“Are you ready for the next recession?” This is a question I see on BiggerPockets almost daily.
There’s been a lot of talk lately about bubbles, up markets, down markets, if commercial real estate is overheated, if there’s too much student loan debt, and so on and so forth. I’m often asked what my personal economic prediction is for things going forward.
Although I have my own opinions on where I think things are headed, the one thing I do know for certain is that markets will change, including the real estate market. The real question is not just when will it change, but how can you prepare for it now and deal with it when it happens?
The Problem: A Lack of Liquidity
In the late 1980s, I was a newly licensed realtor and interest rates were coming down from a high of 18 percent. That’s right—18 percent.
In fact, a little while later, I purchased a home owner-occupied at 11 percent with six points (aka 17 percent, due to the fact I was self-employed and in business less than five years). Ouch! Remember that the next time you complain about rates!
Fortunately, I owned it for many years, eventually selling it at a profit—proving there’s a deal in any market. But I digress.
Anyway, back in 1987, the real estate company I worked for had a great training program where all the newbie agents had a senior agent train them in exchange for a percentage of our commissions. I was lucky enough to be trained by the “top sales dog” of the company at the time.
He was no doubt number one in listings and sales, and I learned a lot from him in that regard. However, his private real estate endeavors were another story.
He had 25 rental properties back then, which is a considerable amount even today. So I thought he really knew what he was doing. But not long after our training, he was losing all 25 rentals, filing bankruptcy, and was no longer a practicing agent.
What happened?
Well, I came to learn that he was extremely over-leveraged with very little equity and little to no reserves. He couldn’t handle the cost of any move outs or required repairs (i.e., township and Section 8—HUD required).
He got in even more trouble when he couldn’t re-rent multiple properties, and unfortunately, he quickly went into default on his mortgages. The house of cards came crashing down.
What happened to him taught me early on many valuable lessons about reserves, over-leveraging, and access to cash.
Related: Want to Secure Your Family’s Financial Future? Before You Pay Off Your Properties, Consider THIS.
The Importance of Reserves in Real Estate
It was easy to see that my former real estate sales mentor had done several things to increase his odds of experiencing a disaster. First, he had no reserves.
So when I was starting out, I made sure to set aside about $2,000 to $3,000 in cash per property. Later on, as my portfolio grew, it became more about access to cash for similar amounts—whether through credit cards, home equity lines of credit, or business lines of credit.
Keep in mind these numbers were specific to my “buy box,” which was properties under $100,000. Even to this day, I have access to significant capital if need be, and I strive to have the right entity structures and financing in place in case I need to access cash quickly.
The Danger of Being Over-Leveraged
Today, working in the distressed debt space, I’ve come to learn that unfortunately bad things can happen to good people. The four main reasons borrowers default on their mortgages are death, divorce, health reasons, and job loss.
What you learn from working in this space is that just because these people face a setback doesn’t mean they can’t get back on track; after all, most people had to qualify for their mortgage at one point in time. But some of us make choices that lead to being over-leveraged to the point that a default becomes almost inevitable.
Many folks get into trouble taking on too much overall debt, with things like student loans, credit cards, auto loans, or home equity loans (or a combination of these). It’s easy to get into debt, but it’s not always so easy to get out.
And when you’re an investor in addition to being a borrower, as your portfolio grows, it’s easy to imagine having to replace three roofs and two heaters in a short period of time. When that happens and you don’t have some form of liquidity, you’re in trouble.
For other investors though, it’s more than just reserves and access to cash. It really starts with having the right mortgage.
Related: To Leverage or Not to Leverage? Why the Answer Isn’t as Simple as You Think
The Solution: Choosing the Right Mortgage for You
When I started in real estate, it was a time of high interest rates and adjustable rate mortgages. Plus buy down mortgages were being invented.
The buy down was a mortgage that had a low rate initially but jumped up a point each year until year three. Then it stayed fixed for the next 27 years.
The adjustable rate mortgage (ARM) was even worse: it adjusted with a potential 2 percent increase each year that was capped and an overall 6-point cap on the life of the loan. (Each point is 1 percent of the mortgage amount.)
You can see how these kinds of loans could be dangerous types of debt for certain borrowers, particularly those who aren’t ready when adjustments happen.
Right before the last real estate crash, I decided to make half my rental properties fixed rate mortgages and half adjustable. It turns out, I made (or saved) a lot of money by freeing up cash to remain liquid with the ARMs, because the interest rates stayed very low for a good 10 years.
I also made sure the properties attached to these mortgages still cash-flowed, even at the highest potential rates of the ARMs. Plus with more monthly net cash flow, I was protected with larger reserves if and when interest rates reset.
And using 30-year mortgages similarly enabled me to have more monthly liquidity via lower payments compared to a 15-year mortgage with a higher payment.
Did my equity grow more slowly? Sure. But there was more money in my pocket to take care of repairs, move outs, and everything else along the way.
5 Ways to Recession-Proof Your Real Estate Investing Strategy
I’m not so sure you can predict when the next real estate market shift will occur for many reasons—namely because real estate markets are localized. But there are many things you can do to get ready.
- Fix your rates. If you anticipate rates rising and you plan to hold real estate, then consider fixed interest rates on your mortgages.
- Develop more access to cash. This could be everything from increasing credit card limits and taking out equity and business lines of credit to developing more private money relationships. It’s good to do this before you need to (i.e., when you’re physically and financially healthy).
- Build up your cash reserves. Your access to cash and cash reserves should be at a level that’s commensurate to your portfolio. Don’t just be in accumulation mode; preservation mode can be just as important. Remember it’s “not what you make, it’s what you keep.”
- Employ asset protection strategies. This is also important to do before the need arises. Develop safer investment buckets, such as trusts, qualified plans, and insurance contracts, to sweep some capital and profits off the table during the good times.
- Diversify investments. Invest in areas aside from hard real estate, especially ones that aren’t as market-driven or illiquid as real estate. In other words, don’t put all your eggs in one basket (or asset class).
So am I ready for the next recession? I think I’m as ready as I’ll ever be, and hopefully some of these tips will help you get to a similar stage of comfort.
It’s very easy to get caught up in the frenzy and momentum of up markets, but it’s very hard to stay the course and make plans for the rainy days. Similarly, it’s difficult to argue against the fact that “cash is king” in down markets, and the best time to sell is when the market is up.
What are you doing to prepare for the next market fluctuation?
Let me know in the comment section.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
