How to Make Real Estate Market Predictions - If you want to predict where we are in a real estate market cycle at any time, you should learn to read the economic indicators. In this real estate market article J. Scott shows us how to read the indicators and make judgments for ourselves.
The information within is a transcript of a seminar that J. Scott gave to investors, which he gave me permission to record.
Mr. Scott holds an MBA, and is a successful real estate investor and co-host of a top rated Bigger Pockets podcast.
About J. Scott
What I’m presenting today is mostly data and my interpretation of the data. No doubt, some of you are going to disagree with some of my interpretation of the data. Great. I brought my wife, she's here, she'll tell you how often I'm wrong. So, there should be no surprise if you disagree with my interpretation of the data, and I’d be happy to discuss it. Now quickly about me. My wife and I moved to Florida with our kids about three months ago. So we're new to this area. We have a tech background. We both spent most of our careers in Silicon Valley in the tech world.
We moved into real estate back in 2008. We started flipping and from flipping we went to rentals. We've done notes, we've done new construction, we've done a little bit of everything. We’ve done over $60 million in transactions over the last 10 years. If I'd known about Pete Fortunado a few years earlier, that would probably be double or triple by now. But, I'm a slow learner. I've written four books and my wife and I do in podcast called BiggerPockets.com business podcast. So, anybody that's interested in entrepreneurship, and if you're real estate investors, you should be interested in entrepreneurship, feel free to tune into our podcast. Based on number of downloads, we're in the top one 10th of 1% of all podcasts in the world.
I don't sell anything, but I will sell my wife, and then you can make her an offer. My wife is helped me write all these books, but she was instrumental in writing this one. It’ll cover negotiating real estate. She's the best real estate negotiator I've ever met. She has her own boutique brokerage. She does staging, she does design, she does consultations. She mostly focuses on higher end stuff, but always happy to work with investors. So, if anybody needs a great broker, a great designer, a great stager, somebody to help you negotiate or just consult, get in touch with my wife, Cal Scott.
What we are going to cover.
Okay, so let's jump in. First, we're going to talk about why understanding the economy is important. We're going to talk about what an economic cycle is and just go into a little bit of history about economic cycles. We're going to talk about where I think we currently are in the economic cycle and I'll have the data and other information to, uh, to back that up. And then finally we're going to talk about how we as real estate investors can take advantage of at different points in the economic cycle, and use that information to increase our profits, minimize our risk, minimize our headaches. How we can change up our strategies, our tactics, at different points in the cycle, especially the point that I think we're in now, to improve our real estate business.
Understanding the Economy
So first let's start with what an economic cycle is. Why is this important? Why is this whole topic important? First of all, anybody that started investing around 2008, or start paying attention around 2008, probably thinks that economic cycles are driven by real estate. That when real estate goes up, the economy goes up. When real estate crashes down, are there lending issues? The economy goes down. That happened in 2008 but historically that hasn't been the case. Historically, real estate isn't the thing that drives economic cycles. Real estate gets dragged along through economic cycles. In 2008 yes, it was massive lending crisis, a massive real estate crisis that caused the downturn. Go back to 2001 and it was the attach of 9-11 caused the downturn, and back to the late eighties it was the savings and loan crisis.
Back to the 70s, it was oil go back all the way to the 30s and we're talking tariffs and wage issues. So, lots of things cause economic downturns and upturns. Real estate typically isn't the cause.
It's important to understand the economy, because the economy impacts real estate more so than real estate impacts the economy. And again, there are going to be exceptions. 2008 was an exception, but typically speaking, the economy is going to drive real estate more than real estate drives the economy. Generally real estate is a trailing economic indicator; however, housing starts are a leading indicator. So basically, what that means is what we see in real estate, the data, the impact on real estate is generally three to four months, about a quarter behind what we see in the broader economy. When we see the broader economy start to crack, when we see issues, generally, we're going to see those same issues about a quarter to four months later in real estate.
Historically, everything I talk about today is going to be based on history. I'm a big believer that history is the best predictor of the future, but there's always going to be exceptions. And we're going to talk about some exceptions that we're seeing today. We're going to talk about some exceptions we've seen in the past. So, everything I talk about is historically accurate, which means it’s a pretty good chance that it's going to be accurate to the future, but there's always exceptions. So historically, real estate is a lagging indicator to the economy, and understanding cycles are going to allow us to maximize our profits, minimize our headaches, minimize our risk as real estate investors. If we understand where the economy's going, if not in detail, just in general terms, we can modify our strategies, we can modify our tactics to help us improve the way we invest in to minimize your risk.
The Economic Cycle
Let's start with what is an economic cycle. So, we have this little curve. The up part of the curve, that's what we call an economic expansion. The economy's going up and I want to go over what drives an economic cycle, because once you understand this, it kind of makes it a little bit easier to everything else. There are only two big factors that impact an economic cycle. Lots of little stuff, but two big things that impacts economic cycle. One is inflation. Everybody goes and plays. It's a general increase in prices. And then there is recession. Well, recession is an effect of the economy. The second is interest rates, inflation and interest rates. Those two things go together to basically create this curve, this economic curve.
So, what we typically see is when we are right around the bottom of the curve, we're generally coming out of recession, we're recovering. Businesses are finally getting back on their feet. Consumers are getting back on their feet, people are getting jobs again, employment is going up, unemployment's going down. Things get better, people start to spend more money. As people spend more money, businesses do better, and businesses get bigger. Their employees benefit because they're getting paid more and management is getting paid more in bonuses. They hire more employees. Basically, we snowball upwards in our economy. People spend more money, businesses do better, employees do better. They spend more money. So that snowball continues to go until we get somewhere around the top.
When we get somewhere around the top, and we saw this probably somewhere around 2016 or 2017 things got so good that businesses had to start hiring more employees, building more factories, bringing in more inventory and product, and they had trouble doing it because when unemployment's at 3.6%, where are those new employees coming from? Two places. You either have to encourage people to come out of retirement, or you have to steal them from your competitors. How do you encourage people to come out of retirement or steal from your competitors? You pay them a lot more money. So right around the top, businesses start to see this problem where they had to start paying employees a lot more money so that they can keep up with the increased demand and they have to start spending more money on their factories. They have to spend money on real estate. They have to spend money on the extra inventory.
Inflation
So right around the top, businesses start spending a lot more money to keep up. Who ends up paying for that? We do. We do. And that's inflation. They increased their prices because their prices are increasing because they're hiring. More workers are buying more inventory, they're building more factories. So, we start to see it plateau around here. Government doesn't like inflation because it hurts our ability to live. If we had to spend more for our housing, spend more for our food, spend more for our fuel, that impacts our quality of life. So right around the time we're seeing this the government's going to step in and say, how can we slow down this inflation?
Slowing Inflation
Basically, they have two ways to do it. One is they can print more money; they can print more, or they can pull money in. But the big way that they control inflation is with interest rates. They can raise and lower interest rates. Everybody knows what interest rates are. If you raise interest rates, what happens? It becomes more expensive to borrow money, and it becomes a becomes more beneficial to save money. So, when the government or the federal reserve increases interest rates, two things happen. People stop spending because it gets more expensive to borrow money and they start saving because they gain more benefit by putting money into a savings account. So, like raising interest rates, the government basically encourages us to spend less. When we spend less businesses slow down, growth slows down, inflation slows down.
Oops, too much!
The goal is slower inflation, but the result is a slower economy overall. So, near the top the government's generally going to start to raise interest rates. Things are going to slow down and we're going to get to this top and generally the government is bad at modulating and they'll wait a little bit too long or they'll raise rates a little too high. We'll have too much of a slowdown and we will start to snowball down the other side. So just like we snowballed up, we'll start to snowball down. Now when we get towards the bottom here, the government will do just the opposite. They will lower interest rates, and lower interest rates will do two things. Again, it'll make it cheaper to borrow. So, people want to spend more money and you'll get less money in savings. It's cheaper to borrow so you don't want to save money. What are you going to do? You're going to spend. People start spending. We get to the bottom and we see the growth go up again. So, this is what drives these economic cycles. Two things, inflation, interest rates.
Okay, so when we have back to back to back to back to back cycles, which we have had for the last 160 years in this country, this is what it looks like. Well, not really like this actually looks more like this. Not every cycle is going to be the same. Some cycles are going to last a little bit longer. Some are going to be tighter or shorter. Some recessions are going to be worse, some expansions are going to be better, so we're going to last longer and shorter.
So, this is more what an economic cycle looks like or back to back economic cycles look like, but actually not really. This is what economic cycles in our country, so this is the past 65 years or so worth of data. This is GDL. Everybody here know what GDP is. Gross domestic product.
So, this is the key measure for if we're in a recession, U S government defines if we're in a recession, your GDP, which is the total output of all industry in this company, in this country. If that growth of that output slows for two straight quarters, they say we're in a recession and it starts growing again. When it's positive number, that growth is a positive number. We're out of the recession, so these gray bars, these are all the recessions since 1950 and the blue line is the GDP growth. For each quarter since 1950 and we'll get back to this in a minute, but this is what our economy has looked like for the last 65 years. So, then the question becomes, where are we today? Because this is important. We're probably gonna treat our business differently, depending on where we are in the curve. How we want to treat our businesses as real estate investors. It's good to find the strategies and the tactics that we're going to want to put into play to basically maximize your profits, minimize our risks.
Where are we today?
Oh, where are we today? I like to figure out where we are. I like to try and discern where we are using three techniques. First tiny, we'll talk about timing means, second about observation, third about economic data. So, these are the three things that most economists use. These are the three things that I look at. I'm certainly not an economist. But, I'm a big fan of economics. I have an MBA, I study economics, but I'm not an economist. But these are the three things that any economist will look at to determine where we might be in an economic cycle and where we may be heading. So, let's talk about these a little bit more to see probably where we might be today. Let's start with time. I mentioned that this is what our economic history looks like for the last 65 years in the US, these are our recessions.
This is just a smooth down curve. This is not 70 years’ worth of data. In that 70 years we've had 11 recessions. Who here can do basic math? We want to know how often a recession tends to occur in the US you can divide 70 by 11. You know what, every six and a half years historically, if you go back even farther, it's closer to five and a half or six years. But over the last 70 years, we've seen a total cycle including a recession, including an expansion, about once every six and a half years. That's a good historic data. Now again, doesn't mean that every recession is going to be six and a half years. Some are going to be longer; some are going to be shorter, some might be that exactly. But on average, we see a cycle full cycle occur every six and a half years.
This is what it actually looks like.
So, this is the last 33 cycles covering the last 160 years. Again, if you do the division, you'll get closer to five and a half or six years because cycles used to be much shorter. But basically, these are each of the cycles, each of the last 33 cycles over the last 160 years. This is our average of about six years per cycle. This is where we are today. So, we are actually, I did this slide a few months ago, so we're a few months past this, so we're about 140 months into the current cycle that we're in. Typical cycle last somewhere on the order of 70 to 75 months, we're almost double what we typically see. So, from a timing perspective, it's safe to say that we're overdue for a recession. Does that mean that's going to happen next week or next month or even next year? Absolutely not. But this is a good indication that we're probably closer to a recession than we are to, let's say the beginning of the expansion.
We probably don't have 10 more years. So, it's just one piece of data and this piece of data that tells us that if a recession were to happen tomorrow or next week or next year, we shouldn't be too surprised. Next is observation. When we talk about observation, this is the least quantitative measure of where we might be in the cycle, but this is just looking around us and saying, how are people acting? How are people reacting? What is the personal level of optimism? What's consumer sentiment look like? We're all real estate investors, so we all know anybody that's been doing this for a few years knows what this industry was like two or three or five or 10 years ago, and so you have some idea of is there irrational exuberance? Are we more like 2007 right now or 2009? I think it saved to say that we're probably closer to 2007 than we are to 2009. Not saying we're necessarily in 2007 levels of exuberance and craziness, but closer to 2005 and 2009 so that observational data is another piece of the puzzle.
When I look at where we are in the economic cycle, all the data, I think of it as a puzzle and you've got one piece of a puzzle, you have no idea of what the picture on that puzzle is. If you have two or three are 10 pieces of a thousand-piece puzzle, you don't know what the puzzle looks like, but the more pieces you put into place, the clearer the picture becomes. So, observations, just another piece of data. So, when we talk about observation, a lot of people talk about consumer optimism or consumer sentiment.
Consumer Sentiment
Just to give you a good idea of over the last, what is this? This goes back to that 20 years, 30 years of what consumer sentiment is look like. And typically, again, the gray bars are the recessions. The blue is the data. Typically, what we see is before a recession, consumer sentiment tends to drop during a few months to a few quarters before the recession. In some cases, the consumer sentiment doesn't drop until the recession. So, again, not a perfect indicator, but just to give you an idea of where consumer sentiment is today, people tend to be very confident in our economy.
Some would say just by looking at that graphs, what I see in the past, is a lot of more unstable ups and downs and quick drops, than when you look at this last 10 years. It's kind of a more of a steady rise, just a little ups and downs. You showed more recessions back 70 years ago, there were smaller gaps and that was the industrial age. Now we're in the informational age and there's more data and more availability and more technology to stabilize the economy. So, they would say they don't see another recession for eight to 10 years.
I think pretty much every economist out there would be surprised. But I've talked to people that wouldn't be surprised and certainly there are exceptions and maybe this time is different. That's actually a big common denominator of all downturns. Is there's always going to be people who say, this time is different. Something's different this time around than for the last 33, something's different this time. And eventually they are going to be right. Eventually something's going to be different. Is it this time? I don't have a crystal ball. I'm not an economist. Even if I were an economist, I'm not going to try and predict if this time is different, I’m just presenting the data.
One thing I'll throw out here is that a big piece of consumer sentiment isn't necessarily what the number is, whether we're at 60 or whether we're at a hundred, or whether we're at 120. It's more than the trend, and the trend has been more indicative of where we're headed than with the specific number is this is missing one data point, which was the August consumer sentiment number, which was down the most that it's been down since 2012 just in the last month or two, consumer sentiment has dropped tremendously.
It's the media’s fault.
Now, I'm sure a lot of people will say, well, yeah, it's the media's fault and I'm not going to get into politics. But I will point out that I've been paying attention to recessions for about 30 years now and it's always the media's fault at this point in the cycle, the media is always going to glob onto whatever that bad piece of news is. It's not necessarily because they hate the president, or they love the next candidate, or they love the president. Typically, it's because they try and sell newspapers. They try and get people to tune into the TV show. So, they're always going to tell you the bad stuff. Nobody wants to hear the good stuff, that's not going to get you to buy newspapers. So, you can think the media has an agenda. The media does have an agenda. It may not be the agenda you think, but maybe it is. So again, I'm not going to try and get into that.
Sentiment drives the economy.
The point is because consumer sentiment plays such a big role. Consumer sentiment isn't just an indicator of where the economy is, consumer sentiment actually drives the economy. If you think that the economy is going to sink tomorrow, if my wife thinks that the economy is going to sink tomorrow, what are they going to do? They're not going to go out and buy that car. They're not going to go out and buy a new house. They might buy. less real estate. They're not going to want to buy a watch. They may not go out to dinner as much, because their optimism is reduced. And when they stopped going out to dinner, when they stopped buying the watches and the cars and the houses, what happens? That impacts the economy. So, consumer sentiment isn't just an indication of where the economy's headed, consumer sentiment actually drives the economy to a large degree. So, when we see a drop like this one mitzvah indication that people are less optimistic, but two, it means they're going to start acting in a way that's less optimistic, that's going to have a snowball effect. So, a lot of people say the media is causing a recession. Yes, the media is always going to cause a recession and public sentiment is always going to cause a recession.
A difference this time?
If we're going to say today is different, this time is different. One of the big things that has been different the past decade or so is the rise of the internet, the rise of information. There was a lot of differences. There was a whole ton of quantitative easing or flooding the market with money in 2008. There's a global comedy now that didn't exist 20 years ago, but the internet and information age is a big part of one of those things that's different. There's public access to a lot of data. People share information, people share public sentiment. So, this is a big piece of it.
Last piece of economic data. This is purely quantitative. You can interpret it however you want to. It's like a puzzle. If I give you one piece, you're not going to be able to tell me what it is, but if I give you a hundred pieces or a thousand pieces, you're going to have a better idea of what you're looking at.
One of the big pieces of economic data that we're looking at these days is the yield curve. You may not know what it is, so we'll talk about that in a little bit.
Economic Data and Indicators
There's something called the Buffett indicator, which has been historically a good indicator of where the economy is headed. GDP or gross domestic product, we talked about that.
Business investment is a huge one. How much businesses are spending to expand their business spending on factories, spending on inventory, spending on people.
The unemployment rate, that's a big one, tends to be a trailing indicator, but it's still a very good indicator of where the country's headed.
Housing starts, while real estate tends to be a lagging indicator and we don't plan to generally look at real estate, determine where are the economies edit. It mostly tells us where it's been. Housing starts as a good forward-looking indicator. Housing starts is basically the number of private permits that builders are applying for them. It’s an indicator of how many houses they're getting ready to build.
Foreclosure rates have been a good one.
Historically, stock market or stock market volatility has been a good one.
And we talked about consumer sentiment.
These are all good pieces of quantitative data. I could list a hundred or maybe even a thousand more that are probably less important. But again, it's a puzzle.
So, let's talk about the yield curve because who here has heard the term yield curve the last few weeks? Okay. A bunch of people, but a lot of people don't know what the yield term is. This is a big one and I just want to cover it because we all like to be able to have conversations at cocktail parties and sound like we know what we're talking about. If you pay attention to this, you might be able to seem a little bit smarter at the next cocktail party.
The yield curve has to do with government bonds. We often call them T-bills or treasury bills. Long story short, two pieces of information you need to know;
1) government funds itself in large part, because we're running at a deficit, we spend more money than we take in, the government funds itself in a large part by selling bonds. Basically, a bond is just a note. The government says, lend me money and I'm going to pay you back interest on that money for some period of time, and then eventually I'm going to pay you back your principal. Does that make sense? The interest on bonds referred to as yield instead of interest, which is why we have the word yield, it's interest on debt.
2) The government's going to loan you money for different periods of time. They may loan you a bond that might expire in one month, which means you give the governments some money, they give you a one month bond, they pay you interest for one month, then they get your principal back after that one month. They may lend money for three months or six months or 12 months, or longer periods of time. And so, there are different expirations and there’s like 20 different expirations for government bonds. In general, the longer the maturity, the longer you lend the government money, the more they're going to pay you in yield, and this makes sense.
But the government doesn't decide how much they're going to pay you. It's all driven by market forces, supply and demand. But in general, if say to you, I want you to loan me $100,000 for a month versus I want you to lend me $100,000 for 30 years. Would you to be willing to loan me at the same rate for a month? Are you willing to accept the same interest rate for a month as you are for 30 years? Probably not. You’re going to want more interest to lend for 30 years because of opportunity costs. You have the risk that that interest rates go up at that time. Loaning me money at 3% interest rates, but in 15 years you can get 6%, so you’re taking a risk by loaning money for longer periods of time. So typically speaking, when you loan the government money, the longer you loaned the money for, the more they're going to pay you an interest.
Okay, so let's take a look at what that looks like.
This goes back to January 2004, these are actual data points. If you loan the government money in 2004 let's say you lone them money for three months, they were going to give you about 0.7- 0.8% interest for that three months. Two years, they're going to give you closer to 2% on your money. In five years, they're going to give you closer to 3 ½ %, seven years closer to 4%, 10 years closer to 4 ½ % percent, and if you loan the government money for 20 years, they give you more than 5% back. And again, this was 2004, now how many people wished they had lent the government money for 20 years at 5%. A lot of hedge funds wish they did. So, these are the data points for each of the yields for the different expirations of bonds back in January of 2004 probably a particular day in January.
If we draw a line through each of these pieces. Each of these points we get a curve. This is what's referred to as the yield curve. So, a yield curve is for any given day for any specific set of explorations. Does that make sense? So, everybody now knows where the yield curve is. So, what does the yield curve mean? This is what we've generally referred to as a healthy yield curve. Low expiration bonds at low interest or low yield, higher expiration bonds have higher yield and basically goes up linear from there.
This is what we tend to see in a healthy economy. Now when investors, and when I say investors, I'm talking about people that invest in treasury bonds. And when I talk about people who invest in treasury bonds, I'm typically talking about hedge funds, big companies, governments, people that are investing not thousands of dollars, not millions of dollars, but typically investing hundreds of millions or billions or even trillions of dollars.
When they start to get scared, they do two things. Typically speaking, I mentioned that yields for treasury bonds are driven by market forces, supply and demand. And as demand goes up, the yield goes down. If everybody in the world wants a seven-year bond, what's going to happen? The rates on those bonds are going to decrease. Because why should I pay more when everybody wants this product, I'm going to pay less interest because there's a lot of demand for the product. Does that make sense? So, when demand goes up, yield goes down. When demand goes down, yield goes up. So, when investors start to get a little bit worried, two things happen. One, they start to buy long-term bonds. They want a place to put their money long-term. They don't want to risk the market crashing tomorrow and having their money in real estate. They don't want to risk the market crashing in two months and having their money in three months bonds and then not having anything to do with it in three months. So, when investors start to get scared that something bad is going to happen to the economy, they buy lots of 30-year bonds, or 20-year bonds, or 10-year bonds, longer term bonds that drops the rate. They don't want their money in short term bonds because short term bonds are bad. It doesn't provide them a lot of protection like longer term. If something bad is going to happen next week, they want to be protected for a long period of time. So, they stopped buying the shorter-term bond and those rates go up, those yields go up.
So, what we see when investors start to get scared, and that was 2004, now this is March of 2006.
What we see is a flattening out in this curve, long term rates drop, short term rates go up, middle kind of evens out. This is what the yield curve tends to look like when investors just start to get concerned about what's going on in the market, what's going on in the economy, whether it be local, whether it be global. This is what we start to see. And then when things get really bad, you see the yield curve that looks something like this.
This is called an inverted yield curve. This is when investors start to get really scared. Historically 90% of the time when the 10-year yield and the 2-year yield invert, that’s when the 10 year yield is less than the 2 year yield, 90% of the time that means the recession has happened in the next six to 18 months.
It doesn't mean it's going to happen next time. Obviously, we don't know. You can't predict, but 90% of the time with only two exceptions, that inversion of the yield curve has led to a recession in the next six to 18 months. We started seeing an inversion in the yield curve back in December 2018. It wasn't the big 10-2 inversion, which is kind of the big predictor. We saw the 10 – 2 inversion about a week and a half, two weeks ago. So, there are a lot of people who look at this data and say “90% of the time when we see this happen, we've had a recession the next six to 18 months, and it just happened. Does that mean we're going to see a recession in the next six to 18 months?”
I don't know. I don't have a crystal ball, but the data indicates that historically we would. Is this time different? I don't know. So anyway, that's the yield curve.
This is where we are now.
This was December 2017 a healthy yield curve. By March of this year, we had flattened out and this is where we were about a week and a half ago, so we had the inversion of the yield We saw an inversion of the yield curve and I'm just going to go through what we're seeing today for each of the economic indicators. It may give us an idea of where we might be in the cycle.
The Buffet indicator.
I won't talk a lot about this, but Warren Buffett is a big believer. He didn't invent this or make this up. But he's a big believer in the idea that the value of all the public equities in the country, so the stock market basically. If you compare the ratio of that value to the GDP, the total output of the country historically speaking, if it's somewhere around 0.9, the stock market is valued correctly. So, in a healthy economy, the ratio of all the equities, all the public equities in the U S to GDP is somewhere around 0.9. If that ratio is higher than 0.9, Buffett would say, and a lot of economists would say the stock market's overpriced. If that ratio is under 0.9, a lot of people would say that the stock market is underpriced. Back in 2007 the Buffett indicator got to 140%. Today the Buffett indicator was 144%.
So people that believe in this indicator would look and say the stock market could be overpriced by up to 50%, and if I showed you the graph, you'd see that typically speaking, the reversion back to the straight line than you would expect typically happens in six to 12 months. We've been well over that 0.9 for a long time. So again, maybe this times an exception, maybe it's not, I'll let you draw that conclusion. I'm just providing the data.
GDP
What we've seen over the last several years, is about 2% growth for much of 2010 to 2017. Back in 2018 we saw big tax cuts; we saw GDP jump to about 3.5 % to 3.6%. And now we've seen GDP dropped back down to about 2%.
So, GDP is pretty much where it’s been for the last half dozen, eight years. So a lot of people would say GDP is pretty healthy. Other people would say, well, we went from three and a half percent back to 2%. That's a really bad trend. But by the same token, we went from two to three and a half and that was a really good trend. Tax cuts played a large part of this. So, what does this mean? We don't know, but there's no reason to think that GDP isn’t pretty healthy right now.
Business investment
Future business investment in this probably had a lot to do with public sentiment, corporate sentiment, CEO sentiment, business investment in Q2 was down considerably. This is one of the biggest indicators. CEOs tend to think that the economy is getting ready to turn. They spend less money, they buy fewer factories. They might have less inventory. They lay off workers. You stopped hiring workers. They stop spending money again, so it's a self-fulfilling prophecy. When they spend less money, they're actually causing harm to the economy. So, this is actually a pretty bad indicator.
Unemployment
Unemployment at 3.7%, that's fantastic. It got down to 3.6% we've been 3.7% for the last eight months, I think it was. Historically, that's a fantastic number. Now the problem with 3.7% is that unemployment's always great, until it's not. So, it's probably not getting any lower from here. Hopefully it doesn't get any higher than this for a while. But 3.7% is pretty healthy, or very healthy.
Housing starts.
Housing starts to kind of been all over the place where this is the number of permits that builders are applying for. And again, this is one of those self-fulfilling prophecies. When builders stopped building, that's a large segment of the economy. When builders get scared and say, I'm going to slow down and I'm going to stop building because I think we're at the end of the cycle. They actually impact the cycle. They stop hiring contractors, they stop hiring and they actually impact the economy. So, housing starts is important. What we saw earlier in 2019 was a big drop off in housing starts summer of 2019 we saw that pick up a good bit. So that's kind of been all over the place. We don't really know what builders are thinking, but across many parts of the country, builders are still optimistic.
Foreclosure rate
The foreclosure rate started trickling up in July and August, certainly not anywhere like 2007 or 2008 but that number's starting to pick up a little bit.
Stock market
Stock market is obviously up. That's a good thing. It tends to be a lagging indicator. Stock market volatility is the thing that's the biggest leading indicator when it comes to the stock market. And we've seen a ton of stock market volatility, whether that systemic or whether that's just a result of what's going on in politics, I'm not going to try and try and predict. But we've certainly seen more stock market volatility than we've seen in a long time. And then consumer sentiment as we discussed, consumer sentiment is down to good bit. So, you look at all of these, and again, there are a hundred of these indicators. I picked the ten or so that I think are our most interesting and are really very much a mixed bag.
Some of this data's measured quarter to quarter, some of it's month to month. Some of its semiannually. So, it's all based on the most recent data. Economics is a lot like the weather, what you see in San Diego isn't necessarily going to be what you see in Buffalo. Buffalo weather's going to be a whole lot different than San Diego, but in the summer, both are going to be warmer. In winter, both are going to be cooler. So, what we're seeing now is we're kind of changing seasons.
We're at the inflection point road at the top and we're starting to see different things in different markets. I've been in Seattle and I've seen San Francisco numbers, their housing markets have dropped 15 to 25% of the last six months. You come down to Florida and you see a strong market. I lived up in DC up until the last few months, DC is tremendously strong. So, we're starting to see different things playing out differently in different markets. And that's a good indicator that you're at one of those inflection points, either at the top or the bottom. Because if you're strongly on the upswing or strongly in the downswing, you're going to see pretty much the same type of movement in every market.
You won't see the exact stuff in every market, but you'll see the same types of trends in every market. What we're seeing is very different trends in every market. So, everything's a very, very mixed bag. When I put everything together, my take is that right now we're somewhere right about here.
Typically, if you go back to the last 33 cycles, that peak, what we call the inflection point at the top lasts three to six months. You get there for a few months and then you go over the other edge. If I look back at the data, I was saying the same thing a year ago. I think we've been there for another six to 12 months.
At this point I am confident, and you can disagree with me. I'm perfectly happy with that. I'm confident to say that we are not going up much from here. Now, whether we're going to stay at the peak for another week, month, year, two years, I don't know. I don’t know when the downturn will occur again. Week, month, year, two years. I don't know, but I am confident saying, and maybe I'm wrong, but I'm confident to say that we are not going up much from here. We're not seeing this leveling off and then suddenly something's going to happen that we're going to take off.
It may not be next month. It may not even be next year. But I think we are closer to the peak that the expansion. That's the best I'm going to do with prediction. Keep in mind a lot of things factor in politics, and global economy. It’s always been the big wild card. You could say that US economy is tremendously strong. In a lot of ways, the US economy is tremendously strong, but these days the US economy doesn't live on its own. It doesn't stand on its own. We take cues, there's enough global trade and when other economies are hurt or hurting, it's going to impact us. Just like consumer sentiment. So, there's a lot of things that could happen that could influence whether the recession starts tomorrow or next week or next month or next year, or five years from now. I'm not smart enough to figure out exactly what it is, but I believe it's closer than 8 – 10 years.
What Should You Be Doing Today?
Then the question becomes, how do we make money today as real estate investors? And for a lot of you, this is all that matters. The details don't matter. How do I make money? How do I reduce my risk? So, I'm going to throw out a few tips. If you're a house flipper, yes, you can still flip houses. I'm still flipping houses. My partners are sitting right over there, and we flip a bunch of houses. But here's some of the things that I'll say.
Don’t Get Bogged Down.
Keep projects quick. We're not doing new construction anymore. We're not adding square footage anymore. We're not doing pop tops where we added a second story. We're keeping projects down three months, four months at the most because if the downturn starts, we don't want to be in the middle of a project. We don't want to be in the middle of a 12-month project, waiting for permits when the downturn starts. So, we're sticking with projects that we can be in and out of quickly. So, if we see the downturn come, we can finish up and get it sold quickly.
Watch Your Margins.
Next, keep your margins greater than your worst-case scenario. So, my wife and I did a lot of houses in Washington, DC up until a few months ago. When deciding what projects to take on in Washington, DC what we decided was to use the worst-case scenario we could expect in most markets around the country, and we flip in a lot of markets around the country. Pretty much the worst-case expectation is what we saw in 2008, I think that's safe to say? At some point we may see something at some point we're going to see something worse, No doubt. If you study economics, you know there's going to be another depression at some point, 5 years, 50 years, a hundred years. We could go into that, but for the most part, 2008 is probably as bad as we're going to see in the next recession and probably won't be that bad. Just statistically speaking about basing it on the date and just historically, we're probably not going to see another 2008. So, if you assume that what happens this time is going to be as bad as 2008 and you take steps to ensure that you mitigate your risks to 2008 levels, you're probably pretty safe. So, for example, in DC in 2008 we had a 16% drop. So, I can infer that during the next recession, probably the worst-case scenario is that that market drops in DC up to 16%. Is every one of my flip projects is generating a return on margin of greater than 16%? If so, I shouldn't lose money.
Now in Atlanta, we saw drops at 30 - 50% in some areas. So, if I'm flipping in Atlanta, I'm not going to be happy with 16%. I'm happy with 16% margins in DC because I know worst case I'm going to break even. In Atlanta I'm not happy with 16% margins because there's a good chance I'm going to lose money if we see anything even half as bad as 2008. So, what I would suggest to all of you, if you're flipping houses, is figure out what your area dropped in 2008. That's your worst-case scenario. Then sure that your margins are greater than that. Or, if your margins are less than that, you're willing to accept the risk. So maybe in 2018 things dropped 20%, and you're willing to lose 5%, then you can do a 15% project. But look at historical data to help you mitigate your risk moving forward, and always have multiple exit strategies.
Have Multiple Exit Strategies.
If you're a flipper, make sure that you can rent the house, you can lease option in the house. Make sure you have multiple exit strategies. Five years ago, if you were flipping a house, you didn't need a backup strategy because you knew you're going to sell the house at a profit. These days have multiple backup strategies.
Rentals
If you're a buy and hold investor, you can always buy rentals. Know the numbers. Now we look back historically in 2008, in a lot of areas, market rents didn't drop. In some areas market rents dropped dramatically. Typically, what we saw, the worst case drop in most markets, and there were certainly exceptions, you go to places like Atlanta or Detroit, things are much worse than this, but in typical market, worst case drop was about 10% of market rents, same with vacancies.
In a lot of markets vacancies didn't increase. But there are plenty of markets where vacancies did increase. Pretty much worst case in most markets was about 10%. So, if you are modeling a rental property, multifamily or single family, if you model a pro forma that assumes 10% drop in rents, 10% increase in vacancies, see if it still pencils out to numbers that you're willing to accept. Basically, you have to decide what you're willing to set except, but if you're willing to accept 10% increase in vacancy and 10% drop in rent, then you're probably going to be safe in a worst-case scenario.
Focus of “C” Properties.
Typically, what we see during a recession is what's called rent compression. This means the nicest houses tend to see the largest drops in rents. If you're in class A, your properties are going to see up larger percentage drop in rents than your class B properties. Your class B properties are going to see a larger percent of drop in rents and your class C properties, your class C properties probably are not going to see a big drop off.
That's why things like class C properties, things like mobile homes tend to be pretty recession resistant. So, if you're buying rentals now and you're trying to decide between A class, B class, C class, D class mobile homes, tend towards the lower, if you're concerned about the recession. Maybe your strategy is different than mine, but I'm focused on C class. I just invested in eight mobile home parks and I'm pretty comfortable with that investment. There aren’t a lot of syndications that I would invest in these days, but I'm comfortable with mobile home parks.
Lending
If you're the lender, yes, you can still lend. I'm actually lending a lot these days. But I'm not lending to flips anymore, because flips scare me. I'm scared when I do my own flips, but I'm extra scared when somebody else is doing flips with my money. So, I'm doing a lot of lending to buy and holds. Everybody’s familiar with the BRRRR method? Buy, Rehab, Rent, Refinance, Repeat model? I'm doing a lot of lending to people that are doing that. They're buying properties, they're renting them out, then they’re refinancing in a year, I'm getting my money back. Worst case, the market drops, they can't refinance, they're still generating cashflow, they can probably still pay me. Worst case, they pay me a little bit less. We work out a deal, and in five years when the market returns, I get my money back plus back interest. So, I'm not too concerned. I like cash flowing properties because they are going to pay every month. It’s going to pay my borrower every month, so they don't have to default and hand back the property. If somebody wants to give me a cash flowing asset as collateral, I'll lend against anything.
Raise Your Rates.
If you're a lender, now's a good time to be raising rates. A lot of people are lowering their rates right now. I'm raising my rates. I'm adjusting for my risk. I think there's a higher risk these days. Does it mean I'm making fewer loans? Yes. I’m making fewer loans, but I sleep better at night. So if you're a lender decide should be lowering your rates just to compete, or should you be leaving the rates where they are, or raising them to sleep better at night? But that's what I'm doing.
Know Your Foreclosure Laws.
Know your foreclosure laws. So, depending on what state you lend in, foreclosures work very, very differently. I'll lend in Georgia much faster than I'll end in Florida because in Georgia I can foreclose in 90 days. In Florida, I'm going to spend a year and a half. In Maryland, I'm going to spend a year and a half. So, I'm very careful about knowing my foreclosure laws. David Witte is the guy to talk to if you want to know about foreclosure laws.
Commercial
If you're doing commercial stuff, yes, you can still buy commercial. I like mobile home parks, they’re recession resistant. I like self-storage. Self-storage tends to be very recession resistant. When people start losing their jobs and have to downsize or have to move back with mom or have to move in with other people, they don't like to sell their stuff or give their stuff away. What do they do? They stick it in a storage compartment or storage container. So self-storage tends to be really good during the recession. Another thing is people go to school during the recession, college admissions increase during a recession. People lose their jobs and decide l may as well go back to school and get qualified to do something else. So, college rentals tend to do very well during the recession. Medical tends to do very well during a recession. If you're into retail, go find a retail strip center that is anchored by a grocery store. Find someplace that has a liquor store in it. Because these things tend to be recession resistant. People still need groceries. People are, if they're drinking before the recession, they're going to be drinking during the recession. These needs can be very recession resistant. So, figure out what things are recession resistant and focus on those. Don't go out and buy a high-end multi-use commercial, class A commercial because that's going to get crushed. But there's plenty of commercial out there that'll do well.
Notes
I’m starting buy a lot of notes. I like notes. One, know your bankruptcy laws, or talk to David Witte again, probably give you some good tips there. I like buying second mortgages. If you know anything about notes, thinking about buying seconds, but know your borrowers. Focus on exiting through the borrower. And look for big discounts on notes.
That’s about it, if you want to know more pick up J. Scott’s book “Recession Proof Real Estate Investing” on Amazon.
Disclaimer: I am not an attorney or CPA. The content herein is merely opinion, and should in no way be considered legal or financial advice. Please seek professional legal and financial advice for your specific situation.
