“Are we in a real estate bubble right now?” Trust us, we’ve heard this question asked a LOT lately.
In this episode of The Real Estate Guys™ show, we’ll dive into that question.
- The three components that converge to create market bubbles
- Why real estate is a good investment class for avoiding bubble trouble
- How to react in a hot market … AND
- How to prepare for when prices inevitably do deflate
You’ll hear from:
- Your bubbling host, Robert Helms
- His falling-a-bit-flat co-host, Russell Gray
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Are we in a real estate bubble?
Our primary caution to you is that all-time highs do NOT equal market bubbles.
It can be difficult to parse whether a bubble is, well, bubbling up. Here are the three different components to rising prices:
- Leverage. Financing means pulling money from the future to bring in dollars today. But the ready availability of money can end up driving prices higher, even though many loans are fashioned to make things more affordable.
- Disparity between supply and demand. When there’s more demand than supply, prices go up … even if the price no longer matches the value of the commodity.
- Inflation. Inflation causes currency to literally lose its purchasing power. So it takes more currency to buy the exact same things.
When you see runaway price increases, take a minute to consider what the cause is. Is the fundamental value of the property increasing, or is rampant speculation driving prices up?
When the factors above start to change, the price of a property can increase … or decrease … significantly. So pay attention.
Don’t get so caught up in a hot market you get blinded to the actual value of an investment. Buy because it makes financial sense … and not because everyone else wants to buy.
If you don’t know better, it’s easy to believe you shouldn’t be buying anything right now.
But real estate is a very different investment than most. Every single deal is unique, which means YOU have a ton of flexibility to add value to a property.
Real estate allows you to negotiate on the front end, manage operations on the back end, and analyze any given property on its own individual merits, instead of just looking at the market or asset class as a whole.
Real estate is not a commoditized asset. That gives you the power to strike individual bargains.
Tips for buying in a hot market
The vast majority of investors invest in stocks and bonds. They’re used to having zero control. As a real estate investor, there’s a lot you can do to position your portfolio for success.
Avoid the bubble mentality. Don’t buy because everyone else is buying.
Don’t treat properties like commodities and hope something good will happen. Pick your investments individually, and make sure you have a Plan A … and a Plan B and Plan C.
Then, do a sound analysis and underwriting.
Wondering whether there’s a difference? There certainly is.
Analysis means gathering the numbers and putting them together to get an estimated return.
When you get a pro forma, make sure you double-check the analysis … the math isn’t always correct.
Underwriting goes one step further. A proper underwriting process pulls third-party financial statements to verify the numbers from the analysis match reality.
It’s very important to underwrite all of your deals. Do this by gathering all the information you can from trustworthy parties … financial statements, rent rolls, copies of rental agreements.
You can even go a step further and verify information with tenants independently.
Next, you need to make sure your assumptions hold water. Check the property tax, the property condition, and maintenance schedule.
Evaluate the total cost of an investment, including needed rehab.
Last, look at your potential revenue. Evaluate rents to see if they match market rates, and see whether there’s any opportunity to make improvements and increase revenue.
A note … you CAN’T underwrite your way out of risk. But to minimize risk, you want your eyes as wide open as possible.
How to position your existing portfolio
Underwriting is important when making a new investment, but what can you do about your existing portfolio?
Quite simply, you can go through the same process you would with a new purchase.
Use zero-sum thinking to ask yourself whether you’re getting the most from your investments.
Look at the numbers … cash flow, debt and interest rates, and equity. Is there any room to improve the property?
You might think about moving some equity around. Many real estate investors think the only option for accessing equity is selling a property or doing a 1031 tax-deferred exchange … but you have a third option.
Consider a cash-out refinance, which allows you to transfer equity from a developed property to a market or property type with upside potential.
To proactively strategize about bubbles, separate your equity from your properties.
But be cautious … always do underwriting and analysis on potential purchases. You do run a risk when you thin out your equity, so make sure you hedge your bets as much as possible.
Making a risky purchase could mean being locked into a property when equity and cash flow decrease during a downturn.
So, ensure you have a plan for holding on to the properties you purchase in the event the market crashes and you go underwater.
Time heals a lot of wounds … we’ve seen many investors hold onto properties during a downturn only to make a killing once the market starts perking up again.
It may well be that the market you’re in has bubbled to the point where selling makes sense. When considering where to put your equity, be cautious and be smart.
Roll with the highs and lows
There are quite a few things you can do to protect yourself from the downside of bubbles and benefit from the upside.
- Seek out recession-resistant pricing. You want to look at rent pricing that is just below the market median. This is the sweet spot … you’ll get people coming down from the top in bad times and people coming up from the bottom in good times.
- Follow the barista rule. Some markets are more affordable than others. If your barista can afford to live in the same area they work in, that market has recession-resistant pricing that isn’t artificially inflated.
- Be in a position to pick up bargains when the downturn comes. Have the wits to pull some chips off the table when the market’s at the top so you can make a killing when the market deflates and there’s blood in the streets. In other words, keep some liquid equity close at hand when the market starts getting hot.
Bubbles aren’t bad … markets naturally rise and fall. You just have to be resourceful enough to catch the waves.
Now go out and make some equity happen!
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