When you’re sitting around the dinner table, conversation is bound to turn to today’s economic climate and what the future holds. With the Federal Reserve reducing interest rates for the third time in 2019, the canary in the coal mine is definitely singing a cautionary tune of a slowing economy. The big question is, what will happen to the value of our assets, specifically when it comes to real estate? Now is the best time to follow the Oracle of Omaha’s golden rules: 1. Never lose money, and 2. Never forget rule No. 1.
But let’s take a pause here: Not losing money does not mean not making money. We need to take into account the current market cycle and how we can best be prepared for what is coming. By being disciplined with investments, you can still gain capital at a competitive rate with smartly allocated funds. This is achieved by adopting a core concept of recognizing value in its simplest form — distilling down to the intrinsic value of an asset.
Economic Dips Force Real Estate Risks
Consider the present state of real estate:
• Competition to acquire assets is fierce.
• Prices for property, construction, materials and labor are up.
• Debt is plentiful.
Coupled with the lagging economy, these forces may urge us to wait out this cycle to see what the market may bring. We could hang out on the sidelines till the Fed decides next steps in mid-December. But let’s be frank here: We cannot sit around wondering if we are going to lose or make money. We need to deploy capital now.
For many, the urge is to take flight for safety, investing in Main & Main in New York City or Chicago or San Francisco. When that next recession happens, and it will, these individuals are real estate-protected. Sure, the asset will take a little hit, but by being poised in a primary market, the property will not lose intrinsic value.
The flaw of this strategy comes down to supply and demand. You, Bill, Suzy and Phil are all thinking the same thing, so market prices skyrocket, and you could end up overpaying double or triple what your asset is actually worth.
Middle Markets Are A Safe Haven For Investing
Let’s take a step back and look at the bigger picture. It is a big country out there and there are a lot of secondary — or tertiary, we’ll call them — middle markets. These are the Charlestons, Austins, Nashvilles, Raleigh-Durhams and St. Louises, and the list goes on. These markets are vast and fragmented. Opportunity abounds, and where there is opportunity there are deals, which turn into loans. Now, forget about the lovely neighborhoods, how great the developer is or the stories of attraction spun by a city. This is when you lean in on core value metrics.
Entrepreneurial private hard money lending firms can home in on this by sorting through the noise of these countless markets to find real deals that adhere to the intrinsic value concept. By applying a formula, say, lending approximately $75 for every $100 of intrinsic value on an asset, standards can be kept high. The smaller the loan-to-cost (85% or less) and loan-to-value (75% or less), the safer the deal, and money is less likely to be lost. We’re back at rule No. 1.
Now, consider the state of real estate in middle markets:
• Supply and demand pressures to acquire assets are reduced due to the vastness of this class of cities.
• Fragmented markets can keep prices competitive but not as high as in many primary markets.
• Debt is still plentiful.
Putting Stock In Intrinsic Value
What does this mean for investors? You might be sitting on funds wondering how not to lose money in an uncertain economy. You could take an aggressive standpoint, rolling the die, chasing a deal and hoping that you win a lion’s share. This will take time to research the markets and all of the variables that interplay for each one.
This is where I believe we as private hard money lenders should be tasked to do the legwork. Hard money lenders tend to be experts in targeted middle markets, often peppering in a primary market or two, granting loans on assets that have high intrinsic value. Raise funds at, say, 7% (much higher than the national average for savings accounts, which are prone to losing APY with Fed cuts) and invest them in properties at 10%. With a margin of safety built into each loan, you take a more cautious route to making money.
Diligent shops that drive marketing efforts can bring in more deals in the middle markets. The goal is to ferret out the value to help Wall Street deploy large amounts of capital into smart investments. And these investments can further capitalize on the market as assets expand across the vast landscape.
What this all boils down to is Warren Buffet’s rules with a little addendum: 1. Never lose money, and 2. Never lose sight of being patient, because your money can make more money. Be diligent, be safe and be prepared for the next downturn by focusing on value.