Phil McAlister/ Bigger Pockets
The financial markets have seen a whirlwind of activity these past several days. As news of coronavirus quarantines and speculation on trade roils the markets, I’ve heard every opinion from, “Sell everything and buy gold and canned goods,” to, “This is a tremendous buying opportunity.”
I’m here to tell you that for real estate investors, the best thing you can do is calmly follow a disciplined approach.
I do put money to work occasionally in other assets, like stocks, options, REITs, commodities, and ETFs. However, I continue to believe that real estate is far and away the best investment in today’s climate.
Real Estate Returns Trump All
Real estate has the most attractive risk-adjusted return profile. Even with the recent pullback, the broader stock market is priced to provide dismal returns over the next decade or so, in my humble opinion.
Bonds may be even worse. You’d have to go extremely far down the risk curve into junk bonds before you could find anything approaching the yield on a real estate investment.
Not that the average person can invest in private equity, but in that space, acquisition multiples are through the roof and there is a significant amount of operating risk that just isn’t present in real estate.
Why Real Estate Is Still a Good Investment
As absurd as cap rates have gotten in real estate—and they are absurd—our space is definitely the “cleanest dirty shirt.”
You can find good deals and create value, rather than remaining subject to the whims of market forces beyond your control.
Would you rather own a 4 percent cap high-quality apartment that has potential for growth (it may be a 6 percent cap in five years) or invest in a corporate bond that has a yield to maturity of 2.8 percent. Plus, if interest rates rise, the value of the bond will be slashed.
How about some stock in the S&P 500, with a dividend yield under 2 percent and valued at levels last seen in the dot-com era?
Despite ultra-low cap rates, a case could be made that, as long as capital markets continue to demand yield and have a risk-on mentality, cap rates could compress further.
There are certainly ways for you to get your face ripped off in the real estate game. Generally, here is how to avoid that gruesome outcome.
Make no mistake, I do feel that the real estate market is frothy. I think a lot of the easy money has already been made, and good deals are hard to find. There are plenty of ways to lose money in this market.
An important but often under-appreciated point to make here is that risk preference means everything. Regardless of the fundamentals, with cap rates this low, if for any reason investors begin to put a higher risk premium on assets, cap rates can suffer. You don’t necessarily need declining rents or oversupply for this to happen.
Simply, the broader capital markets perceiving and pricing risk differently would be sufficient to impact real estate prices negatively. Deep pessimism in the stock and bond markets, or the broader economy, can spill into real estate, even if rents are on the rise and the supply-demand balance looks strong.
How to Not Lose Money in Real Estate
Moderate, Long-Term Leverage
Putting high leverage on a deal is the fastest way to lose your money. In a situation where market values are impaired and you have an otherwise appealing asset, your main risk will come when refinancing the loan.
If you start at an 80 percent LTV, it doesn’t take much in the way of rent declines or cap rate increases to put you in a position where you’ll soon be giving the keys to the bank. Resist the urge to use short-term debt at high leverage points.
A widow-maker is a real estate deal where there is a component of the deal that can completely wipe you out. An example here would be a high-cap rate, retail net lease deal. It may provide great cash flow for a few years, but if you lose the tenant, the likelihood that you can replace the rents, especially without paying through the nose for tenant improvement (TI), is very low.
This kind of deal can wipe you out. You’re counting on one event—a lease renewal—to make or break the investment.
Investing in high-quality residential or commercial real estate locations with a bright future is even more important than usual right now. Any buildings that feel an outsized negative impact will be the marginal ones.
A well-located apartment building near employment centers, transportation networks, and entertainment options will likely suffer far less than their less optimal competitors.
But What About a Recession?
Before the coronavirus scare, my opinion on the matter was that the economy seemed vulnerable to a recession, but my base case was that 2020 would continue to show modest growth.
Now it’s a little more up in the air. A lot depends not on how serious the virus is but on how seriously people react to it.
If people around the globe decide to stay home more often, which appears to be happening, supply chains may lock up and people may hunker down a bit. This could theoretically tip an already slow-growing economy into recession.
It would be a shame if a bug that looks to be only slightly more dangerous and far less common than the seasonal flu caused a recession, but we should allow for the possibility for now.
However, my response ultimately would be: “Who cares?”
As Always, the Economy Will Bounce Back
Recessions aren’t as bad as people think. Recessions are a necessary component to a functioning economy to clear out malinvestment and reallocate resources to more productive uses.
I certainly don’t mean to sound flippant. Anyone who loses their job or faces tough times deserves our sympathy and help. However, if unemployment reaches the level it hit during the last recession, about nine in 10 people will have jobs. Businesses get formed in recessions. Bills get paid, and people persevere. The economy will bounce back.
This recession won’t be like the last recession—no two are the same. If you’re sitting around waiting for 2010 prices on real estate, you may be waiting a long time. On the other hand, you may be right—in which case, kudos to you. I can’t tell you how to handle your investments.
I, for one, feel confident in my ability to manage risk appropriately, use leverage wisely, and continue to grow my wealth and cash flow streams, even in a recessionary environment.
In conclusion, my advice would be don’t panic, stick to a disciplined approach, manage your risk, and continue to pursue your investment goals. Good luck out there.