How to Invest in Real Estate in a Market Downturn - Real Estate Diversification

Portfolio Diversification

    While investing in real estate is one of the most hands on ways to grow your money, it is still principally the same as investing in the stock market. You or your company has a certain level of acceptable risk, and with it a corresponding rate of return. Diversification of your real estate portfolio is just as absolutely critical as your stock portfolio. It’s all about managing the risk. Like stocks, real estate is highly cyclical. You can absolutely bet on it that this isn’t the last downturn we’ll see, nor have we experienced the last hot market either. That’s the great part about real estate; it never gets boring. Sure I’d prefer decades of hot markets (obviously not feasible), but I honestly believe that, over the long run, downturn markets are where you really make the most money. Think about the “golden rule” of investing: “Buy Low, Sell High.” If you look at the bigger long term picture, which you should be doing, there is no better time to Buy Low that during a real estate downturn. I’ll explain that more a bit later.

Back to diversification. If you consider investing in the market (via securities, etc.), there are actually two forms of diversification. There’s broad spectrum and narrow spectrum diversification. Narrow spectrum diversification is what most individual investors focus on. It’s what you’ll read about in all the money magazines and see on all the t.v. shows. Narrow spectrum diversification involves spreading your money through various types of securities in order to narrow your exposure to risk (i.e. stocks, mutual funds, money market, etc.). You can even narrow the focus more within narrow spectrum diversification by spreading your money through foreign vs. domestic stocks, aggressive vs. conservative mutual funds, etc. For an individual investor, it’s an absolute must in order to maintain sustainable income growth over time.

Institutional investors (hedge funds, corporations, etc.) do the same, on a larger scale of course, but they also take their diversification another level. Broad spectrum diversification includes the diversification of a portfolio over stocks and bonds. On a big enough scale, this is the only way to consistently work with the economy, instead of against it.

The Stocks and Bonds / Flipping and Rentals Analogy

    It’s common market knowledge that stocks and bonds have a directly inverse relationship. Stocks have more risk, and correspondingly more potential for return. Bonds are the opposite. They’re guaranteed by large institutions, as well as the governments of our and other countries. Therefore, stocks are much more desirable. When the stock market goes down, however, investors run for bonds -- a safe haven for their money while the stock market works through its downturn. Then, when the market returns, back come the investors, pulling their money out of bonds and dumping them back into the stock market. This is why stocks and bonds have a directly inverse relationship. When stocks go up, bonds go down, and vice versa.

It’s still all about timing, however if they can time it right, institutional investors can make money in any market, no matter what. It’s just a matter of understanding your markets, and more importantly, having a game plan as to how to react to market pressures. This is where the analogy becomes real for real estate investors. When the housing market is hot, like it had been for several years prior to last, everyone wants to get into real estate. Consumers are inundated with articles and stats and figures and friends and relatives telling them they need to buy a house. “Quit throwing your money away renting!” It’s practically screamed from the rooftops. Accordingly, it has a halo effect on the economy itself. More people want to buy homes, the demand for homes goes up, so follows home prices, and people that currently own their homes find themselves sitting on a virtual pile of cash. They do a cash-out re-fi, and spend the money on something else. Car, boat, vacation, remodel. No matter what it is, they’re dumping their money into the economy. The economy gets hot, and banks and lenders loosen their lending standards and nearly start giving money away to anyone and everyone. This then makes owning a home a possibility for an even greater number of people, and the cycle continues. While everyone is buying homes, no one is renting....so the rental market dries up. Demand falls, rents fall, vacancy rates rise. This is the inverse relationship. Housing = Stock, Rentals = Bonds, and housing is to rentals what stocks are to bonds. Inversely related.

So this is basically, in a few short sentences, what has happened in the past 5-7 years. You know what happened next. Demand kept going up, so prices kept going up. Prices kept going up, people kept taking money out of their homes and putting it in the economy. The rate of economy spurred the availability of credit, and more and more people could get homes. This is where current events break from the historical real estate cycle. Enter the subprime mortgage. That’s for another article, but suffice it to say, there are factors to blame for the current state of affairs in real estate, and they’re not historical factors. Anyway, everything changed. People got freaked out about the real estate market (thanks in part to a media driven frenzy) and started dumping their homes on the market, trying to “beat” the “looming crash.” This in turn created a massive supply that no historical demand could keep up with. Because of this excessive supply, a downward pressure on prices devalued homes, and depressed the housing market. Add on top of that the credit crunch, as lenders tightened their standards in order to shore up their bottom line, and you have a perfect storm of excess supply and weakening demand (due in equal part to the media frenzy and the lack of freely available financing). So what happens next? Exactly like our institutional investor friends in the stock market, people run towards rental properties. I hear it over and over again: “I’ll rent until the market gets better.” And correspondingly, the effect is more rental demand, increasing rents, and decreasing vacancies. Essentially, the perfect time to invest in rental properties.

The Bottom Line

    The analogy with stocks and bonds is helpful because it proves that money can be made in real estate in any type of market. As promised, here’s how our company approaches real estate investing:

As a real estate investor, your time and money are your resources. Now think of your resources as a big pie. Because, as we just discussed above, you don’t want to put all your resources into one type of project, you need to split the pie up into wedges. Now, there are so many different avenues to invest in real estate, comprised of hundreds of “wedges,” but I’ll just focus on the two main wedges -- buy and sell (flipping properties) and buy and hold (rental properties).

The size of each wedge depends upon the market conditions. Our resources are allocated to the “buy and sell wedge” via renovation costs, carrying costs, and time spent scouting and buying properties (our realtors, of course, handle the selling end). The thing about flipping properties is that it ties up your resources for extended periods of time. Our company doesn’t do the 1 or 2 week “flips” you see on T.V. We spend time, energy, and money, renovating a home and physically making it better. It’s the only way to assure success in this business. Especially in a market like this, buyers can tell when something was done hastily, or even altogether wrong. There’s a reason why This Old House takes nine months or more to renovate a home. On the other hand, the “buy and hold wedge” requires initial capital, but not very much time. The allocated amount of resources is less.

Back to the pie. Unless you have unlimited resources, your pie is only so big. This makes dividing the pie important. You need to determine how to maximize your pie as a whole. Although we don’t typically stand to a hard and fast rule, we never allocate less than 20% of our resources to one or the other “wedge.” Meaning, in a hot market, we’ll still spend a minimum of 20% of our resources on rental properties, with the rest on buy and sell deals, and vice versa in markets such as ours today. With that in mind, our determination goes from there. So, at any given time, we’re trying to determine how to divide up the remaining 80% of our resources. This is when the issue becomes one of degrees. After evaluating the real estate market, we categorize it in varying stages, much like an analyst would evaluate a stock. For example, an analyst would rate a stock Sell, Underperform, Hold, Market Perform, Buy, and etc. We evaluate the real estate market similarly. Ours aren’t very flashy, but they’re self-explanatory: we have Cold, Cool, Moderate, Neutral, Warm, and Hot. Notice that there is one additional “bad” market factor -- this is because there are more shades of a bad market than a good one.

We currently rate the real estate market at a Cool. I anticipate in the next six months that it will change to a Cool trending towards Moderate. 3-6 months ago, we rated the market at a straight Cold.

In Application

    Finally, having “rated” the real estate market, we shift our resources accordingly. As I said before, we always have a minimum of 20% on our two major wedges, so we start from there. In a Cold market, we go bare minimum. 20% “buy and sell” and 80% “buy and hold.” It’s the exact opposite on the Hot side. And it goes correspondingly from there, as follows:

        Hot:   80/20

        Warm: 65/35

        Neutral: 50/50

        Moderate: 40/60

        Cool:    30/70

        Cold:     20/80

        Within these ratings, however, there are shades, depending on specific market data. Like I mentioned earlier, I anticipate the market will shade more towards Cool trending towards Moderate in the next 6 months. Since that’s in between, it would look more like 35/65.

Conclusion

If you’ve read any of the articles on here, you’ve heard me say time and again that now is the absolutely best time to invest in real estate. You have to be smarter about it, sure, but if you play it right, you can make more money in a “down market” than you can in a hot one. Buying and holding rental properties is one of the many ways to do this. With real estate valuation going the way it currently is, there are so many deals out there I can’t even begin to quantify them. I’ve heard another investor say there’s “blood in the streets.” I’m not quite that morbid, but I agree, the panic that has set in has created a perfect scenario for real estate investors to gobble up a disproportionate amount of the available inventory. Then it just becomes a waiting game. You’re of course able to draw income from these properties (if you’ve found the right ones), but the better part is that you simply hold on to them until it becomes profitable to start selling them. Our company recently began to really embrace this strategy, and have begun acquiring details that work as a blend of rental properties and flip properties. We scout properties like we would for flip properties, but then, instead of renovating as we would like, we simply do a light renovation, with relatively inexpensive yet durable appliances and flooring (we love laminate floor -- it’s super durable, yet also looks great. It’s a landlord’s dream). The plan is then to hold the property until we feel that the market is again good to begin selling everything. At that point we’ll replace the inexpensive items with the nicer materials we put in our renovated properties, do the additional renovation work such as adding bedrooms and bathrooms, and then sell it. As we acquire these types of properties, we’re setting up a schedule in which, once the market says it’s time to implement it, we’ll slowly scatter, renovate, and sell these properties. And because of the current “down” market, we’ll have more properties than we know what to do with. Honestly, I couldn’t be more excited -- remember, you make your money when you buy, you realize those profits when you sell. What’s great about today? It’s time to buy, buy, buy. Get started!