How To Invest in Real Estate When Everything Is Crashing

The financial markets are reflecting a very significant reversal in Federal Reserve policy. Before January of 2022, the Federal Reserve introduced unprecedented liquidity to the financial markets, using their set of tools and measures. How they do this can get very technical, but for the layman, the big picture idea here is that they flooded the system with liquidity. Liquidity drives markets in a very significant way. Many financial analysts are now comparing the stock market with the dot.com bubble of 2000-2001. Consider that the Price/Earnings ratio of TSLA was well over 150 at its peak. For fun, compare this PE with a typical rental found here in Austin, or San Antonio, TSLA is 10X higher. I just purchased a home where after rehab the PE came in at 10.4, on a cost-to-earnings calculation. I find it interesting to compare specific real estate projects to stocks. But the PE ratio is NOT applied to real estate. We use better terms like Net Operating Income, Cap Rate, Cash on Cash Return, etc, to help us gauge value and capital efficiency. We've seen a bubble in residential real estate for sure, but it's still 10X LESS, then TSLA on an earnings basis.

The Federal Reserve has now reversed policy and is hiking interest rates. The cost of debt is increasing and therefore the easy money now becomes expensive money. Liquidity is leaving the financial markets. The effect is that now crypto is down 70% from its highs, the S&P 500 is down 25-30%, and real estate is also taking a hit, although values move much slower in real estate. So the question is, how ought we to invest in such a climate?

Cash is King (In the Short Term, But Long Term It's Trash)

Take a look at this chart below. This is the USD in comparison with other currencies from the beginning of January 2022 to June 15, 2022. As you can see, the USD has increased in value by 9.4% against the Euro, the Pound, Japanese Yen, Swiss Franc, and other currencies that make up the DXY.

One of the reasons for this is that other central banks in Europe and Asia continue to increase their currency supply while we, in the US are decreasing ours. Additionally, there is a higher demand for dollars over assets of investors move out of US risk assets to elect to hold dollars instead. Compare 9.4% of increased value in relation to other currencies and you begin to understand why foreign investors like the USD right now. Even with our very high rates of inflation (8.6% headline) the dollar position is sensible until the volatility of the financial system stabilizes.

So the old adage "Cash is King" holds, and has held over the first half of 2022. Even with the cost of inflation, it has been a far better move than sitting in risk assets so far this year. Do you remember all the headlines about CEOs cashing out of the markets last November and December? This is why. They saw what was coming.

In regard to investing in real estate, I'm adjusting my underwriting assumptions for a less rosy view of rent growth. Also, I will focus on the ability of the asset to cover fixed-rate debt and provide cash flow. Cash flow is very important during a market like this because you cannot count on appreciation if any when the Federal Reserve is hiking rates and sucking liquidity out of the system. In fact, we will see price depreciation in the near term. We don't usually invest based on Fed policy anyway, but more than ever, fundamentals are crucial. Multifamily apartment deals, storage, hotels, and industrial can all be great investments in this climate provided the cash flow is there and expectations in regard to occupancy and rent growth are held to conservative standards. Also, if you are an LP investor, this is the time you want to demand a stress test table from the syndicator. This will help you understand how occupancy and future NOI will impact your IRR or AAR if things don't go according to plan.

The trouble with sitting too long in USD is that you're holding melting ice. Fiat money is probably doomed eventually, so it's always a good trade to exchange it for hard assets. The USD is losing purchasing power by about 8.6% (per CPI) or higher per year. This is terrible. The risk-free 10-year treasury gives you back about 3% now. This means the real yield on the USD is 8.6-3, or -5%. If you can invest and beat -5% you're ahead of the game. This is why I'm not just holding cash, but focusing on high cash-flowing assets that are conservatively underwritten. 2-3 years ago it made sense to give up some cash flow for a higher equity expectation at the sale because the liquidity in the markets drove rents higher. Higher rents produce value in CRE. Today this has all changed.

The consumer, i.e. renter is more stressed than ever. The 5-9% annual rent increase expectations need to be scaled back to 2-3% at least. In fact, there may be some projects that should be underwritten with no rent increases for the next couple of years. It will be interesting to see if any syndicator actually does this, but for the LP, you want to get into the mechanics of these assumptions and learn what is happening in the local submarket you're putting capital into.

Finally, whether we go into a recession or not, real estate deals can still be very good. There will likely be distressed assets out there that savvy investors will acquire and see incredible returns in the coming years. This is a climate where bad managers will have to throw in the towel. There are many investors who have realized returns of 6-10X in CRE. This hasn't been easy over the past few years as values have gotten so high, but in a downturn, these opportunities will present themselves. Sticking to conservative principles will pay big time over the next couple of years.