I invest in real estate in several different ways, including Real Estate Investment Trusts (REITs), real estate debt securities, and single family homes that I have lived in for a period time before turning the properties into rentals. I plan to purchase additional real estate down the road but if I have learned one thing from my previous real estate purchases it is you need to buy real estate with some understanding of where we are in the economic and real estate cycles. In addition to other factors I’m not going to discuss in this post, you should always think about where we are in these cycles before deciding whether to make a real estate purchase (whether as a home or an investment property). Buying real estate at the top of a market can hamper your plans to achieve financial independence while buying real estate after a drop in the real estate market can give you the ability to become financially free much more quickly. I’ve summarize two examples from my own experience to illustrate this point.
My Worst Real Estate Investment – Las Vegas in 2006
I failed to take into consideration the economy and real estate market cycle when I purchased an investment property in Las Vegas, Nevada in 2006. I had purchased a property in California in 2002, sold the property in 2005 after doubling my money, and I was looking to re-invest some of those profits back into real estate. On a trip to Las Vegas I visited a new community that had seen its new homes going up in value by 5-10% every month. I purchased one of these properties thinking I could ride the wave of appreciation for a year or two and then sell the property for a quick profit. What a mistake in thinking on my part! The index below charts home prices in Las Vegas over time and you can see what happened to home prices before and after 2006:
I purchased my Las Vegas property for $225,000 in 2006 and the value dropped to as low as $65,000 sometime in 2012. I was able to rent the property to cover most of my expenses while I owned it but in 2015 I cut my losses after losing my tenant and I sold the property for a little over $175,000. I lost in excess of $50,000 on this investment and it was painful.
In hindsight, all I had to do was look at the above real estate chart in 2006 and consider where the economy was in its growth cycle and I could have known that real estate prices were likely going to drop sometime during the next several years. I would have never predicted the magnitude of the correction but I should have been able to see that my speculative real estate strategy for this Las Vegas property was not a good one.
One of My Good Real Estate Investments
In 2012 the real estate market was still licking its wounds from the Great Recession of 2008 and there were a significant number of properties still in foreclosure, being short-sold, and being sold as real estate owned (REO) properties. An REO property is a property that has been bought by the bank in a foreclosure auction and then listed on the market after the bank buys it. One such property popped up in Southern California in 2012 for a little over $380,000 and I quickly acquired it. Interest rates were low, the property’s value had dropped by 30%-40% since 2007, and the property was in a good rental area if I needed to hold the property for a while. The index below charts home prices in Los Angeles over time and you can see what happened to home prices before and after 2012:
I purchased the property for $385,000 and a little over two years later I sold the property for $600,000. I would have held on to the property for longer but I needed to move to Northern California for my job (I should have held on to it longer but sometimes we don’t optimize things based on non-financial reasons). The company I was working for at the time paid all of the selling costs and I wasn’t ready to manage it as a rental while being in another location. I made this purchase during the tail end of a correction in the real estate market and at a time when interest rates were low and therefore my payments were affordable. I’m not saying I timed this purchase perfectly but I could and did conclude that I was purchasing this property during a period where I was likely to see its value go up over the next 5-10 years. It was also a great rental area with high demand so I could cover my costs if I needed to hold onto it longer than I anticipated. Real estate, if bought properly, usually gives you a Plan B in case Plan A doesn’t work out.
What about Real Estate Today?
Today, the U.S. economy has been growing for over a decade and is still going strong according to key leading economic indicators. Real estate prices in most major U.S. metropolitan areas have been going up for almost a decade after bottoming out sometime between 2010 and 2012. Here are some key facts:
- The U.S. economy has seen quarterly GDP growth since 2014 and has not suffered a recession (2 quarters of negative GDP growth) since the Great Recession of 2008.
- The U.S. unemployment rate is less than 4% and at a historical low for most demographics.
- The S&P 500 Index has seen tremendous growth over the last ten years. After the Great Recession of 2008, the S&P 500 Index hit a low of 889 points in February 2009. Ten years later it has gone to over 3,000 points. The most recent growth cycle is longer than any growth cycle seen by the S&P 500 Index.
- U.S. home prices have also performed exceptionally well following the Great Recession of 2008 and in most areas are at pricing levels above the highs seen in 2007-2008. In 2012, 78% of home sales were affordable for a typical family based on current incomes and interest rates while in late 2018 that number had dropped to 56%. Similar affordability issues are facing renters who have seen the increase in rents significantly outpace their income levels.
- The current growth cycle (2009-2019) in the economy has been supported by U.S. and global fiscal and monetary policies. Using their most conventional tool to support economic growth, the central banks of the world have been reducing interest rates to record lows since the 2008 Great Recession to stimulate growth.
- In 2016, the Federal Reserve started to raise rates but by 2019 it had begun to reduce rates against to try to avoid a recession. The Federal Reserve does not have the ability to reduce rates like it did to combat the Great Recession of 2008. For example, when the Great Recession of 2008 started the fed funds rate was above 5% and was reduced to almost 0% to try to stimulate the economy. Today, the fed funds rate is at 2% and the Federal Reserve has limited room to reduce rates unless it goes into negative fed funds rate territory like other countries have done to try to stimulate economy.
- Central banks from around the world also turned to quantitative easing (“QE”) to help promote economic growth following the Great Recession of 2008. QE stimulates an economy by having a central bank buy securities and treasuries from its private member banks which causes added liquidity to the economic system by increasing the flow of money into markets. QE has the same effect as increasing the money supply. The Federal Reserve has had three phases of QE and would likely consider a fourth phase if the economy begins to falter in 2019-2020. The global central banks have used over $20 trillion dollars of QE since 2000, with much of it coming to support the global economies after the Great Recession of 2008.
- Politically, the U.S. is polarized with no sense of bipartisanship at the Federal or state levels of government. The current White House administration will try to do everything in its power to avoid a slowdown in the economy prior to the November 2020 election cycle but the Democratic Party seems willing to suffer a recession in the near-term to reduce the prospects of the current administration’s re-election. Bipartisan efforts by Congress to improve the prospects of a healthy economy in the near-term through fiscal policy are unlikely and therefore government’s influence on the status of the U.S. economy will likely come from Federal Reserve monetary policy actions and agreements or disputes regarding global trade efforts.
I wanted to give you the above facts because you can’t time downturns in the market or economic recessions but you can see trends. The current information shows the real estate market and economy have been on an upward trajectory for quite a while and history has shown that years of growth are always followed at some point by a downward adjustment. Unless the financial engineers of the world can find a way to eliminate market cycles it appears obvious that we are at the late stages of the current economic cycle and it would be prudent to avoid any big real estate purchases at this time unless other factors (such as local demand, a great price on a specific purchase, etc.) are significantly in your favor.