What Bubble?
The day was April 24, 2004. Chad bell was making his attempt at history. He was going to blow the world’s largest bubble according to the Guinness Book of World Records.
Chad stood there in front of the cameras, lights and judges. He inhaled, paused and slowly began to blow. The crowd looked on in expectation. Some whispered that he wouldn’t break the record, others looked forward to him succeeding. There was one thing they all agreed on however; the bubble was going to pop. It was going to pop but no one knew when. Finally, when the bubble reached a whopping 20-inch diameter, a new world record, it finally popped in a spectacular fashion.
The onlookers that said the bubble would burst were right, but it took a lot longer than most expected.
This is much like what is happening right now in real estate. People are afraid to invest because they feel a bubble is going to pop. I overheard someone comment the other day "this contraction is taking a long time to come." People have been prophesying the real estate bubble to pop since 2016 (probably even earlier). Years later the market is still expanding and the US experienced one of the longest expansions in US history – almost a new record. Similarly, Australia experienced its longest economic expansion in history – over 27 years. I imagine the Australians that stood on the side watching wished they hadn’t kept waiting for a bubble to burst only miss out.
Should you invest now or wait for the market to crash?
You’ve probably heard the saying “a broken clock is right twice a day.” Real estate is a cycle so yes there will be a contraction or a correction or a bubble bursting; whatever you want to call it. This is the same with stocks and every other investment vehicle but there is a reason why the wealthy take their money out of stocks and shelter it in recession resistant real estate.
Smart money says it's not about timing the market but time in the market. Real estate is a cycle and that is a great thing because you can make money at all points if you understand the cycle. Our first priority is making sure investors don’t lose money and that they preserve their capital. Instead of being afraid we are making smart investment decisions with our investments so that the investments will be recession resistant, and our investors will be protected and able to make money even if that bubble pops.
Here’s how: We make our investments recession resistant by investing in assets that match the profile of those that did well during prior recessions.
5 Smart Ways To Prepare For And Invest In A Bubble
Long Term Financing
Many investors prior to the financial crisis entered into short term bridge loans with lump sums due after 2-3 years. Because of the decrease in property values and market conditions they were not able to make these lump sum payments. Other investors had fixed rate debt that became adjustable rate debt in a period which interest rates skyrocketed. Investors were not able to produce the same cash flow they expected after those rates reset.
Recession Resistant Approach: When we finance our deals, we look for long term, fixed rate financing that extends at least 2-3 years beyond the needs of our business plan.
Responsible Leverage
Many investors took on risky loans with 90% financing even all the way to 100% financed, no money down loans. Investors that took on these types of deals were able to succeed in a market that was on the rise. As soon as the rental markets softened, they were no longer able to meet their required debt service, and worse, some had to sell at a loss as they could not maintain their properties.
Recession Resistant Approach: We finance our deals with, at a minimum, 80% LTV (loan to value) but most frequently 75%. This allows the property to comfortably produce enough income to cover debt payments.
Sufficient Capital Expense Reserves and Working Capital
If the investors did not have a problem paying their debt at first it became a problem once capital expenditures came up. Roofs, boilers, HVAC and other issues would arise but there was no money to cover these costs as the investors made no reserve savings to handle these expenses. They would have to choose between paying their debt or fixing the building. As this maintenance became deferred over time it would increase the problems at the property and decrease the number of units that could be rented.
This leads to less income from the property to pay debt and expenses. Which leads to more deferred maintenance. Which leads to less income from the property to pay debt and expenses. Which leads to more deferred maintenance. Which leads to…You can see where this is going.
Recession Resistant Approach: We adequately look at capital expenditure needs upfront when investing in a deal and put that money aside; in addition, we have an ongoing capital reserve that is saved each period for future issues.
Buying Investments With Built In Equity
In a down market property values decrease. Investors may have to sell their properties for many of the previous reasons listed above. If the property has lost value and the investor is not able to maintain the property until the market recovers, they will have to sell at a loss.
Recession Resistant Approach: We fix this by looking for and buying properties under market rate so there is built in equity. Further, we "force appreciation" to increase the value of the property through physical and operational improvements. With all of this built-in equity we have a sufficient cushion to absorb decreases in value so that if we need to sell, our properties will be worth more than what we bought them for.
Cash Flows On Day One
Many of the problems that arose for investors were because they did not have enough money to cover expenses and debt. In the heights of the market, investors took on deals with negative cash flow based on the fact that the expected income they would earn at the exit of the deal would be more than the negative cash flow they had to pay out while owning the property. This may work when the market is going up but once the market softened they were stuck with negative cash flowing properties that could not appraise or sell for what they expected.
Recession Resistant Approach: We fix this by buying properties that cash flow as is; if there is a down turn in the market and we are not able to execute our business plan we can still pay our investors if all else stays the same. Even if there is never an increase in rent, there is still in place cash flow to pay returns to investors.
How To Invest In Any Market Or At Any Time In An Economic Cycle
Gravity shows us that what goes up will come down. As investors, we should not be blind to our current market cycle but with wisdom and knowledge we can remove fear and make smart investment decisions. Choosing an investment team that prioritizes capital preservation and making recession resistant investments is key.
As you can see if you follow the 5 smart ways to prepare for an invest in a bubble you will have success. The 5 strategies are:
Long Term Financing
Responsible Leverage
Sufficient Capital Expense Reserves and Working Capital
Buying Investments With Built In Equity
Cash Flows On Day One
Interested in learning more about investing in multifamily apartments? Give us a call or check out some of the other free resources we have available at Investupmultifamily.com.
