This is not the first time we’ve been here.
In fact, it’s the second time already in our short trek through this century.
But we can learn from others’ mistakes. You can learn from my mistakes. I’ve entered my third decade as a real estate investor, and the pattern is all too familiar.
What am I talking about?
I’m talking about the potential of a real estate bubble bursting and the possibility of it ruining you and your investors.
I experienced this myself in 2008. But I experienced it, through others, about 200 more times in recent years.
As co-host of the How to Lose Money podcast, I interviewed over 230 successful entrepreneurs and investors on their harrowing experiences of loss and pain on their road to success. And many of those stories had something to do with the Great Financial Crisis.
My Thesis
My BiggerPockets friends, we’ve witnessed a doubling of retail mortgage rates, from about 3% to about 6%, in the past six months. Commercial interest rates have risen from about 3% to over 5%. Yet we are witnessing little to no cap rate expansion in most commercial sectors and little to no price softening in residential real estate. Why?
My thesis:
When a cycle reaches its top and begins its descent, there is usually a lag time between reality and seller expectations. This lag time can lull optimistic buyers into a state of denial and tempt them to overpay for assets, causing them significant risk and potential financial ruin.
I’ll demonstrate the likely reason for this lag time through an imaginary conversation between a seller and broker. Then I’ll discuss some implications. Although this example is from the commercial realm, where I live, the concept applies equally to the residential realm where I spent over a decade.
The Conversation
Broker: I think I can get a buyer at $3 million for your property.
Seller: I’m still holding out for $3.5 million. You told me I could get $3 million last year, and I told you I’d wait a year to get my price. Are we there yet?
Broker: To the contrary. Interest rates have caused a pullback in buyers, and I don’t think you can get your number.
Some months pass…
Seller: Well, okay, I will consider $3 million. Send that offer for $3 million over.
Broker: The market has continued to soften. It’s likely I can only get you $2.5 million now—if that. And it will probably get worse.
Based on this conversation, you can see how the disparity between the seller’s and buyer’s expectations could cause a time lag. I think we are in this time right now.
The Wall Street Journal reports a decline in transaction activity for the past quarter. My friends in residential investing report that while prices haven’t softened much, there is a significant slowdown in buyer interest, translating to a lower number of offers for new listings.
The Problem
The problem is the temptation to overpay for assets during this transitionary period. Many of you discovered real estate investing and BiggerPockets after the Great Recession. You’ve only experienced rabid demand and ever-escalating values.
For those who have bought and sold properties or invested passively, you’ve probably experienced significant gains. You may be feeling brilliant, and you probably are. Seriously.
But don’t mistake your profitable track record for invincibility. The market has been your friend for many years. But this same market can be a cruel mistress when it turns on you. You can’t count on the market to create wealth.
The rising tide has lifted all real estate boats for the past 12+ years. But don’t forget Warren Buffett’s haunting words:
“Someday, the tide will go out. Then we’ll see who’s skinny dipping.”
Many of you have spent the past several years frustratedly chasing deals. You’ve been outbid by insiders or speculators posing as investors. You may have scratched your head, as I have, about the high prices others paid. But you watched one after another make a hefty profit when they went to refinance or sell a few years later.
It hurt to miss out, and you could have even thought, “Maybe I was wrong. Perhaps it really is different this time. Maybe I need to jump at the next deal I can get.”
But remember the words of Howard Marks: “Trees don’t grow to the sky.” Herb Stein wryly quipped, “If something can’t go on forever, it will eventually stop.” We’re playing a game of musical chairs, and someone will likely be chairless when the music stops.
The vast dissemination of investing education, media, and real estate coaching, combined with the unprecedented influx of capital into our realm has caused this period to be one of the riskiest ever.
If you’ve finally got the opportunity you’ve been waiting for—the chance to acquire an asset that hasn’t been outbid by dozens of other buyers, beware of what you are paying for. You may be buying into trouble.
Don’t be lulled by this time lag. Don’t overpay for assets declining in potential cash flow and value due to interest rate hikes. Get off the crazy train.
The Clocks at Cinderella’s Ball
We may be able to see the bubble forming. But we’re not psychic. Nor are we entirely rational. So, we can’t know exactly when the bubble will burst, nor how badly it will tank real estate values.
Value investing legend, Howard Marks, has written what I believe is the most helpful treatise ever penned to help you think clearly about this. It’s called Mastering the Market Cycle – Getting the Odds on Your Side. Marks reminds us to think and act rationally based on the current signs of where we are in the cycle.
Howard has taught me this lesson when considering the current situation. Though we can’t predict the timing and severity of cycle tops and bottoms, we can see clear signposts to gauge where we are today. And we can act appropriately for where we are in the cycle right now.
Warren Buffett likens the current overheated situation to dancing at Cinderella’s Ball:
“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities, that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future, will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”
A Gift to the Rational Investor
We’re in a very short window where we can see the writing on the wall. The signs are unmistakable. A logical look at what’s happening should tell us to beware. This is a gift to those who are paying attention.
Don’t be like Belshazzar, the ancient King of Babylon. History tells us that he boastfully paraded his wealth and success. But as a 2nd generation king, his victories were built on sand by the efforts of others.
When warned in writing by a mysterious hand (the origin of “the handwriting on the wall”), the king listened intently but apparently didn’t renounce his ways. As a result, his kingdom was swiftly ripped from his hands.
If you see the handwriting on the wall of your real estate investing world, you may want to pause and consider your next actions.
Don’t be optimistic with your underwriting. Don’t mistake seller expectations for an accurate valuation for you and your investors. And remember one more quote from Mr. Buffett:
“Successful people say ‘no’ a lot. The most successful people say ‘no’ almost all the time.”
There’s no shame in saying no. It may position you with the cash reserves and wisdom to capture a great deal when others run for the exits.
There’s nothing crazy about that.
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Editor’s Note: This is the first in a multi-part series on real estate investing in these turbulent times. The author will provide an opposing perspective in his next post. Stay tuned!
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.