Real Estate Market: Mistake Avoidance

When the consequence of your decision has little to no downside, you have eliminated a large majority of the risk. Elimination of risk (or prudent management of it) is much of what financial life is about. Understanding the risk factors that exist in any marketplace, real estate, stock market, small business, etc., should always be the goal as decisions made with full knowledge of the associated risk means better decisions.

The financial world changed in 2007. From the early 2000’s to the market crash of 2007, much of what would now be considered risky behavior was hidden by the rapid increase in values. Making a good decision was replaced by making ANY decision. Poor decisions were in effect negated by the fact that owning property meant appreciation. With values moving 7-10% in any one year, owning a highly leveraged property meant increasing your equity position by a factor much greater. A property valued at $300,000 purchased with 10% down ($30,000) increasing 10% to $330,000 in a calendar year meant that the equity position had increased by 100%. It was powerful math and led buyers to increasing bold and risky decisions.

When the market began to reverse course in 2008 and really begin to free-fall for the next 12-18 months, the true risk profile of each individual deal became horribly exposed to all. Properties that had equity positions of 30-40% (which was considered ridiculously conservative during the last days of the bubble) all of a sudden found themselves with little to no (or even NEGATIVE) equity. When the mortgage industry froze in place, effectively destroying the ability to monetize real estate, the ability to use property as collateral for cash disappeared and robbing Peter to pay Paul disappeared with it. This exposed the all-important risk factor that appreciation hides, cash flow.

Mistake avoidance, in its simplest form, means understanding the worst-case scenario. For many, the use of debt is the primary vehicle by which property is acquired. Understanding the true risk, not just of the loan, but what the underlying acquisition of the asset means to an owner’s entire portfolio, is the most important element of risk management. It went ignored by most up until 2008. For now, with the lessons of 2008-2012 still fresh in all of our minds, the market has begun to show a collective caution about how and what they acquire. The unchecked optimism that defined the marketplace pre-bubble is largely gone and it has been replaced by a feeling that the world is subject to change and that appreciation is not guaranteed. Cash flows are underwritten more strictly than before and far more attention is paid to a buyer’s equity contribution to any purchase.

It is a better way to underwrite.

For the next several years the market will fight to get back to normal where supply and demand is balanced and more generally accepted consensus of where the market is headed is recognized by all. We are at the beginning of a cycle that tends to last roughly 20 years (if 1987-1990 is any indication) and each cycle begins with the idea that we will learn from the past. We will see how long it lasts.