Investing works in cycles where asset values rise in bull markets and decline in bear markets; these dynamic periods can lead to massive amounts of wealth changing hands. The time to invest aggressively is often when other investors are fleeing the market. And the time for caution is during an extended bull market when high asset prices are hard to justify. Unfortunately, it is at these peaks when many investors decide to buy and overpay for assets.
To become a better investor it is important to watch for the warning signs that a bull market has run its course. No one can perfectly time the market, but paying attention to market fundamentals and broader economic indicators can help to avoid overpaying for real estate towards the end of bull markets. The last decade has seen a dramatic rise in home prices with many markets reaching record highs. Now is a good time to pause and review some of the factors that caused the last real estate crash in the 2007-08 during the global financial crisis. As we look at the current real estate market there are both positive and negative signs.
Housing Supply and Lending Standards
The supply of housing is much smaller today than it was leading up to the global financial crisis. Many of the homebuilders who left the market after the last recession never returned and those that survived were careful to avoid the same mistakes of overbuilding. This means housing inventories are lower which keeps prices higher. In addition, banks have tightened up lending standards over the last decade. They are conducting better due diligence on buyers before approving loans, which should reduce future mortgage defaults. We are also seeing that buyers have more equity in the properties they buy as they contribute a larger down payment. These factors indicate a healthier real estate market than in the run up to the global financial crisis. In comparison, prior to the global financial crisis buyers were able to purchase homes with a zero down payment and in some instances even received cash back at closing. It is not a huge surprise that this ended badly. Buyers who have no equity in their homes have little to lose if they default on their loan.
Pandemic Risks Remain
On the other hand, some worrying market indicators exist. The COVID-19 pandemic has fueled demand for larger homes as buyers seek more space to be able to work from home. This demand has seen the median price of existing homes climb 15% over the past year to $313,000 even though the economy has been in a recession. We could see demand for housing slow after vaccines become readily available and people are less confined to their homes. This could lead to a shift in spending away from housing to other activities such as travel, outdoor entertainment, restaurants which could reduce demand for housing as spending patterns realign.
The economy is also not out of the woods yet. The 49,000 new jobs created in January was lower than expected and the government is still relying heavily on stimulus spending (which is incurring more public debt) to try to spur economic activity. Congress is working on another $1.9 trillion relief plan in response to the pandemic. If the current economic recovery loses steam we could see job losses rise again, demand for housing slow, and prices decline. Price-to-Rent Ratios are Unbalanced
One warning sign that looks similar to the period leading up to the global financial crisis is the price-to-rent ratio in some markets. This is the ratio between the cost of a property and what it costs to rent. If properties rise in price, but rents do not, this ratio becomes unbalanced. In the years leading up to the global financial crisis, the price-to-rent ratios in my area went from an affordable 1 to 1 to an extremely expensive 3 to 1 just prior to the crash. Back then people were buying investment properties that cost $3,000 per month to own, but only rented for $1,000 resulting in a loss of $2,000 per month.
Investors were hoping their properties would continue to appreciate so they could sell at a profit. Banking on appreciation is speculating, not investing. When property prices fell investors were unable to sell for a profit. Since the rents did not cover expenses, their losses quickly accumulated, and many inventors defaulted on their loans. Foreclosures started to rise which led to a dramatic decline in property values, wiping out $7 trillion in real estate value in the first few years of the recession. It might be wise to look at the price-to-rent ratios in your market to see if they are similarly out of balance.
Government Intervention Could Be Affecting Rents
There are a few other factors affecting the price-to-rent ratios. In response to the pandemic, the government intervened by placing moratoriums on evictions and foreclosures. The eviction moratorium was extended through March and may be extended again this year. This moratorium is likely distorting the market and putting downward pressure on rents because landlords are reluctant to raise rents when they know there is no option to evict, unless the tenant has violated some other term of the lease. If this moratorium continues it could stifle rent increases through 2021. Once it is rescinded, landlords will be freer to align their rents to market rates which may improve the price-to-rent ratio.
Similarly, the moratorium on foreclosures may be distorting property prices. The foreclosure moratorium could be hiding weaknesses in the market as property owners are in default but able to stay in their property. These losses are not currently reflected in the market, but will once foreclosures resume. As banks foreclose, the properties are are usually sold at a discount to market prices, which can lead to price declines in the market. Sellers lower prices in order to sell before the market sours and buyers become more patient if they anticipate prices will fall further.
If you are looking to invest in real estate now, be cautious as we are deep into an extended bull market. Over the last decade property prices have tripled in some markets and some of these prices are hard to justify. Be sure to assess the price-to-rent ratio before you buy, especially if rents are low and there are no indications that they will rise quickly in the coming years. If rents are too low in your area consider buying rental properties in another market with a better price-to-rent ratio. Also watch for what happens when the eviction and foreclosure moratoriums are lifted. If you are looking for a home to live in, it may make better financial sense to rent now instead of buying. Renting can be a better option if the price-to-rent ratio significantly favors renters.
Most importantly, determine what you can afford and buy a property based on proper due diligence, not speculation. If your research indicates it is not a good time to buy, then wait. A sellers’ market can quickly become a buyers’ market. If you are looking for more detailed information on investing in real estate and obtaining financial freedom consider reading Become Loaded for Life! and the 10 Stages Workbook.
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