Stop Worrying about a "Crash"

[Account Closed]

Debate about a coming crash seems to be the hottest topic in real estate recently. What is a crash anyway? A recession? A total meltdown like 2008?

No one can predict the future (except I can tell you with certainty that Mitch Trubisky will be an all-pro one day), and no one can time markets perfectly. The good news is, you don't have to. Maintaining a disciplined approach and understanding where you are in the cycle is all that matters. If you can do that, you can confidently move forward in real estate investing. There are many reasons to believe both the economic recovery and the real estate cycle are long in the tooth. But unless you want to sit on the sidelines and watch everyone else accumulate wealth, you need to continue to pursue deals. Here's a brief recap of where we are and how we got here:

• The Fed and Central Banks around the globe injected an unprecedented amount of liquidity into financial markets, and drove interest rates artificially lower, much lower than the market clearing rate would have otherwise been.
• Early on, the "smart" money came into real estate and found once-in-a-generation deals. This attracted more attention to the space, and as the dust continued to settle, more and more capital flowed in. 
• As the recovery progressed, due to the artificially low interest rates and perceived government backstop, capital started chasing all assets from stocks to bonds to real estate to very aggressive heights. This triggered a cascading effect where all investors had to move further out on the risk curve to find yields that were acceptable. Higher prices means lower prospective returns. This is why we hear constant stories of people that can't find deals anymore.
• Leverage increased throughout the economy as a result of artificially cheap credit. 
  • Global debt to GDP is now well past 2007 highs
  • Corporate balance sheets are loaded with debt
• Many real estate sponsors, fund managers, hedge funds, PE shops, etc. have had to justify very optimistic investment outlooks in order to continue raising capital and doing deals.

Now the economy is entering it's tenth year of recovery, which ties for the longest expansion on record. We have a stock market that is, by the most reliable/correlated measures, the most overvalued in history. Stocks have had the longest streak without a 20% drop in all of history.

The takeaway here is not that a crash is imminent. The takeaway is that right now, there is an increased appetite for risk, chasing yields, and a low level of skepticism among investors. This is driving an environment where too much money is chasing too few deals. Real estate now is like a party in college where the guy/girl ratio is 10:1. It may seem for now like the sponsors raising money in syndication are doing great deals (some actually are) and making money, but as one really smart rich guy said "It's only when the tide goes out that you learn who's been swimming naked." Historically speaking, it has been prudent to be a little more cautious in environments like today. 

So what should you do? I dunno, I'm just a guy. But here are a few ideas.

• Looking back at historical multifamily data, when the "crash" happened 10 years ago
  • Rents declined 1-2% a year for a couple years
  • Vacancy crept up a couple percentage points
  • Credit tightened up drastically
• The people who got killed were those who didn't understand the full risk of what they were doing
  • Spec development in shaky markets
  • Over leveraging 
  • Using high cost, short term bridge debt

Overall, the single most risky thing you can do is be over-leveraged. Even if you're doing okay  with cash flow in a downturn, if you are over-leveraged and your loan matures when interest rates are higher and so are cap rates, this is how you end up giving the keys to the bank. If you aren't over-leveraged, even a pretty severe recession won't wipe you out if you're generating good cash flow. 

So will there be a recession? Absolutely. Will it be relatively soon? History would suggest yes, but not the data. Will it be a "crash?" Hard to tell, but the toxic financial instruments aren't as prevalent as before. Should you care? No.

Just be disciplined. Pass on the risky stuff. Look at long term debt at lower leverage points. focus on cash flow. Learn how to stress-test your deals. Invest in value-add deals (but not where you need an expensive bridge). Maybe politely decline the advice of the guru who taught you how to buy deals at 95% leverage with no money out of pocket. Ultimately, just go outwork the next guy and make good deals. Or just go watch TV and complain. I don't care. But I'm doing deals. 

[Brian Burke]

Well said, @Account Closed.  Not much I can add to that--been saying nearly word-for-word for the last couple of years.  Three years ago people were saying that I couldn't keep doing deals, couldn't keep buying, couldn't keep generating the kind of returns we have.  But here we are.  Certainly we don't expect to produce the same kind of return as we would in an asset acquired in 2010, but that's not the point.  The point is that if we employ the right strategy in the right location and use conservative underwriting, stress test our numbers, have multiple exit strategies, and conservative leverage points we can keep doing this for quite a long time.  And do it safely and produce returns to boot.

The most recent adverse cycle was the worst one since the great depression.  So that's what people remember--and many use that memory to visualize what an adverse cycle looks like.  But I've seen many adverse cycles in the three decades I've been involved in real estate investments.  They don't always look like that.  Your description was far more accurate than what I see thrown around so often.  

I frequently see people post that they are waiting for a downturn to buy.  Ok, that's fine if that what makes you comfortable.  But if you are waiting for a drop in pricing you might not be seeing the forest through the trees.  If prices rise 3% for three years, and then there is a 10% downturn you are buying in three years what you could have bought today for the same price (because you probably won't buy exactly at the bottom--you'll miss it while you wait for it to drop further and it starts to rise).  Trouble is, financing will be harder to get then, which means a larger down payment, so your returns are lower.  If you use investors in your deals I can guarantee that the investors knocking on your door today will vanish until the downturn has fully reversed.