Staying Disciplined At The Market Top
Everyone seems to be waiting for the bottom to fall out of several investment markets: real estate, stocks, cryptocurrencies, etc. We may be waiting a while for this to happen, but volatility and uncertainty does pervade the daily news cycle. In this environment, it is difficult to form an opinion about how to succeed. How do you navigate an expensive and unpredictable real estate market? There are really two options: wait patiently on the sidelines or stick to your investment criteria and stay disciplined.
While easy to say, waiting on the sidelines can be excruciatingly difficult. If you firmly believe that the market is about to drop, and you have a war chest of capital stocked and ready to take advantage of an inevitable downturn, it’s not difficult at all. However, if you’re wrong and the market continues to improve, the fear of missing out will drive you crazy. You’ll be tempted to jump back into the market at all costs and overpay for that property you really don’t love just to make up for lost time. Unless you are as astute as the analysts behind high-profile, headline-grabbing investment firms or you have a balance sheet that makes you impervious to any market fluctuations, the more practical option is to stay disciplined in your decision making.
To stay disciplined is to always be aware of the downside risks in order to adequately protect your property investment. Having been involved in real estate transactions during the last downturn, here are three key things I’ve learned about staying disciplined:
1. Rely on history: There is so much data available to every investor that there’s no excuse not to use historical information. Look at rent growth for the past 10 or 20 years — long enough to capture previous recessions — and see what the historical average is. Underwriting above-average growth for the foreseeable future is difficult to justify at this point in the cycle. Also, not all cities grow at the national average or rate of inflation, so it’s important to analyze the market that you’re invested in.
2. Focus on stabilized yields: Given that we’re in a rising interest rate environment, there is a good chance that cap rates will increase as well. We know that higher cap rates result in lower values. However, any sort of inflationary pressures or continued economic growth can improve rents and net operating income. Keep in mind your exit cap rate will likely still be impacted by the rise in interest rates. To combat this trend, focus on the stabilized yield. Once the property has been renovated, leased out or improved in some respect, determine the yield you’re comfortable receiving. If you can live with that return while the market is in flux, you’ll be prepared to succeed once the market normalizes.
3. Don’t over-leverage: If you’re concerned about overpaying for a property, the last thing you should do is also over-leverage the property in the hope of financially engineering an acceptable return. In fact, it’s prudent to do the opposite and actually refuse the “extra” debt from your lender to ensure that you’re able to hold on to the property if values or rents decline. Additionally, since interest rates are rising, it’s more important than ever to match the maturity of your loan with your investment period and to get as much prepayment flexibility as possible from your lender. A conservative debt strategy is always sound decision making.
In this volatile market, the best offense is often having a good defense. We craft our investment criteria and set return thresholds when we create a new investment fund or start our businesses. It becomes awfully tempting to mold these two into something different when the market dynamics shift away from our strategy. Much like not giving in to the breakroom donuts at the office when you’re on a diet, the end goal of purchasing quality, high-returning, real property is much more satisfying than the instant gratification of buying a deal just for the sake of it.
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