Market Corrections and how to approach them

[Yashar E.]

Hello BPers,

As we all spend time analyzing deals and determining “flip” or “buy and hold” I was wondering if anybody here currently runs their numbers anticipating another major market correction.

I am not sure if another housing crash comparable to the last one is possible. In any instance, it seems reasonable to think when a correction does occur, which ever market is hit, there will be issues that trickle down. Some issues would be tenants keeping up with rent and new homeowners buying recently rehabbed homes at the current market prices. These would specifically be problems for Flippers and Buy/Hold Investors

For example, to prepare do you run the numbers for potential rental property based on percentage decrease in rent amount? For Flip properties do you buy if numbers total to 60% instead of 70% of the ARV?

Previous to this past weeks market gloom and more so presently I have been pondering the best way to approach this method. Or on the other side of things, is it necessary to make such preparations? Any insight or past experiences would be much appreciated.

[Jonathan Twombly]

@Yashar E.  As @Omar Khan and others have pointed out, you need to be aware of two different kinds of corrections that could affect real estate, and prepare for both.

There is a correction in the real estate market, which would cause cap rates to go up and sale prices to go down.  This could happen because inflation rises, the lending environment changes, real estate becomes overbuilt, or just because the bull market runs out of steam after so many years.

Then, there is a correction in the general economy - i.e., a recession.

Many investors conflate the two because, the last time the real estate market collapsed, it coincided with a general collapse of the economy.  But it's important to keep them separate in your mind.

For example, in the late 1980s, the economy was booming but the real estate market collapsed because of overbuilding and the S&L banking crisis.

Many people, like Grant Cardone, have pushed the view that rental real estate does well in a downturn, because after the Great Recession, rental real estate - especially multifamily - did really well.  Many people lost their homes and had to rent, and many others wanted to buy but no longer qualified for mortgages.  Many people - including me - took comfort from this and drew the conclusion that rental properties do well in recessions in general.  We all felt that, in a recession, businesses disappear, but people have to live somewhere.

However, I have come to revise this view, looking at vacancy statistics in the markets where I invest.

What I noticed was that, when the recession hit, vacancy spiked.  It spiked big.  Unemployment went to around 11% nationally.  Areas with high concentrations of working class people were hit even harder, because manufacturing and the service economy bore the brunt of the recession.

AFTER that, when the foreclosure crisis really got going, people started moving into rental homes.  But it's important to remember that the people who lost jobs were not necessarily the ones who moved to rentals - because without a job, you don't qualify for most rentals.

The people who moved to rentals were the ones who had jobs, but either could no longer qualify for mortgages or could no longer afford their mortgages after their payments re-set and the interest-only period was over.  They had counted on selling or refinancing when this happened, but the recession stopped it.

In the next recession, vacancy will spike, as it always does, and it will hit workforce housing the hardest.

HOWEVER, this time around, landlords will not have a housing crisis to bail them out.

Since the Great Recession, lending standards have grown much stricter.  The home ownership rate has plummeted.  There is not a huge cohort of marginal home owners waiting to lose their homes in the next recession and then move into rental housing.  (Of course, there will always be people who lose their homes, but this time around it will be more like the traditional way people lose their homes - they lose their jobs and cannot pay their mortgages, not that they have jobs and their mortgages re-set to a level they cannot afford.)  On top of that, there has been massive construction of rental housing in the last decade, and many cities are hitting oversupply.

There is going to be pain for landlords in the next recession.

So, bringing this back to where we started, in my view, this is what you need to watch out for.

1.  Real estate market correction:  If you have a solid rental property that is cash-flowing, and we have a real estate market correction without a general recession, then you will be fine.  The decline in value will be on paper only, and if you have long-term fixed debt, you can just ride it out.  What you need to be concerned about is whether the market correction hits just before you need to refinance, because you may be forced to refinance at a lower valuation, which means that you will have to put additional equity into the deal to pay the first loan.

And, of course, if you are a buyer with dry powder when the correction happens, you are a happy person.

2.  Economic correction (recession):  This is the scary proposition, especially for people buying now at the top of the market.  If a recession hits, you will lose tenants, unless you are renting to the kind of people who don't lose as many jobs in a recession (i.e., white collar professionals in recession-proof industries).  If you are renting primarily to working class people, your vacancy is going up to be sure.

If you purchased the asset at a low price and have a small nut for debt service, you will be able to ride out the dip in occupancy.

But what happens if you bought at the top of the market, at a high valuation, with a huge debt service nut to pay?  Then you are putting yourself in danger of having to fund the mortgage payment yourself if there is a recession.

(Many people buying in comparatively high cap rate markets, like Rust Belt cities with declining populations, are going to have some very scary times ahead when the recession hits.  The reason these markets have higher cap rates is not because they are overlooked, but because they are passed over intentionally by most investors because of the risk they pose.)

The way to protect yourself right now is not just cash flow.  It's buying the best, most well-located properties, close to the best schools and the best jobs.  It's buying with the right tenant mix of stronger white-collar tenants, or blue-collar tenants in recession-proof industries like education and healthcare and government.

It also means stress-testing your deals so that you have a very comfortable cushion of vacancy that you can run through and still make your debt service.  You need to find the historically highest level of vacancy in your market and make sure that your asset can withstand that level of vacancy at the price you are paying/debt you are taking on.

You need to be buying at a 1.5x DSCR at the very least, to make sure that when vacancy spikes on you, you can still meet the 1.25x DSCR that you need to stay afloat, when you consider the routine capex needs that a typical apartment complex is going to need.

If you are buying an SFR, you need to determine how many months you can go without a tenant, because if your only tenant loses his/her job in a recession, you now have 100% vacancy. How many months of this can you survive?

Right now, we are at the tail end of a real estate buying frenzy.  People who are not careful right now are going to find themselves in a world of pain when the next recession hits.