There is a widespread view that real estate is one of the most stable asset classes for which to grow your wealth. This is despite the cyclicality of the real estate market and the fact there have been numerous real estate market downturns in the last century. You don’t have to look too hard to find many doomsayers suggesting a new real estate market downturn in 2021. So why do many (including myself) continue to place faith in real estate?
It is an undisputed fact that you will increase your real estate return if you hold onto the asset for the long-term. However, that is true of almost all asset classes. For example, over the past century, the stock market has outperformed all other asset classes by a healthy margin. Yet, people continue to trust real estate. My viewpoint is that people trust the tangibility of real estate. You can both see and touch the asset with your own eyes. This places an unnecessarily high amount of faith in real estate, and casts a blind eye to negative market forces influencing this asset type.
Another reason I believe people trust real estate over public equities is due to the absence of sensationalism. To illustrate, I am quietly confident that those of you reading this post would be able to comfortably cite more stock market crashes than real estate downturns. A stock market crash typically gets the A-list Hollywood treatment in terms of publicity, and invariably sows the seeds of distrust among the wider public on that asset class. However, a fact missed by most is that it is also common place for housing markets to experience 15-20% corrections and have real estate market downturn periods that rival typical bear markets.
For some of you reading this, you may dismiss this comparison with one argument – people live in houses and therefore will always place value in them. That is true for an owner model. But why is this relevant for an investor? As an investor, your decisions should be on selecting which asset class gives you the most healthy yet stable returns over your preferred time horizon, and those that increase the ‘passive’ component of passive investment over time. Real estate isn’t the only asset class which ticks these boxes.
Real Estate Market Downturn - My Own Personal Experiences
Regardless of the asset class in which you allocate your resources, investment returns are not one-sided. For all the glorious highs, there are equal, if not memorable and pitiful lows. Take real estate in Perth for example. We have been in a depressed market for the 5th year in a row. To put things into perspective, I had a bank valuation of over $6.4 million in the summer of 2014. Over the past 5 years, that valuation has not exceeded $5.4 million. I will note that bank valuations are not representative of market prices. However, it still represents a 16% decline in overall value for a sustained period, where at times it even exceeded a 22% decline!
While the overall value of my portfolio has been down, it has not rattled me or my family. Our investment strategy has always been to own and pass on these investments when the time is right. So we have been comfortable with riding out the lows, however long they may last. However, we’ve sought to bolster this mindset by implementing a few key investment strategies that should be employed by the savvy investor, particularly those that are interested in coming out stronger on the other side of a real estate market downturn.
Maintain A Healthy Debt/Equity Balance
This is fundamental for any real estate investment strategy, however you truly recognise the fruits of this balance during a downturn. As I mentioned previously, I am not averse to utilising debt to finance one’s investment goals, particularly real estate. It is not mathematically advantageous to pay for houses in cash when interest rates have been as low as they are for such a long time period. Put another way, when the cost of borrowing is low, you are disincentivized from paying for your investment properties using cash, as you could instead allocate that cash towards other asset classes which yield higher average rates (e.g. the stock market).
If you were to obtain a mortgage, the typical starting point for your debt/equity balance would be 80/20; i.e. 80 percent debt vs 20 percent equity. This is supported by the fact that banks will lend up to 80 percent of the home value, on the basis you will contribute the remaining 20 percent. Failure to do so does not prohibit you from obtaining a mortgage. However, you will be required to take out private mortgage insurance/lender’s mortgage insurance (see here).
While this is the starting point, it is advisable for that split to be closer to 60/40. You have much greater control over the investment, and are in a stronger bargaining position with the bank when it comes to managing or refinancing your loan. I have typically tried to target a 55/45 split, where I can continue to benefit from favourably low interest rates while still not being fully beholden to the banks. I have tried to maintain this balance over my entire portfolio instead of on individual properties, given rate and term differentials on the individual mortgages.
Take Advantage of Refinance Opportunities During a Real Estate Market Downturn
One of my biggest investment regrets was to not refinance my home loans to be principal and interest repayment loans at a much earlier date. For those looking to obtain a mortgage, your most commonly occurring repayment options are interest only or principal and interest (“P&I”). Depending on your circumstances at the time, an interest only repayment schedule may be appropriate. However, as your disposable income and overall equity increases, it may make more sense to have a P&I repayment schedule.
While the overall monthly mortgage payments may be slightly higher, your effective monthly interest component will be reduced over time. This is because you are reducing the principal balance over time. While this can accelerate your repayment period, the more significant impact is you save more money that you can use at your discretion. Over the past two years, I’ve sought to convert all of my home loans to principal and interest. However I wish I did it earlier when I was still in the workforce and had the ability to pay off greater portions of the overall debt at a much quicker rate.
Another benefit of principal and interest repayment terms is, in almost all cases, you can negotiate a lower interest rate than if you were to select an interest only loan. Having access to potential rate arbitrage is crucial in a real estate market downturn environment, particularly if your once stable rental streams may be jeopardised. Further, paying off the principal quicker only serves to improve the debt/equity balance outlined above.
Diversify Your Real Estate Portfolio
Diversification may not be as commonly used a term as it is among public equities. However, the concept theoretically benefits investors in the same way that exchange traded funds would be preferential over individual stock picking. Put simply, diversification can lessen the impact of high market volatility.
There are many ways to think about diversification in a real estate context. For example, as I mentioned in an earlier post, owning a few apartments can help with mitigating market volatility, as these housing types typically fare better during downturns compared to single family homes. Further, spreading your portfolio across multiple local areas, while tedious, may prove beneficial during downturns.
For example, individual suburbs/real estate areas may fare better than others, due to geographical or socio-political factors. Despite the overall market being depressed, these areas may potentially recover quicker or fare better than other hard hit areas, thereby mitigating the overall impact of the downturn.
The concept of real estate investment has changed significantly in the past few decades, and in most cases, to the benefit of the investor. Real estate investment trusts (REITS) have been in existence for decades and have proven to be a perfect solution for the investor that wants to break into real estate, but does not necessarily want to get their hands dirty with physical ownership. In the last decade alone, real estate crowdfunding has broken onto the scene as another exciting and lucrative investment opportunity. While there are certainly pros and cons of these options (which I would be happy to outline in future posts), they provide an avenue for further diversification beyond traditional real estate ownership.
Be Selective With Your Tenants
Diversity in tenancy is also important. Having a healthy mix of long-term and short-term stay accommodations, as well as varying tenant demographics can help smooth out microeconomic market trends. For instance, I have personally noticed that my lower-rental tenants are also my longest tenured tenants at my single-family investment properties. In a down market, where my house appreciation value may suffer, I remain grateful for the stability of these tenants to provide me with baseline cash flow.
Alternatively, my shorter stay properties typically demand a higher rate than the rest of my portfolio, despite the property costs being fairly comparable to my single-family homes. Depending on the reason for the downturn, the rental streams generated from these properties may suffer. However, I have further mitigated this exposure by ensuring that these property types represent only a small portion of my portfolio.
Whatever You Do, Don't Panic!
Going back to the very start of this blog post, it’s helpful to lean into the conventional wisdom of real estate being one of the safest asset classes. While there will be market volatility, remember that you still own an asset that is a necessity for life preservation. If anything, you would be trading away short-term price appreciation for stable rental streams.
Over the past five years, I could have easily let fear creep into my thought process and sell off some or all of my properties. It may be 16 percent down today, but what if it goes down 25 percent tomorrow… or 40 percent… or even worse??
Fortunately, I have been doing this for long enough to not be phased by downturns, and I remain confident that my investment strategy and goals remain unchanged during times of market volatility. If you possess a similar mindset, and hold the true belief that you will achieve a healthy return on your investment over a sufficient time horizon, then you too should not be phased during a real estate market downturn.
I hope you found this post useful, if nothing but reassuring. Please feel free to leave a comment below on what has been your mentality towards a real estate market downturn and your approach to dealing with them.
The content outlined above was written, edited and published by the Lost Realtor. The author has over 20 years or real estate sales and investing experience in the Australian property market. He has held senior positions in Australian building companies, including being the General Manager of the residential sales division of Collier Homes. His qualifications include a Bachelor of Commerce degree and a Graduate Diploma in Building and Construction Law.