Housing markets, like every other market, are cyclical.
In our Facebook group for landlords and real estate investors, I hear investors worry all the time: “What happens if there’s a housing market correction? I could lose everything! What do I do?!”
For anyone biting their nails and losing sleep, here’s a spoiler: the market will dip.
Now, it may not happen over the next year. When the market dips is a matter for speculation and debate. But the important question isn’t if or when a market will drop, but how real estate investors should prepare for and operate during a market correction.
Here’s what real estate investors need to know about real estate market downturns, as talk heats up about when the next housing market correction will strike.
The Normal Real Estate Market Cycle
In a housing market crash, demand disappears even as supply continues growing. Because construction takes many months or even years to complete, it takes time for new supply to slow down to meet lower demand.
Most buyers get spooked by falling home prices. But at a certain point, prices drop low enough to spur demand again. Prices level off, and gradually start climbing again.
Real estate values rise alongside demand, and then as values rise, supply follows suit. Homebuilders gradually pick up the pace of construction, and sellers increasingly grow tempted by high housing prices to list their home for sale, until once again supply starts outpacing demand.
Because a chart is worth a thousand words, here’s one courtesy of Marshall Funding:
Notice that vacancies are the metric used to measure the balance between supply and demand. In your particular market, pay close attention not just to the actual vacancy rate, but also to the direction that vacancies are trending. Decreasing vacancies indicate an upward-bound market, while increasing vacancies represent a market poised to drop.
As a final note, keep in mind that housing markets are all local. Often, different cities will be in different phases of the housing cycle, and undergo real estate corrections at different times.
Corrections Represent Opportunity
Real estate investors can make money at any phase of the housing cycle. But real estate market corrections create an especially juicy opportunity.
When other buyers are huddling on the sidelines and gnashing their teeth about lower home values, investors can buy at a discount. Think of it as an occasional “sale” on real estate.
Nowadays, real estate investors lament “It’s so much harder to find a good deal than it was in 2013!” But they forget just how spooked most buyers and investors were in 2010-2014. It’s easy now, after years of strong home value appreciation, to talk about how cheap real estate was back then. But most people were too scared to touch real estate at the time, and that’s why it was so cheap.
The next time prices drop in a housing market correction, instead of standing on the sidelines, consider investing instead.
How to Avoid Losing Money in a Housing Market Correction
“It’s all well and good Brian to tell me to jump in and buy real estate when it’s just crashed, but how do I protect myself?”
Great question! I’m glad you asked. Here are five ways you can avoid losing money in the next real estate market correction, starting today.
1. Invest Based on Today’s Cash Flow, Not Tomorrow’s Appreciation
In a real estate correction, homes values drop. But rents may not drop at all – in fact, they could rise!
When you buy real estate assuming that it will appreciate, you are speculating, not investing. Sure, the property may appreciate; or it may plummet in value by 25%. You don’t know, nor do you have any control over the market.
Instead, invest based on today’s rental cash flow. After running the numbers through a rental property calculator, are you satisfied with your cash flow and ROI? If the property temporarily drops in value but the rent stays the same, will you still be content with your investment?
If the answer is no, look for a property that offers better long-term cash flow.
Rents Rarely Collapse
Rents are far, far more stable than home values over time. To illustrate this point, check out this chart of inflation-adjusted rents since 2005 (blue is median, green is mean rents):
(Chart courtesy of the Department of Numbers)
Note that rents did decline – in 2008, inflation-adjusted median rents reached a (then) peak of $932, before declining in 2009 to $916, then $912 in 2010, and $898 in 2011. They then proceed to rise again.
Remember, those are inflation-adjusted to today’s dollars: nominal rents barely budged at all, but when rents stand still, they do lose money to inflation. But even the inflation-adjusted rents didn’t drop by much: from peak to trough, they dropped by $34.
Housing values, in contrast, drop by far more in housing market corrections. Consider the following chart showing both nominal and inflation-adjusted home values in the US:
One reason is that during real estate corrections, demand shifts from homebuying to renting. No one wants to buy a house when values are in freefall, so they rent instead. Renting is where people retreat when housing markets are in turmoil.
If you base your long-term rental investments based on today’s rents, there’s very little risk of a significant drop in rent. That doesn’t mean rents can’t fall – they can – but even when they do, they don’t fall like home values fall.
As a final chart, take a look at how rental vacancy rates moved since 2000:
You can see vacancy rates rising even as real estate values and rents rose throughout the 2000s, which actually defies the normal housing cycle. It was an advance warning that the housing market was abnormal. Note that in the last eight years declining vacancies have mirrored rising rents and home values, as one expects in a normal housing market.
2. Choose Low-Risk, High-Return Markets
No market is immune from real estate corrections. But some markets are inherently riskier than others, and some markets have a higher risk of rents falling.
Which, as we’ve discussed, is the greatest threat to a long-term rental investor.
So how can you tell which markets are at a higher risk for rents falling?
Before we dive into analyzing local markets, let’s pause for a moment to review what causes rents to decline. Rents fall for three main reasons:
- They were overpriced in a rent bubble
- Demand falls and vacancies increase
- Local unemployment rises and tenants lose their ability to pay the rent.
These are not mutually exclusive; one can cause another, or several can occur simultaneously.
As a real estate investor, your first goal must be to buy mathematically, based on research and data, not based on emotions. That sounds easy, but it’s all too easy to fall in love with a property and then overpay or ignore warning signs.
Here are several ways to analyze markets, to buy in areas with a lower risk of falling rents in a housing market correction, and avoid even looking at properties in riskier markets.
Check Real Estate Trends
Start with the most obvious: are rents and real estate values rising or falling?
An easy source for this data is Zillow:
Review Historical Vacancy Rates
What’s today’s rental vacancy rate? More importantly, what direction is that vacancy rate trending?
For the top 75 metro areas in the US, the Census Bureau provides quarterly rental vacancy rates.
You can also view vacancy data on Moving.com – I’ll use my sister’s town of Bel Air, MD to illustrate:
Beware of any market with rising vacancy rates.
Check Population Trends
Is the population growing or shrinking? While there’s a niche in buying cheap properties in declining markets, it’s tricky and best left to specialist investors.
Buy properties in markets with growing populations. You can check population data on Google:
For county-level population trends, you can get detailed data from the Federal Reserve:
Another measure to look at is the age distribution of the population. Growth markets tend to skew young, with plenty of kids and young adults. Young adults are more mobile and follow strong economies, whereas older adults are often the last to leave declining communities.
You can find age distribution data on CityPopulation.de:
Review the Economy
Once again, look not only at today’s economy and unemployment rate, but at which direction it’s trending.
Try AreaVibes for town-level unemployment information:
For county-level data, once again the Federal Reserve offers a beautiful historical graph:
But the unemployment rate is not the only data to check. How diverse is the local economy? Coal mining towns didn’t do so well when coal mines shut down. The same goes for steel mill towns, or auto manufacturing towns (Flint Michigan, anyone?), or any other town over-dependent on a single industry.
To check the distribution of jobs across industries, try DataUSA.io:
3. Buy Properties with Room for Improvement
Another strategy to avoid losses during real estate market corrections is to buy properties that can be improved if desired. It leaves you the flexibility to either double-down and invest more money into ratcheting up the property’s appeal and asking rent, or leaving it as-is to keep it affordable in a correction.
The worst property for investors to own is the best property in the neighborhood. You can easily improve your property, but you can’t easily improve the neighborhood.
Buying dated properties also leaves room for you to “force equity” by updating it and adding value.
4. Less Leverage, Less Risk in a Housing Correction
I overleveraged myself in the lead-up to the last housing crisis. I borrowed the maximum possible loan amount on each property, crushing my cash flow and leaving me upside down when housing values collapsed.
To protect yourself in the event of a housing market correction, you can lower your risk by using less leverage. Instead of maxing out your loan at 85-90% LTV, consider 65-80%.
With a lower LTV (loan-to-value ratio), you’re less likely to become upside-down in a real estate downturn. You’re also far less likely to feel a cash flow pinch or experience negative cash flow.
Also be careful to avoid variable-interest loans or balloon mortgages. The last place you want to find yourself is forced to sell or refinance in the midst of a real estate correction, because your property will be worth far less. Refinancing is far more difficult during a housing correction, as home values drop and credit markets tighten.
Instead, borrow long-term fixed-interest mortgages for your rentals.
Another leverage-related strategy to lower your risk is to pay off one of your properties’ mortgages. With one less mortgage, you cash flow jumps, and it leaves you with a free-and-clear property that you can borrow against in an emergency.
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5. Improve Your ROI with Better Property Management
Deni and I love to talk about the “Four Horsemen” of rental returns:
- Rent defaults & evictions
- Turnovers & vacancies
- Major repairs
Your job as a landlord is to minimize the risk of each. For example, you can minimize the risk of rent defaults and evictions with obsessively-thorough tenant screening. But it doesn’t end with running credit reports and eviction reports, or the likelihood of an applicant paying the rent on time.
Beyond tenant screening reports, you can minimize your turnover rate by screening for how long an applicant is likely to stay. How stable is their housing history? How stable is their job? How long do they intend to stay? Are they willing to sign a multi-year lease agreement?
Speaking of lease agreements, you can use your lease to minimize the risk of damage and repairs. For examples, see these protective lease clauses.
To completely eliminate the risk of defaulted rent payments, you can insure against it. Literally: Steady offers rent default insurance, so if the tenant stops making payments, they pay the rent while you start the eviction process.
You can also reduce your risk of rent defaults by collecting rent electronically. Here’s an overview in under 100 seconds of how you can automate your property management through an online landlord app like SparkRental’s:
We teach an entire course on how to maximize returns by automating, delegating, and eliminating expenses and labor as a landlord. But if you do nothing else, focus on only leasing to high-ROI tenants, on pruning your higher-risk and higher-headache tenants, and retaining your good tenants for as long as possible.
Other Ways to Weather the Storm Without Stress
Far too many real estate investors lose sleep during housing downturns. They see their equity dropping, and their net worth along with it.
First, remember that equity exists only on paper. It only becomes real upon sale. So? Don’t sell during a real estate market correction!
If your cash flow is strong, you can keep collecting rents and enjoying the passive income. No muss, no fuss. Your equity may have dropped, but who cares? You can ride out the correction and watch it rise again.
Earlier, I mentioned leverage, and how less leverage leads to lower risk in a real estate correction. Another way to lower your risk is liquidity.
The more money you have set aside in cash, the less exposed you are to any of the curveballs that could come your way in a recession or real estate downturn. You can withstand the occasional turnover or vacancy or repair. With an adequate cash cushion, you don’t need to sell or borrow money if a big expense hits you.
And you’re in a position to buy rental properties at a discount, while everyone else is panicking about real estate.
Housing market corrections are nothing to fear, if you invest analytically and remain ready for a real estate downturn at any time.
In fact, many real estate investors look forward to real estate corrections, because it creates fire-sale pricing on properties!
The people who get in trouble during housing corrections are investors who speculate on appreciation, and who overleverage themselves. If you invest based on today’s cash flow, in growth markets with sound fundamentals, with leverage no higher than 80% LTV, you’ll be well positioned when the next housing market correction comes around.
Let it come. You’ll be ready for it.
What have your experiences been, with real estate market corrections?