The Recession is Coming!

There is so much chatter in the US today about an upcoming crash! It seems that not a day goes by, where there’s an article that is trending on why the economy is crashing within the next 18 months. Lowered interest rates, trade wars, inverted curves, government deficit, overvalued stocks, tech bubble, real estate bubble, everything bubble.

The economy crashing is a hot topic and will always be popular. When the economy crashed in 2008, the news was that it would keep getting worse and when it started getting better, it was that we are going to go into a double dip recession. When that didn’t happen, it was that we are going to see a crash within 18 months and it’s been like that for a long time now. I remember sitting at a conference in 2015 and the sentiment at the time was that we are in “extra innings” and the economy would be crashing soon. Well, it’s 2019 and we are in “extra innings” still and guess what? The economy will be crashing within the next 18 months.

The great thing about predicting a downturn is that eventually you will be right and then you can brag to everyone on how you predicted it and how everyone should have listened to you. Well, here is my prediction: The economy will have a downturn within the next 15-20 years. I know it’s bold, but I just needed to throw it out there.

I am not telling you to ignore the possibility of a recession. Trees don’t grow to the sky, however, you cannot control the economy and can’t predict when a recession will happen. So, what do I do? I plan on a recession happening. That’s right, I plan on there being a recession every day, every year. In 2008 I was prepared for it to get worse, in 2012 when it got better, I planned for it to get worse and still today, I plan for it to get worse. That’s not to say that I am negative and walk around saying the sky is falling, but instead, I make sure that my business is strong and remains in a good position with solid legs to withstand a recession.

Let’s dig in and look at what that means:

Plan – The first step is to plan for issues to happen. Knowing that occupancy and rents could drop and expenses could rise, helps you stress test your property. It forces you to take care of potential future expense now, while times are good. It forces you to dig deep to see what is possible and what you can do now to help make sure you’re prepared and best of all, able to avoid or lessen the burden.

Buy for cash flow: Speculative buying can be fun and exhilarating (or nerve wracking), but buying for cash flow with the chance of appreciation due to market fundamentals is a much more sound recession resistant way to invest. One of the major downfalls of the great recession is that people bought for appreciation only. They lost money each month on their rental, but justified it, because it was a tax write off and was going to appreciate. That is a great way to get crushed in a downturn. Make sure you have ample cash flow. That doesn’t mean just a little cash flow, but solid 8-10% cash on cash.

Stress test your buildings as well. Look back at historical data to see how bad it got and for how long. Then use those numbers and worse to see what would happen to your building. Can you survive and better yet thrive?

Have ample cash reserves: This means you put money aside into an account that can pay for the rainy days that may come while you hold. I suggest putting 6 months or more of principal and interest payments into the account and then continuing to grow that account at $300/unit/year. If you are doing a large value add or your property is not stable, then I would plan on a larger reserve. I have done as much as a year of P&I payments.

Over budget expenses: Always try to error on the side of caution, especially with large renovation projects. It is too easy to under budget. I have a lot of construction experience and still fall into that trap. It puts a lot of pressure on you and your investors when you blow past your budget, so be sure to add in 15-20% extra.

Same with operating expenses. You may think you can do repairs, maintenance and unit turns for $500/month because it’s renovated, but in my experience, new stuff breaks just like the old stuff. Add in some extra money for each line item or add an extra line item for overage costs to protect yourself and investors. Also, make sure expense go up 2-3% each year on your budget.

Under-project income: Rents are increasing at record levels and look to continue to increase, however, you’d be foolish to project rents to increase greater than inflation, which puts you roughly at 2-3%. Can your market beat that? Sure, maybe it increases 6% each year. You then look like a genius!

The next point on rent is to be sure that you use comparable rents in your area. Look for boundaries like railroad tracks, major highways, commercial/industrial districts that potentially cut your area off from another area with different rents. Never use the top rents for your assumptions! Maybe you get there or even create new top rents, but you’d be a fool to assume that you’re going to create a new market.

Purchase in markets and neighborhoods with Job growth and population growth: You may be able to find good cash flow in Cleveland, OH, but is there anything happening to support growth? Look for markets and neighborhoods that have jobs coming in. Make sure those jobs are diverse in industry and pay level. For a city that has a lot of labor jobs, bringing in a plant that will bring in more labor jobs in similar industry is a risky bet. Those jobs are all at the same pay level and if the industry suffers, the town suffers (think Detroit). Look for trends in the long term and short term to ensure that you are in markets with strong, diverse growth. Check out my article on Emerging Markets for more detail and resources.

Pay attention to occupancy: Look for markets and neighborhoods with consistently strong occupancy levels – and stress test for the worst. Also, look at the building permits being pulled and deliveries expected. A market like Dallas/Fort Worth has been strong since the Great Recession, but vacancy has recently gone from 4% to 8% due to the massive amount of building (22,000 units in 2018). Look carefully to see if the population growth will keep up with the unit growth. In a case like Dallas, I would look at the overall deliveries in multifamily and single family and be sure the population is growing 2.5 times greater than that number. More importantly, be sure the population is growing in the neighborhood that you are buying in.

Look back as well to the last recessions and see what the occupancy dropped to. Make sure that you are comfortable with running your property at those low occupancy levels. If you can make money at the historical lows, then you are well positioned into the future.

Final thoughts: Buy right, manage right and finance right are the main points for a strong real estate investment. Ultimately, we cannot predict a recession and fearing over one is not a way to run your business. Be aware that a recession will happen, set yourself up for success during the recession and take full advantage of the discounts during a recession.