This post originally appeared on Doug Marshall's Blog Marshall Commercial Funding Blog and is republished with permission. Find out how to syndicate your content with theBrokerList.//?#
Recently I’ve been asked, on more than one occasion, “When should we stop investing in real estate?” Good question.
As a commercial mortgage broker I have had the privilege to work with several highly successful real estate investors throughout my career. And I’ve observed that these clients are always seeking out new investment opportunities. They are continually keeping their eyes and ears open for the next good real estate investment. It’s their passion. It’s what “floats their boat.” So in a sense, I believe you should follow their example and never stop investing in real estate.
That said, the real estate market is cyclical and I believe we are currently in the quadrant called the Hyper-Supply Phase. This phase is characterized by an increase in new construction resulting in a steady increase in vacancy rates and for the first time in a long time, concessions will begin to creep into some neighborhoods. Rent growth, though still positive, grows at a much more modest pace.
As the real estate market continues to advance, the downward slide at some point in time becomes readily apparent to all and a precipitous drop in real estate fundamentals happens, usually overnight, or so it seems. When this occurs the real estate market has slipped into the Recession phase. And the cycle of market emotions moves from anxiety (where we are at the moment) to denial (everything’s fine, just you wait and see), to fear, to desperation, to panic and finally to hopelessness.
No one wants to be in the unfortunate position of having recently purchased an overpriced property prior to this market adjustment. No one wants to get caught with their pants down but unfortunately some of us do. It’s like playing musical chairs and you discover you’ve been too slow to find a chair to sit on.
My Loser Property
In June of 2007, I purchased my first rental property. I believe if you could identify the peak of the last real estate cycle it would have been June of 2007. And because we bought it at the top of the market, that property never performed well. We simply paid too much for it. We owned the property for eight years and it limped along until it was sold.
Eventually we sold the property for a modest gain resulting in a 7 percent Internal Rate of Return. It could have been far worse. There were a lot of investors who lost their properties because they overleveraged their assets with debt and when the property’s vacancy rate rose these properties couldn’t support the debt.
When will we slip into recession? I wish I knew. Anyone who can accurately predict when the real estate cycle is poised to make this transition is a far better prognosticator than I am.
Are you a net buyer or seller of RE today?
Another question asked of me, “Are you a net seller or buyer of real estate today?” I had to think about that question and to my surprise so far this year I have been a net buyer of real estate. That surprised me. But the two new acquisitions have been value-add plays with obvious upside. Each property had a glaring issue that needed to be resolved. One was a fractured condo and the other had a vacancy issue. Both issues were solvable.
I’ve not yet sold a property this year but if someone were to offer me a silly stupid price for a couple of my properties that aren’t cashflowing well at the moment I would gladly sell them. The rest of my real estate portfolio is doing quite well and I am reluctant to sell these even at overinflated prices. The cash flow from these other properties will help me get through the next recession when it finally hits. Again, I’m clueless as to when that will happen.
Three Reasons to Stop Buying RE
So back to the original question, “When should we stop investing in real estate?” Here are some reasons when we should stop investing.
- When a realistic pro forma for a proposed purchase no longer yields an acceptable cash-on-cash return. In other words, don’t buy a rental property when the numbers no longer make sense. Don’t assume that rental rates will continue to rise simply because they have for the past several years.
- Stop buying when you sense real estate investors are not acting rationally. When you hear words like, “This time is different” realize the folly of such a statement. Those four words have been used to justify some incredibly bonehead purchases. I remember, prior to the Great Recession, hearing people justify buying single-family homes because everyone knows that home values never go down. And when the recession hit, home values plummeted. So much for that theory.
- Do a vacancy rate breakeven analysis for your purchase. Find out what the vacancy rate for your asset type was at the height of the Great Recession. I believe for apartments, the worst the vacancy rate ever rose was to twelve percent. Assuming a 12 percent vacancy rate, how much debt can you leverage the property and still have breakeven cashflow? If that breakeven analysis results in more equity required at closing than you can afford then don’t buy the property.
I will continue buying and selling real estate as long as it makes rational sense to do so. There will always be sellers who either mismanage their properties or don’t have a vision for how they can optimize their property’s cash-on-cash return. When you find one of these properties put the seller out of his misery and buy it from him. Both of you will be glad that you did.
Those are my thoughts. I welcome yours. In your opinion, when should we stop investing in real estate?