Real estate prices fluctuate based on supply and demand, but because so many demographic, economic, and policy changes influence the markets, it’s virtually impossible to know what to expect.
Before the COVID-19 pandemic, for example, economists weren’t predicting a downturn in commercial real estate. Now, Morgan Stanley’s chief economist warns of a crash more damaging than the 2008 financial crisis. On the other hand, unexpected gains are common as well. In May 2020, Zillow predicted a drop in home prices and home sales followed by a slow recovery in 2021. But instead, a homebuying boom caused prices to skyrocket before 2020 came to an end.
With the ever-changing markets, what seems like a good investment one year can look like a poor choice the next. But even with all the uncertainty, there are some enduring truths in real estate that you can always depend on as an investor. And understanding these tenets can help you navigate the shifting landscape with more confidence.
1. Due Diligence is Essential to Every Deal
“Due diligence must always be done before you put any money into anything,” says Bradley K. Warren, Strategic Real Estate Investing Advisor at Real Estate Bees. “That is what most people fail to do, and it’s why they lose money when they invest in real estate.” It starts with market analysis to ensure a market is viable before you even look at properties.
You may need to analyze market rents or construction costs and get estimates from property management companies or contractors to form an ROI hypothesis. Due diligence also includes analysis of property taxes and homeowners insurance when estimating a deal’s overall performance and extends to examining the physical asset as well—for example, you may want a mold inspection in addition to a standard home inspection. The more thorough you are, the less risky your investment will be.
Warren also says to look at the track record of anyone you look to for real estate investing advice. “A lot of these gurus make more money selling their course on how to invest in real estate than they’ve actually made investing in real estate,” he says. Due diligence includes collecting references and evaluating past successes and failures of potential mentors.
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2. Location, Location, Location
This probably goes without saying, but location is everything in real estate, according to Kristina Morales, a Realtor with 20 years of experience in multiple markets. The right location can yield both greater-than-average cash flow and appreciation.
Look for cities with growing economies and thriving cultural scenes, and identify neighborhoods that are safe and boast nearby amenities and green space. Even within the same neighborhood, one property may be better positioned for high returns than another. Get hyper-local and consider whether a property is too close to the freeway or too far from the park.
3. Home Values Revert to the Mean
Home prices tend to follow the principle of mean reversion. Following a period of rapidly rising prices, home values tend to fall until they reach the statistical long-term mean for that market. If prices have been rising exponentially in a market, that market is likely to experience falling prices. It’s why prices are expected to fall the most in pandemic boomtowns like Austin and Phoenix, where home prices skyrocketed due to an influx of new residents and other factors.
The good news is that housing price increases during periods of appreciation are generally more pronounced than housing price decreases during a downturn from the fundamental value, or what is typical over time in that market. And investors can use this knowledge to buy while prices are low, waiting to sell until prices are high. Of course, knowledge of individual markets is helpful as well since home prices in cyclical markets like San Francisco tend to vary further from the mean than home prices in linear markets. But no matter where you’re looking to invest, remember that what goes up must come down.
4. A Good Investment Requires an Upfront Exit Strategy
“Be clear about your exit strategy before you even invest,” says Warren. That’s because knowing whether it’s a short-term or long-term investment changes your approach and what constitutes a good deal. Whether you’re aiming to rent the property for decades or flip it as quickly as possible, Morales says to purchase with your sale in mind. “Have the foresight that one day you are going to have to sell it,” she says. “And as an investor, what are those things that are going to draw renters to the property, or what is going to draw buyers to purchase your flipped property?”
5. You Need a Good Realtor and Lending Partner in Any Market
“There’s no condition in which the value of your Realtor and your lending partner doesn’t play a crucial role,” says Morales. You might think that you don’t need a listing agent in a buyer’s market, but regardless of the conditions, building the right team is essential. Morales says people often run into trouble when they don’t interview prospective real estate agents. She says to ask questions, such as:
- How long have you been in the business?
- Are you willing to work with investors?
- Do you have experience working with investors?
- Do you know about this area?
- What resources are available should I need a contractor?
- What’s your negotiation style?
- What can I expect from you from an education standpoint?
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6. Even with the Best Tenants, There Will Be Conflicts
According to a survey from renters insurance company Lemonade, 36% of landlords say they resent some of their tenants. Even when you screen your tenants and establish good relationships with them, you should expect some disputes. It could be a disagreement over who’s responsible for a repair. It could be a violation of a community rule that causes tension. The important thing is to maintain open communication and be transparent while resolving the problem collaboratively. This can prevent conflicts from becoming costly court cases.
7. House Price Cycles Are Long
House prices generally cycle through four phases: A recovery phase, when prices are at their lowest. An expansion phase, when job growth facilitates demand for homes that leads to a low supply of homes. A hyper-supply phase, which is often the result of an attempt to meet demand, and finally, a recession phase.
These price cycles are long, and it typically takes longer for prices to move from trough to peak than to fall from peak to trough. Getting from a price bottom to the prior price peak has taken a median of 6.7 years across metropolitan areas, but full price cycles from peak to peak can last decades. Some markets endure longer price cycles than others. For example, in 477 U.S. cities, home prices are still trailing behind where they stood during the peak of the early 2000s housing boom.
It’s worth noting that the National Bureau of Economic Research has only recorded a few dozen business cycles in U.S. history, with peak-to-peak durations varying widely and unique circumstances surrounding each downturn. It’s, therefore, difficult to confidently predict how the economy will respond to different drivers. Even while tracking numerous variables that impact economic behavior, economists are unable to predict a large share of recessions and often miss the mark in forecasting their severity, according to the International Monetary Fund.
Even if investors watch for the warning signs, identifying the recovery phase (an advantageous time to buy) isn’t always possible. But one pattern is consistent, and that’s the extended duration of house price cycles. In other words, if you buy a property in a cyclical market when prices are at their peak, you’ll need a dose of patience if you want to capture appreciation.
8. Diversification is Key to Weathering Recessions
If you buy a multifamily residential building that turns into a cash cow, you might be tempted to buy more multifamily residential buildings in the same area, but this is ill-advised unless you already have an array of real estate assets, like warehouses, vacation properties, REITs, and vacant land.
Even if your knowledge and experience is with one particular type of asset, you should diversify your investments. “Have some money in a number of different areas,” says Warren. “Understand the wider investing strategy, so if one of your assets goes down, hopefully, others are going up.” Not only should you look to diversify within the real estate sector through both active and passive opportunities, but you should also hold non-real estate assets like stocks and bonds.
9. It’s All About the Kitchen and Bathrooms
“Kitchens and bathrooms still sell. It’s probably the number one thing that will attract somebody to the home,” says Morales. The average ROI for a minor kitchen remodel is about 71%, according to the Cost vs. Value Report from Remodeling Magazine. Outdated kitchens and bathrooms, on the other hand, can deter buyers. Other buyer must-haves may be location dependent. Morales says people are looking for basements in Ohio, for example, and not having one cuts your buyer pool in half. Parking and privacy can also be deal-breakers.
“When you’re looking to invest in a property, think about its marketability regardless of the market cycle,” suggests Morales. A lot of times, people get caught up in the emotion when there’s no inventory. But you may not be selling in the same market, so think about the objections that the next person’s going to have about the property.”
10. Real Estate Will Never Be a Perfectly Competitive Market
Investing in real estate is different from buying a potato from the grocery store because real estate transactions have too many complexities, constraints, and moving parts for the market to be perfectly competitive. Perfectly competitive markets (like agriculture) tend to have many sellers providing a homogeneous product and buyers who are knowledgeable and can buy the product easily and frequently. For perfect competition to exist, the market must be easy to enter without transaction costs or government policy constraining buying and selling activity.
In real estate, every property is unique, transactions are expensive and complex, buyer and seller knowledge is limited, available supply and demand often depend on government policies, and there are few participants in the market at a time. The real estate market isn’t perfectly competitive and probably never will be. But it’s interesting to consider whether real estate would become a more accessible or affordable investment if players in the market strived toward the elements of perfect competition—for example, what if zoning restrictions were lifted and technology allowed for lower transaction costs?
11. Let’s Face It. You Can Never Have Too Many Properties
The more wealth you have, the more properties you’re likely to have. While millionaires owned an average of two homes in 2018, according to a report from Coldwell Banker, the nation’s demi-billionaires (the top 0.001%) owned an average of ten homes. Why? Perhaps it’s because smart investments in real estate are strong drivers of wealth for the ultra-rich.
Or perhaps when there’s enough money to get a villa in Tuscany, a New York penthouse, an Aspen mountain chalet, and a California beachfront home, you don’t choose. You just buy them all. Whether demi-billionaires are racking up properties for enjoyment or to build even more wealth, the fact remains: There’s no such thing as too many houses.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
