There's quite a bit of uncertainty in the market right now and many are wondering where to invest. Stock market has performed dismally so far this year with the S&P down over 18%, cryptocurrencies like Bitcoin and Ethereum have lost over half their value after unprecedented optimism about their futures, and inflation keeps eating away at pretty much everything. If that weren't enough, the Federal Reserve Chairman is signaling that interest rates will continue to go up even after two consecutive quarters of GDP contraction, which should further chill the economy.
So why am I still optimistic about real estate?
I know what you're thinking - maybe I'm ignoring some of the inconvenient facts. On the contrary, I think that many of the facts point to real estate doing extremely well in the future and I'll discuss why. I'll also point out some causes for concern and then make a few recommendations on how to invest wisely.
Interested in learning more about the investment process? Click here
Reasons to Be Optimistic
In no particular order, here are my reasons.
Supply and Demand Imbalance
There is a national housing shortage and it's getting worse. During the Great Recession, many home-builders went out of business and the construction of new homes ever since has not fully recovered. Some estimates put the shortage at over 5 million housing units nation-wide which includes both single family and multifamily dwellings. If that isn't bad enough, during 2020, new construction took another nose-dive due to the pandemic and related supply shortages. Now, in 2022, with interest rates continuing to rise, new construction is once again declining.
Why does this matter?
It's basic economics - high demand and limited supply lead to higher prices. That's in large part why the housing market had BOOMED in the last two years. While the recent (and future) interest rate hikes will temporarily curb the demand by making housing more expensive, the fact is that we are millions of housing units short of current demand and it's not getting better. We may see a small and temporary drop in prices in both residential and commercial housing, but eventually the prices will continue to go up because of the housing shortage - which I'll remind you has gotten worse every single year for more than a decade.
Real Estate has Intrinsic Value
Land and property have always had value. We have thousands of years of history on every continent that point to real estate having intrinsic value. In early recorded history, people would gather together and form tribes to defend their lands and territory (aka real estate). In later years, kingdoms would replace the tribes and real estate and the income derived from real estate became the true measure of wealth in most Western societies. Fast forward to the 20th century and the American Dream was for each couple to own their own piece of real estate. Throughout the millennia, land has been highly valued and I don't see that changing because the Federal Reserve raises rates a little bit.
Why does this matter?
An investment in real estate is an investment in an asset that will retain its value. Though there may be dips in pricing every so often, there will always be value in real estate. This intrinsic value shields the market from the extreme volatility of other potential investments, such as cryptocurrency, and reduces the likelihood of an investment going bust. If thousands of years of history are worth anything, real estate will continue to be a measure of wealth for the near future and centuries to come.
Inflation and Leverage
The monthly inflation reports have continued to defy expectations - either that or the Federal Reserve Board continues to deny reality. We live in an environment where prices are going up rapidly and that means real estate values and incomes will also increase rapidly. If we take into consideration that lenders are still providing the majority of the purchase price, we are able to multiply that inflation in our own returns.
Why does this matter?
Let's look at a quick example.
If you buy a property for $1 million in cash and the property appreciates 10%, you can sell the property for $1,100,000 and you have made a 10% return on your investment.
If you buy a property with a $250,000 down payment and a $750,000 loan and the property appreciates 10%, you can still sell it for $1,100,000 and after you pay your loan back, you're left with $350,000. That's a $100,000 increase on a $250,000 investment which is a 40% return on investment. High inflation and leverage together will amplify your returns much more than in "normal" times.
One more note.
If values go down, the leverage works just as well at wiping out your investment, but you don't ever lose money until you sell. The simple answer to this problem is to make sure you can hold on to the property long enough, which is discussed below.
But what about the rising interest rates and projected recession?
Now, as I mentioned, there is some cause for concern and I'm certainly not ignoring the facts.
Rising Interest Rates and Real Estate Prices
The Federal Reserve Board has been hiking interest rates since the beginning of the year and they've signaled that they will continue to raise rates until inflation is under control. At the beginning of 2022, a typical agency loan would have an interest rate of about 3.8%. As of earlier this week, the same loan would have an interest rate of 5.1%.
This rise in interest rates is already having an enormous effect on the commercial real estate market. With the cost of capital rising, many would-be buyers are on the sidelines waiting to see what happens, while those that are buying are not able to pay the same prices that investors saw only a few months ago.
Why does this matter?
We talked about supply and demand earlier in a positive light. Similar to the single family market, with interest rates climbing, the mortgage payments have also gone up and that increase is affecting not only the investor returns, but also how much lenders are willing to lend on a given property. The rising interest rates will have a dampening effect on the demand, which will tend to push values down.
Here's why I'm not too worried.
The Federal Reserve is mandated to keep inflation in check and unemployment low. Raising interest rates to slow down inflation will also affect the country's economic output and eventually the employment rate. When that happens, the Fed will most likely slash interest rates to get the economy back on track and employment up. When that happens, the demand for real estate will also pick up and so will prices.
One more note.
There is an elevated risk for investments with short-term loans that come due when interest rates are high. If the property is not stabilized or the appraised value is not sufficient, the owners may have difficulty refinancing. In some cases, owners may be forced to sell at inopportune times. This is a real risk, but not extremely concerning when looking at a new investment opportunities today in 2022. In fact, some distressed owners may make investing now even better by being forced to sell.
The Projected Recession
I've lived through three recessions as an adult and we're likely already starting my fourth. During recessions, the economy sputters and companies downsize to remain profitable. That means more people will be unemployed and many will be underemployed. During a recession, some renters will have a difficult time paying rent and some home-owners will struggle paying the mortgage pushing the vacancy and foreclosure rates up a bit higher than normal.
Why does this matter?
The majority of a property's income is from rent. If people have a hard time paying rent, the income will necessarily go down. If income goes down far enough, owners may struggle to pay their own expenses and if they struggle to pay expenses, they certainly won't be paying the investors.
Why I'm not worried.
I'm definitely concerned, but not worried. First of all most lenders will limit their loan amounts by the debt coverage ratio - meaning that the property's projected income must exceed the mortgage payments by a certain percentage - most commonly by 25%. Since they typically factor in a healthy vacancy rate in making this determination, the break-even occupancy on most multifamily properties is between 65-70%. That means that a property can have up to 30% vacancy before the cash flow is insufficient to pay the mortgage. Additionally, most property owners keep an emergency fund that they can pull from to keep afloat until occupancy improves.
Recommendations for Investing
The two biggest risks in today's market are the potential for reduced income due to a recession and higher interest rates on loans.
Here are my recommendations for mitigating the risk associated with rising rates and an upcoming recession:
Don't invest in a property that is over-leveraged. The best indicator of this is the debt coverage ratio (DCR). Look for properties with a DCR of 1.25 or more. Personally, I believe this is more important than the loan-to-value ratio.
Make sure the operator has sufficient money in reserve to cover a prolonged recession: 2-4 months worth of normal operating and debt expenses should be sufficient.
Look for experienced operators that know how to properly manage their assets.
Invest in markets with a robust and diverse job market. This should lessen the risk of a recession wiping out the entire economic output of a city.
Make sure the loan term is long enough to weather the storm to avoid the possibility of a forced sale to pay the lender. Personally, I think 5 years is sufficient. Anything longer than that would likely come with significant prepayment penalties, which will limit profitability if rates go down and you want to refinance.