The Next Real-Estate Downturn — How to Prepare, Using BRRR, and Where to Invest
Everyone was buying houses in 2005. It was common knowledge that waiting was a bad idea. House prices soared, and loans poured in like free drinks from an open bar. Many people prospered — until they didn’t. The music had ended in 2009, and people were scrambling to find someone to move the hot potato to. By 2010, the “smart” people were the ones who seemed to be dumb. As the real estate downturn hit full force, foreclosures dominated the economy, and the great real estate boom of 2005 looked more like a ghost town.
Fast forward to 2018, and things are beginning to look a lot like they did back then. Regardless of appraisals or the condition of the house, homes in Northern California often sell for considerably more than the asking price. Demand is outstripping supply, causing prices to rise once more. Local buyers in hot rental markets around the country are often perplexed by how much out-of-state residents are willing to pay for traditionally modestly priced homes.
So, how do you go about it? Is now the time to invest, or should we wait until the next market correction? Are we in 2005, when the market was at its height, or are we in 2010, when there is still plenty of space to run?
You must weigh all the facts if you want to make the right decision. Let’s take a moment to weigh a few business trends, tactics, and possibilities before I make a black-or-white recommendation. There could be a way to invest now and still be in a position to profit later if the market crashes.
Do we live in a bubble?
When we talk about a “bubble,” we’re usually talking about an asset class with an unrealistic, unsustainable valuation that can’t be expected to continue. Home prices in 2005 were determined not by affordability, but by bad loans that allowed people to borrow much more than they could afford in the long run. Nobody could afford those debts when they reset, and the economy was flooded with foreclosures. The market went south as supply grew while demand decreased.
Today’s market presents a somewhat different picture. I work as a real estate agent in the San Francisco Bay area, and none of the buyers I’ve dealt with have made any unusual or obviously foolish loans. Rates are usually set for a period of 30 years, do not change, and are completely fair depending on the buyer’s income. It’s no secret that house prices are rising, but what’s less well-known is how incomes are rising as well. Let’s not forget that since 2006, there have been 13 years of salary increases. That’s a pretty good figure. Prices may have risen, but they have also risen in comparison to incomes. The risk of a large wave of loan defaults entering the market at the same time isn’t very high.
So, do we exist in a bubble? Probably in some regions. But keep in mind that as long as people can afford their payments, it would take an external occurrence to trigger a housing crisis — things like a general recession, a labor market downturn, and so on. Many asset classes, not just real estate prices, will suffer if this occurs. The point is, don’t be lazy and conclude that just because house prices seem high, we’re in a bubble or experiencing a repeat of 2005. There are numerous other factors to remember.
What if I spend too soon and the market collapses?
This seems to be the greatest concern of all investors. It’s a catch-22 situation. If you spend too early and the market collapses, you would have skipped the “once in a lifetime chance.” You could go years without making any financial progress if you wait for the economy to crash. And, when it does crash, all you hear is how real estate can never recover, and you’re too afraid to act. In either case, regardless of the current economy, it’s difficult to take the risk and jump in.
This question also implies that real estate markets are uniform in the world. A “crash” in one place does not necessarily imply a “crash” in another. Specific economic factors drive certain economies, which are unaffected by the rest of the world. What’s an example? Texas is a state in the United States. When the rest of the nation was being pounded in 2009–2010 (California, Arizona, Nevada, and Florida, to name a few), Texas escaped relatively unscathed. Parts of the Midwest that work independently of coastal markets are in the same boat.
So, what’s the answer? Is it better to buy now or later? It’s not as difficult as you would think to have your cake and eat it too. The key is to figure out why you’re afraid of missing out if you don’t buy now. It’s easy, to sum up in two words: the price of opportunity
The price you pay to lose out on one choice when you commit to another is referred to as opportunity cost in economics. In this scenario, if you lose out on House B, buying House A might be an issue. If House B proves to be superior (for example, you purchased it after the market collapsed and charged a lower price), the opportunity cost is the money you would have made if you had waited for House B.
Many people are hesitant to invest because they are afraid of the unknown. So, what are your options for dealing with it? With the BRRRR process, which has been used by savvy investors for years.
What is the BRRRR system, and how does it work?
Buy, Rehab, Rent, Refinance, Repeat is an acronym for Buy, Rehab, Rent, Refinance, Repeat. When you purchase a rental home, it’s the order in which you go through the different phases of the investment cycle. You will be able to buy an investment property with no money down if you BRRRR correctly. This frequently results in a cash-flowing property that has been completely rehabbed, putting more money in your wallet than you invested. When you recover 100% of your resources or more, opportunity cost is no longer a consideration to consider. It no longer is about “House A or House B,” but rather “House A, then House B.”
What gives that this is possible? Traditionally, when you buy a home, you put down a large down payment and then add money for closing costs and rehab. Your investment base, which is used to measure your ROI, is the total amount of money you put down. There is still a high opportunity cost for the conventional model. If you put down $35,000, spend $5,000 in closing costs, and have a $10,000 rehab, you’ve got $50,000 that you can’t put somewhere else.
If the economy collapses, you won’t have $50,000 to invest in the downturn, so your opportunity cost is high. This is the rationale behind the “fear of losing out” that prevents real estate investors from getting started. So, how can you get around it? The opportunity cost, in my opinion, should be eliminated. What’s to stop you from buying the next one, too, if you can buy a property and recoup your investment?
This is accomplished by effectively BRRRRing. In a hypothetical BRRRR contract, you will pay $60,000 for a fixer-upper that needs $40,000 in rehab work. For the same $5,000 for closing expenses, you’re looking at a total of $105,000.
If the property appraises for $135,000 after being rehabbed and leased out at a loan-to-value ratio of 75%, you will refinance and recoup $101,250 of your investment. This means you just left $3,750 in the house, far less than the $50,000 you would have put in if you used the conventional model. The irony of this is that, after withdrawing nearly all of my money, I still added enough equity to the deal to keep it from being over-leveraged. In this case, you’d still have around $30,000 in equity in the house, which is a nice buffer.
It’s not impossible to save another $3,750, and it’s a lot better than saving $50,000. When the economy collapses, you’ll have all that money to put into the next home. If you do it right, you will make much more money than you put in (by finding good offers and rehabbing them carefully), increasing your capital and your opportunity to invest in potential assets. There is no longer any opportunity cost.
What criteria can I use to determine the market to invest in?
While no one has a crystal ball and can predict when and when the market will fall, there are some fairly common metrics you can use to hedge your bet.
Diversified Economy: You should steer clear of any industry that is reliant on a single employer or economic engine. The city of Detroit is a good example. When the car industry collapsed, so did the value of all homes. Since no one could find jobs, all of the rentals became empty (and so did everything else). Other examples include North Dakota (oil-dependent), a region known solely for tourism, and an Alaskan coastal village entirely reliant on fishing.
C-class or better communities: Real estate developers assess neighborhoods in the same way as they evaluate school grades. A-class properties are in the wealthiest areas of town, B-class properties are in upper-middle-class communities, C-class properties are in mediocre neighborhoods with a lot of tenants, and D-class properties are troublesome because of high crime and vacancy rates.
Anything less than a C-class neighborhood should be avoided. When a market flips, investing in nicer communities in economically diverse markets allows you to escape the worst of the negative effects and weather the storm. Inquire with a nearby top-producing real estate agent or property manager for more detail about how a property is categorized.
Cash Flowing Properties: It doesn’t matter what happens to the value of your property if it cash flows (brings in more money than it costs to own). Until you sell, a drop in prices has no effect on you. Experienced buyers purchase assets that generate income and consider price appreciation to be the cherry on top.
Look for properties in places where the “1% law” applies. It’s very likely that property would cash flow favorably if it leases for 1% of the purchase price per month (a $100,000 property that rents for about $1,000 per month). It doesn’t matter what the economy does if you concentrate on buying in places like this and avoid bad neighborhoods and markets that aren’t well-diversified. Your money will be safe.
We can’t predict the future, but if you follow this advice, you’ll have a much better chance of increasing your wealth over time.
