Avoid Getting Hammered on Top of the Market
Real estate market is booming right now. But what we have learnt over the years is “what goes up must come down”. We don’t know how, and when the next recession is going to surprise us all. That is not relevant right now. Whether it happens next week or next year, but most of us agree we have reached the top of the market and the great surprise is around the corner.
With that being said, it is a bad idea to sit and wait for a disastrous crash so that you may acquire at pennies while others are working and making money. There are still opportunities and space for growth.
Before we dive into the details, let me take you back in time and let you see how the market crashed the last time. And where we are sitting in that same pattern once again.
I know this may sound boring but hear me out. It's important to start from here to understand the roots of what has been happening in the real estate market.
One of the most important things that controls the real estate market in terms of investing is interest rate. When FDS deliberately drops the interest rates, investors start making decisions based on poor analysis. They start taking huge risks in greed of high yields. They consider the relatively safe deals to be “low yield” and jump into high risk deals. This is speculating. And we have already discussed the difference between speculating and investing in the last blog.
This is why the market crashes when it reaches its top. People will blame it on anything like hedge funds, ratings agencies and loans etc. but the main problem here is free money flowing around in the market looking for a home.
Investors today don’t feel the need to analyze deals. They are not willing to put effort and find the best deals for long term cash flow. Old value-add deals are selling near the top of the relatively newer ones. If you are active in the market and bid on deals, you are aware of how crazy people get during bidding.
Although there is a great risk in the recession, multifamily assets are inclined to be more stable relative to other assets. The rents may fall but the cash flow will not fall enough to kill you, rather it's the poor structuring, overpayment and bad money management that can kill you. If you do proper underwriting, analyze deals properly and don’t speculate you can easily survive the crash untouched.
Should you do what I say? I can’t give you “one size fits all” advice. But here is what you can do to survive.
Don’t Burn the Boats
If you have a day job and you are starting to invest as a side hustle, keep your job and let the stable income stay until you become a pro in investment. Don’t go all in without experience. Gather experience so that you may go all in when there is blood in the streets. Till then, focus on getting experience and partnering up with others. By partnering up you will learn more and divide the risk.
If you own a considerable amount of real estate consider selling some. It doesn’t mean you sell everything right now in fear of a crash. Hold the stable deals and let that steady high flow cash in. By selling some you will have dry powder ready at your disposal.
Incase of buying, note that there is a clear difference between underwriting and structuring a deal. Doing both properly is what sets you apart from other investors.
As we discussed earlier, most people don’t really put effort into deal analysis. New investors underwrite deals just to hit an IRR metric. Since the tide is on the rise, one can’t differentiate between a good and a bad deal.
Deal Structuring and Leverage
Deal structuring refers to the terms on which property is acquired, level of reserves and a mix between debt and equity. New investors often do considerable damage to themselves in deal structuring.
Guess what is the shortest and easiest way to go broke in the real estate investing business?
It is misunderstanding how to use leverage and the risk that comes with the leverage. Though it is true that leverage can multiply your income but it can multiply your losses in the exact same manners. A simple mismanagement can take you from an investor to broke within no time.
Reduce the Risk
Long story short, the way to reduce your risk here is to understand the risk involved with the downside. And then take active measures to mitigate the risk.
Going with lower leverage is not attractive to investors. And probably your investors will not be convinced because of you offering them low returns and invest with a guy who is offering a 19% IRR. But if you know what you are doing and can convince your investors on how you are taking measures to manage the risk associated. You will have more investors down the line because of surviving the downturn.
It is inevitable that the deals that promised high returns in the last two years won't be able to return. As the debt matures, the investors who rushed to chase IRR over-leveraged and were undercapitalized are going to find themselves in the hot water. Whoever is taking high risks, we will find out in the next few years. Until then, keep hustling and know that safe deals can go a long way.
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