (from now on, to avoid confusion, I am going to call this your AREA). Also, you got to know what market cycle (I will refer to market cycles from now as "market" for simplicity) your AREA is currently in. Why? 

You can buy and sell houses in ANY market but HOW you buy and sell will depend on the market.

In this blog post, I will prove the above statement based on experience and actual market data. But first...

Here are the 4 market cycles or phases:

(pardon my crude drawing - drew this on my tablet)

S1 or Seller's Market Phase 1: I refer to this as a NORMAL market. A normal market is when property values go up proportional to inflation. The US government's official inflation number is 1.6% as of 2014 (although I believe the real inflation figure is really closer to 5% by the time we consider the price of gasoline and asset prices like home prices). In an S1, DOM (Days on the Market) is around 90 days (that's the time that it takes for a house to sell on average).

S2 or Seller's Market Phase 2: I call this your HOT market or bubble. A hot market is when property values go up significantly higher than inflation or significantly higher than 5%. DOM is around 30 days or even less.

B1 or Buyer's Market Phase 1: I call this a DECLINING market. Prices of real estate goes down significantly during this market phase (+10% per year). We experienced this in the US in 2008-2010. DOM can be as long as 180 days or even longer.

B2 or Buyer's Market Phase 2: I call this a STABILIZING market. The price of real estate will not decline indefinitely. At one point, the price will be good enough that it makes sense to buy. Also, when enough big money gobbles up enough real estate inventory, prices will stop declining and the market starts going back to normal (back to a Seller's Market Phase 1).

NOTE:  The above drawing is an idealized representation of reality. There will be fluctuations based on seasonality for example. Also, a market could change from NORMAL market to a DECLINING market due to extraneous factors like loss of jobs (say a major industry collapses or leaves an area). A HOT market may not suffer a declining market - it could go to a stabilizing market and then back to normal again. Lastly, in a real estate market, single family homes could be in an S1 market while apartment buildings could be in S2 market. Each real estate type has different market dynamics.

Even though the above drawing is an idealized version of reality, it is close to what happens in reality. 

Where's the proof?

I can speak for Chicago since I invest in Chicago. Below is the Case Schiller Index of  Chicago single family homes and condos:

As one can see from the above, we were in an S1 Market in the 1990s and the BUBBLE (S2 market) started in 2001 (that's when Alan Greenspan started decreasing interest rates). The real estate bubble popped in 2007-2008 (B1 market) facilitated by the sub-prime collapse and the price stopped declining in 2011 (B2 market). In 2013, we were back to an S1 market and on our way once again to an S2 market.

This is Good BUT How Do We Make Money With This?

In every market, there are good and bad exit strategies to have. An exit strategy is HOW you make money with a property. For example, fix-n-flip is an exit strategy. Renting a property is another exit strategy.

Let's discuss each market phase and the smart and not-so-smart exit strategies to have in each market phase:

1) S1 or Normal Market

Good Strategies (Fix-n-flip, New Construction, Rent to Own)

Bad Strategies (None)

Rationale:

New construction, fix-n-flip and rent to own are strategies that work better when real estate prices are going up. Building a house from the ground up might take up to 12 months. It will be good to know that the market value at that time is higher than when you started.

2) S2 or HOT Market

Good Strategies (Fix-n-Flip, Rent to Own but focus on short term appreciation)

Bad Strategies (New Construction, Land Development)

Rationale:

In a HOT market, short term appreciation plays like fix-n-flip (which takes 6-12 months) and short-term rent to own (12 months) are good strategies. You maximize profits but you take them out quickly because the market could go down. New construction and land development are risky strategies because of the impending decline in property values.

During this phase, unless the cashflow you're getting from your rentals is great, it's time to sell everything you own. Focus on raising CASH so you can profit from the impending crash.

3) B1 or Declining Market

Good Strategies (Renting but you need to focus on CASHFLOW)

Bad Strategies (Fix-n-flip)

Rationale:

Fix-n-flip is not good in a declining market because by the time you finish rehabbing a house and selling it, the value has dropped. Renting is good but you got to buy the properties dirt cheap and the cashflow has to be GREAT. 

4) B2 or Stabilizing Market

Good Strategies (Renting, Rent to Own, Land Development)

Bad Strategies (None)

Rationale:

Land development is a good strategy because you're preparing to cash in when the next market phase comes along - S1 - where new construction will become a viable exit strategy again. Also, in this phase, you should buy everything you can get your hands on because there's no way to go but up :-)

NOTE: The above is a generalization or big-picture point of view. You can find good deals in any market for whatever exit strategy that best fits the property and the AREA. For instance, even in a B1 market, you can find good fix-n-flip deals. You just need to be more conservative in your acquisition price and sell your flips competitively (price it 10% below market).

SO, the BILLION DOLLAR Question: IS IT POSSIBLE TO PREDICT WHEN THE NEXT MARKET PHASE WILL OCCUR?

Yes and NO. Back in November 2005, I read some experts say that the real estate market is going to crash. They were about 2 years ahead of the actual collapse. So yes you can predict when the next market phase can occur but the nature of bubbles is that you don't really know how big a bubble will be before it actually pops. So NO you cannot predict accurately the exact day and month when the next market phase will happen.

I believe though that one LEADING INDICATOR of real estate prices is new foreclosure filings. If foreclosure filings increase every month for 12 consecutive months, that could signal the market is about to decline. Why is foreclosure filings a leading indicator of a decline? 

It takes some time for a foreclosure filing (meaning the homeowner is 3 months behind on his mortgage payment and has received a Summons to Foreclosure or Lis Pendens) to go through the foreclosure process and become part of the foreclosed inventory (REO or banked owned property). 

Also, when enough percentage of houses in a neighborhood becomes foreclosed, the property values in that neighborhood will start declining which will result in further declines because more houses in that neighborhood will become foreclosed (resulting in a vicious cycle of foreclosed inventory leading to declining property values which leads to more properties being foreclosed).

The reverse is also true - declining foreclosure filings will eventually lead to stabilizing property values (B2) and eventually to an S1 or normal market. See the graph below for Chicago and compare this to the Case Schiller Index above:

So, here's the SUMMARY: you need to know your AREA and the market phase your market is in. Why? Because there are good and bad exit strategies in each market. Predicting the next market phase is possible but you cannot pin it down very accurately. The important thing is to be aware of the market and being flexible in your exit strategies. If you do so, you will make money in real estate regardless of where the market is at...even when it's crashing!