How to Hedge our bets?

Question

I have read a lot of threads about whether or not we are in a bubble that is about to burst or maybe we are due for a correction.  There are many different opinions but I would like to ask some of you for your methods for hedging your bets for a downturn that may happen in one or twenty years.  My local Real Estate market (San Antonio)  is strong but I would like to protect myself from a downturn and I worry about hedging my bets with stock market investments that would also decrease in value if there were an economy-wide slowdown or recession.

Lots of the people I listen to or read have great experiences in Real Estate but most have been doing it for about as long as I have (5 years or so) and haven't weathered any real storms, so to speak.  I have taken to reading books on economics etc. to get a better grasp of the economy in general and refresh college courses from years ago.  Are there any investments that you all see as moving in an inverse relationship to the rest of the economy?  Anywhere better than cash to put reserve funds?  Assuming there will one day be a downturn, I would like to have a life raft available.

I have embraced debt to grow, and it has worked, but now I am getting a little jittery as I have surpassed my ability to repay the debts from other income.  I know that businesses operate like this all the time but I'm betting on my own understanding of the economy and at risk is my family's future.  Any opinions?  Anyone who weathered the last downturn?  Anyone who lost it all in the last downturn?

I am coming to this conversation from the perspective of a buy and hold guy of homes valued from about 100-180K.  I have minimum of 30 percent equity in each.  None are owned outright.  I like the perspective of @jason hartman who espouses the idea of using debt as a hedge against inflation - especially in the midst of the potentially inflationary new president (personal feelings aside).  I just feel I should have something else to protect myself in case rents drop.  My real fear is rents decreasing as I am prepared for equity to move up or down.  It is the servicing of debts that concerns me.  Some say that in a downturn, more people rent thus increasing demand for rentals but I worry about a longer lasting downturn and rents themselves decreasing eventually.  I welcome any and all comments and appreciate your time.

-Will

Leland Barrow · Answer

Everything comes down to speculation. However, we do know that historically real estate goes through about a 10-12 year cycle. Seven years on an up cycle and 3-4 years on a down cycle. What happened in 2009 was a bit artificial due to the lending market. I think that is about as bad as it will get. I think using the term "bubble" is not entirely accurate. A bubble is caused by an artificial force on the normal market. In my opinion, we are in a normal market cycle. There is an argument to be made that we may be in for a long cycle because of the artificial force that low-interest rates have had on the market.

Real estate investing is a great investment platform because it is an inefficient market. A house worth $150,000 can be purchased for $90,000. Doing that in the stock market is all but impossible. You cannot purchase stocks that have a market value of $150,000 for $90,000. Stocks are almost entirely an appreciation investment. The general idea is that stocks will be worth more tomorrow than what I pay for the stocks today. Because stocks are such an efficient market investors struggle growing their money at the rate that they want to see their money grow.

What we now have is investors chasing the inefficient real estate market. If they can buy low and sell high then they can leverage their returns more than the stock market. Everything in real estate investing is based on seeking a return. HML are seeking a return better than the stock market. Landlords are seeking a return better than the stock market. Everyone is seeking a return that is better than the stock market.

Those that are at the greatest risk are:

HML- Some have huge amounts of money on the table. They fund the riskiest parts of the business. Many do not adequately vet their borrowers. The loans are secured against property that could go down 20...30...and even 50% in value in a down cycle. I have had HML trying to push money into my hands. That is a concern because if they are doing it to me then they are doing it to a lot of people. You see people with huge amounts of cash want as much of that cash as possible to be earning better than average returns. Holding cash is viewed as holding a hot potato. The more cash that they have out there working for them the faster their wealth grows. However, throwing hot potatoes at random people is a bad idea.

Flippers- flipping is not investing. It is a small business or a job. Flippers that buy at the top of a market cycle have no way of turning a profit and will lose money. It is like musical chairs...when the music stops a lot of people are going to end up holding properties that are far above what the current market value will be. There is a reason why most flippers do not survive multiple market cycles.

Those with moderate risk:

Expensive buy and holds- Rents lag and if a market declines the rents will eventually drop. If you purchase an expensive home in a high demand area and are over leveraged then a decrease in rents can affect cash flow. Most small investors are undercapitalized. Those investors cannot afford to take losses on a monthly basis.

Multi families- Just because it is a multi-family does not mean that it does not have risk. A multi-family property that is over leveraged can face the same issue as a SFH. Down cycles correlate with the general economy. Multi-families that are over leveraged only need a small decrease in market rent to have a huge affect on their profitability.

Cheap buy and holds- You might think they are cheap what can go wrong? The problem with cheap buy and holds is that they do not appreciate. You could hold them for twenty years and sell them at a loss. Every time you change ownership of an investment transaction fees are involved. When you acquire properties you are paying real estate agents and/or wholesalers to broker the sales. Cheap buy and holds can take years just to recoup the transaction fees and return a better than average return. In all reality, cheap buy and holds are terrible at providing a better than average return. Cheap is rarely inexpensive. You can compare the NPV of a million dollar portfolio of cheap buy and holds versus mid-range buy and holds and mid range will almost always perform better when you calculate in transaction fees, appreciation, and increasing equity; not to mention the increased cost of cheap properties with maintenance and management. It is possible that renters can get laid off in down cycles. Cheap buy and holds usually have seasonal and non-knowledge based workers. They are paid for what they do and not what they know. When construction jobs are scarce then construction workers will not have work. Cheap buy and holds rent to construction workers. When vacancy periods are longer rents get forced down. Decreasing rents erases cash flow.

Those with low risk:

Investments with large amounts of equity

Investors with large reserves

Those with diverse portfolios in the highest demand property types.

If you want to protect yourself have cash reserves and do not over leverage yourself. Diversify your holdings and be prepared to have longer vacancy periods. Quality over quantity. Avoid buying the top and bottom real estate. Have multiple exit strategies.

Michael Wagner · Answer

THis is a great question. Its an overly simple answer but my advice would be to find ways to lower your monthly break even point.  Though your leverage is reasonable at 70%, your words indicate that your cash flow is not quite strong enough to comfortably endure decreases in rent.  Deleveraging is the best way to reposition yourself.  And if the market is indeed at or near a peak, wouldnt it be wise to sell at least some of the properties? As a hypothetical, could you sell a property or two and use the profits to either sock away as an emergency fund that you could tap into to cover any shortfalls in a downturn? Or could you use that money to buy one of your properties free and clear?  What I am hearing you say is that you have slightly too much exposure right now if the market were to turn.  The only way to decrease exposure is to give up a portion of your return....higher risk yeilds higher reward.  Find the spot that makes you comfortable.

Finding this spot will require you to look at your current situation, your goals, etc.

I am curretly 50-55% leveraged but have a high monthly nut to cover...roughly 15K per month on $1.8M in debt.  I have grown my networth a lot using that leverage but my income needs are now met and I strive (as it sounds like you are) for less exposure so I have decided to sell off some of the assets and apply the equity gained to the assets I keep.  Doing so will bring my debt free day closer, while only impacting monthly cash flow slightly.  Of course, growth will be greatly slowed using this strategy....but Im not interested in growing right now. I rather grow after the market corrects, not before.

Just my two cents. What works for me may or may not work for others!

Account Closed · Answer

Well the answer is pretty simple IMO.

1) Have plenty of homes that rent for under $1000.  No matter what, these homes will be occupied.  Might not be at the current rate, but they will be occupied in any market.

2) Have enough cash flow to service the debt you have should your higher rent homes not vacant for extended periods of time.  If you have 9 homes and only need 5 to be rented at any one time to pay all your debt, you are probably in a good position no mater what.

3) Plan for bad things, but don't live in fear of the future.  Make sure you are protected with your home and family before working on any rentals.

Jason Hartman · Answer

Our tenants pay down our mortgages and inflation does too. I call it 'Inflation Induced Debt Destruction' and it's the ultimate hidden wealth creator! Thanks for bringing it up @Will Pritchett!

Rick Pozos · Answer

I think it all comes down to diversification. Buy and hold is great, but so are notes, doing a few wholesales cant hurt and a rehab every now and then is a nice boost.

We have a few wrap notes where the part we owe will be paid off in a year, some in a few years, some in 10 or 15 years. So that means our income will get a bump up next year, a few years AND in 10 years.

Since we are always marketing, some of the properties are not in desirable areas or we just dont want them. These are the ones that we wholesale out.

Because we know that things are going to change in the near future (and nobody knows exactly when), we are staying with doing a rehab or two at a time. When we see some signs of things turning, we will dump the rehabs that we are working on quick. Dont want to be the last one standing when the music goes off.

We are pouring just about all we can into paying down debt. Living WAY below our means and making life simpler by turning our rentals into owner financed properties. AFTER the turn, we will be purchasing as many rentals that we can, flipping a few here and there and also wholesaling a few.

How to Hedge our bets?

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