We’re heading into year two of decade three of the new millennium amid some of the strangest circumstances in recent memory. Covid-19 has put governments, societies, and economies through the wringer and the effects are reverberating through the real estate market.
Anywhere you look, reports of surging housing prices, rampant speculation, and historically low inventories pepper even mainstream news cycles. This has caused many would-be investors to ask: should I invest in real estate now? Or await the return of calmer waters?
I should start by saying that I, like everyone else, don’t have a definite answer. However, while uncertainty itself might be certain, looking a bit more closely at major qualms is often a clarifying exercise.
Here are four I hear often:
- The real estate market is a bubble that will soon pop
- The risk of an economic recession means debt is better avoided in favor of liquidity
- Alternative investments like cryptocurrency and precious metals offer more protection and easier yield
- Competition for deals is at a fever pitch
Bubble or Boom?
Let’s start with the notion that what goes up must soon come down in the real estate world.
There’s no doubt that valuations have been going nuts. According to Zillow,, the average home appreciated by 13.2% between May 2020 and May 2021. That increase is a record high in the 25 years the company has been collecting data, and some individual markets have more than doubled that benchmark.
Fast appreciation alone, however, does not invariably signal a pending crash. A better question than whether prices have gone up too quickly is to what degree the surging valuations are divorced from justifying fundamentals.
Take my home market of Denver as an example. Here prices have gone up here almost as fast as anywhere in the country (some estimates come in at a ridiculous 18% as of November 2021). Does this mean Denver prices are doomed to soon come crashing back to earth?
In real estate, appreciation is general sustainable if (1) demand for housing remains strong relative to supply, and (2) housing is still “affordable.”
So, look at the fundamentals first. Supply is low but growing, vacancies are below the national average and didn’t move much during the pandemic. On the demand side, besides increasing housing and rent prices, migration increased in 2020 compared to 2019 despite national decreases in migration. This is underpinned by a diversified economy that boasts a strong tech, healthcare, and energy sector as well as a unique lifestyle appeal. That’s a recipe for continued price increase.
Next, check affordability. While Denver has steadily become less affordable over the years, it is still middle-of-the-pack (63rd percentile in 2020 at 27% median income to median housing price ratio, according to our data) nationwide and well below the upper levels of unaffordability that are mostly tolerated in the nation’s tier one cities.
The level of affordability (or unaffordability, perhaps) that residents are willing to tolerate depends on the inherent desirability of the city. Happily (for investors), this tends to be a positive feedback loop. The more desirable a city becomes, the more the influx of high earning residents quickens and the further an eventual “cooling off” is kicked down the road due to a rising tolerance for high costs of living. Even if prices do cool soon (and there are some signals that they will), that’s a much more palatable outcome than a collapse.
A more in-depth breakdown of how to quantify appreciation prospects can be found in our market analysis. The takeaway, however, is that if you can identify an affordable market with good fundamentals, you can be reasonably confident that its growth is sustainable. This duo of market measures can together be thought of as a market’s resilience.
Still, it’s true that no one knows what’s going to happen next. Valuations could unexpectedly take a nosedive despite the current supply-demand relationship. To the especially nervous investor, then, I would suggest one more metric to pay attention to: rent margin of error. This is the percentage amount rent can decrease and still cover your debt obligation and operating expenses (this is more commonly measured as debt coverage ratio, though I prefer rent margin of error as it also includes expected operating costs).
For residential loans, default is only a risk when you can no longer make your mortgage payment; the property’s nominal value is irrelevant. If rent stays high enough that you can keep paying your mortgage, the market value can go down all it wants without bringing financial ruin. If you’re concerned that today’s market is a bubble, this should shift your focus from a possible drop in prices to a possible drop in rent.
As for what rent margin of error is sufficient, the historical record yields a decent enough line in the sand. During the great recession (which, keep in mind, was driven by a real estate collapse) rent prices (as measured by investment grade rentals) dropped around 6.2% in western markets which were hit the hardest. In terms of YOY change, the lowest on record is a 13.48% decrease during the great depression in 1933. Since then, the greatest YOY decrease in national rents was just under 2% in 2013.
Given that context, I’m confident projects in “resilient” markets that have rent margins of 15% are a safe investment. As an added safety measure, we also bake six months’ worth of reserves into our initial calculations when evaluating assets.
Hedging Recession
This brings us to the next concern… what if the entire economy goes down? Shouldn’t one favor more liquidity and less debt if looking down the barrel of another recession?
Distinguishing “good” debt and “bad” debt is a good place to start here since all debt is not created equal.
Investopedia defines good debt as:
Good debt is often exemplified in the old adage “it takes money to make money.” If the debt you take on helps you generate income and build your net worth, then that can be considered positive. So can debt that improves your and your family’s life in other significant ways.
And bad debt as:
[If] you are borrowing to purchase a depreciating asset. In other words, if it won’t go up in value or generate income, then you shouldn’t go into debt to buy it.
Real estate debt is good debt if any debt is, and a good rent margin hedges the risk of it becoming a bad liability.
What’s more, in this moment the economy is too hot. Inflation is increasing and the fed has already announced plans to raise interest rates as many as three times starting in the spring of 2022. This is fact while any future state of the market is speculation.
That means the choice is the near term is to take on cheap debt that will decrease in nominal value if inflation persists or to put cash in banks (or under your mattress if you’d like) at similarly low yields only to be burned through by that same inflation.
In my view, holding good debt through assets bought scrupulously now is better than sitting idly on a pile of fiat currency.
Of course, in the hypothetical that a recession is just around the corner, having perfect liquidity would allow you to take advantage the market downturn, which, if timed correctly, could make up for any extra costs associated with passing on low interest rates or playing the waiting game**. This is called market timing, and it’s a die that investors have been rolling as long as markets have been around.
I can’t say that playing the market timing game won’t pay off. It does for some people some of the time. I can, however, say that it’s unlikely; it doesn’t take many years of growth to render the cost of waiting higher than the profit won later. This timeline is only expedited if inflation is high in the same period.
As a final point, it is good to keep in mind that while the great recession was a housing driven crisis, there is no rule that says real estate valuations must bottom out along with the stock market.
Take a look at the last four recessions for context:
Even if they do, it could happen in the context of an environment where capital is more expensive, less favorably structured, or just plain harder to find. Again, market timing from a position of ignorance typically results in bad outcomes.
Alternative Asset Classes
And now for the lure of alternative asset classes. If you’re not worried about a market crash or set on eschewing debt for liquidity, you might just be unconvinced about real estate investment in general.
There are perfectly good reasons to look elsewhere. Your personal situation is going to determine which apply in your case.
To briefly touch on some important points, however
If you’re worried about a downturn, it’s not at all clear that precious metals and cryptocurrencies are uncorrelated assets or negatively correlated to the stock market, meaning in the event of a recession one should expect them to retain value (in fact, recent evidence suggests the potential for an opposite correlation of both Bitcoin and gold).
If you’re worried about inflation, real estate is as good or better hedge than just about anything besides stocks.
If you’re focused on returns, RE returns easily beat precious metals pretty much any way you slice it. Even an unleveraged real estate asset anywhere in the country would have appreciated 3.2% per year since 1891, and that’s without factoring in rental income or amortization/compounded returns for a leveraged asset. A well leveraged real estate project can return anywhere between 30% and 100% YOY with the right strategy (or even infinite if you’re a fan of the BRRR strategy). Gold, as a point of comparison, has a ten-year average return of 3.71%.
Admittedly, the same can not be said about cryptocurrency, the poster child of which (Bitcoin) has an absurd ten-year average return of 230%.
Still, while I like crypto, for me the major advantages of real estate are two-fold.
Advantage one is that real estate assets have intrinsic value. That means short of an apocalypse, value will never go to and stay at zero. That also means that buying real estate with good investment principals is not speculative. Buying cryptocurrency essentially always is.
Advantage two (really, advantage one part two) is that because real estate returns hinge on the functioning of the asset, real estate investment enjoys a much healthier effort-reward ratio than investment in cryptocurrency, whose return largely hinges on the valuing of it. The functioning of real estate can be reliably intervened upon, the market’s valuing of cryptocurrency not so much.
Competition
With that, there’s just one more concern left to address. Namely: How can I buy real estate when there’s so much damn competition?
It’s true that buying now can be a headache. After submitting dozens of over-asking bids and getting nothing, one can’t be blamed for wanting to just throw in the towel.
Here, I’d submit three last points for consideration.
The first is that for the right deal, you shouldn’t be overly concerned about buying over the sticker price. Especially with leverage (which reduces your principal to a fraction of the purchase price), differences that result from bidding are often trivial and impact the return of a good deal too much.
As an example, if you identify an asset priced at $500k and can only get it for $550k, the difference in your principal is only $10k with 20% down. Speaking from experience, these differences that seem pivotal in the negotiation phase tend to be forgotten (or even instantly erased) once the deal is done and the investment up and running.
This is not to say that you should be unconcerned about purchase price. There is always a price you should walk away from. The argument is just that the general fact of being likely to pay above sticker price should not automatically disqualify investment.
The second point is that lots of things that seem impossible are not so if you get creative. The outlining of ways you can get creative in finding deals is outside of my scope here, but I would just state the simple fact people are finding deals right now and they possess no superpowers you don’t have.
The third and final point is a cliché: if it’s worth having, it’s worth working for. If you’ve gotten all the way to “buy,” don’t let yourself regress back to “wait” just because the process is annoying. Find quality deals, get creative, and, most importantly, stay at it.
Good things come first to the persistent and then to everyone else.
Conclusion
Should you invest in real estate now even in the face of strange and uncertain market conditions? For me, the answer is a yes due to in part to rebuttals to concerns outlined above:
- You can (and should) limit risk by buying rentals with healthy rent margins in markets with high price resilience
- Market conditions suggest it a good time to take advantage of “good” debt and avoid excessive liquidity rather than the other way around
- Alternative asset classes are either low yielding or speculative and are historically questionable hedges against stock market volatility
- Competition alone should not be a deterrent. Once you’ve done your homework, just stay persistent and run your own race
Thanks for reading! While this post was obviously not rigorous in scope, I hope that for you, like for me, just walking through some high-level reasoning helps check the emotional answer to tough questions.
In times like these, that could be just the sort of immunization we need to keep making good decisions.
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