The Best Offense Is a Good Defense – by Chris Ragland

Sean HarrisIncome, Interest, Investing, Money

Real estate is typically a stable and predictable investment compared to the volatility associated with the stock market. But as we know from the most recent recession, the housing market is not completely isolated from the economy as a whole. That’s why you need to have a good defensive strategy for those times when market conditions are not in favor of investors. So, how does a business that invests primarily in real estate protect itself when a downturn in the housing market occurs? There are a couple of steps private lenders can take to defend their business from the impacts of stagnation or a decline in overall real estate prices.

As a general rule, single-family residential properties are the best type of real estate investment to protect against an economic downturn, and here’s why. During a macro recession, businesses are usually hit hard and fast. If you own a commercial property and one or more of your tenants goes out of business, you lose that revenue. When the economy is uncertain, you aren’t likely to see a lot of new or existing businesses looking to move in. Residential real estate is a much better bet because, even during a recession, everyone still needs a place to live. But even in an economic climate when more people are renting and fewer are purchasing homes, a multi-tenant property like an apartment building poses significant risk because of its geographic concentration. There are a lot of factors affecting consumer behavior, but if the property is in a less attractive area because of say, public transportation for example, it could end up with a high number of vacancies, leaving the property owner without adequate revenue. And like commercial properties, multi-tenant residential properties have much higher carrying costs and are more difficult to sell than single-family properties. However, the strategy during a housing market downturn is usually not to sell.

When housing prices stagnate or begin to decline, borrowers find it harder to sell their investment properties which results in extended loan terms, increased carry costs, lower sale prices and in the worst-case scenario, a higher probability of loan default. So, if you’re the lender, you end up with an increasing number of homes that need to be sold which puts you in the same position as the original borrower, right? Not if you’re smart.

If you’re the lender on this kind of investment, you should have a much lower basis than the borrower, allowing the you to sell the home at a lower price and still turn a profit. A basis below 70 percent, or 70 cents on the dollar, puts the lender in an advantageous position in this scenario. But if housing prices begin declining rapidly, the smart move is to hold the property and lease it. Leasing the property provides cash flow in the form of monthly rental payments instead of monthly interest payments. In this way, you can hold on to an asset until the market is back on the upswing and it makes sense to sell it.

A portfolio of rental properties requires a great deal of maintenance and upkeep. So, the final piece of this defensive strategy is the capability to manage assets from foreclosure to disposition. Managing multiple properties, whether rentals or sales, requires both expertise and flexibility. There are many benefits for a private lending firm keeping these resources in-house. The biggest benefit to having an in-house asset and property management team is that it keeps your costs lower since you’re not paying profit to a third party. But, you also control the timelines and level of efficiency related to any property upgrades and upkeep. If you choose to outsource property management, you will spend more which makes it more difficult to turn a profit in the long run.

In the business of private lending, it is critical to have a plan for every possible scenario – even the worst case. Otherwise, you stand to lose a lot of money. To be blunt, if your strategy is all offense, you’re doing it wrong. You have a better chance of winning the game if you’re looking farther down the court and planning your next move in advance.