Recently I was asked to write about the future of the real estate market in Rhode Island and the U.S. over the next few years. Specifically, I was asked if we are in a “bubble” now, or will be soon.
It’s always difficult to call the top (or bottom) of a market—even the best professionals get it wrong.
It is certainly challenging as a professional to see a “bubble” forming and know that it must “pop” at some point… but have no good indication of exactly when that point will arrive.
If you get out of the market as soon as you see a bubble start to form, and sit in all cash instead, then you can easily miss out on the lion’s share of gains even though you also eliminated the possibility of any losses.
In stocks, you can hedge your positions with stops and options—basically insurance for your positions. But it’s a bit tougher in real estate since it’s so illiquid compared to stocks.
However, spending time to find properties which have good positive cash flow—and completely disregarding any potential appreciation—is a similar kind of “insurance” for income-producing real estate.
The danger, I think, is when new investors come into the market because they think “real estate is going up” and they expect appreciation, without looking at fundamentals (cash flow). It’s the real estate equivalent of looking for a hot stock tip, wanting the rewards without being willing to educate themselves and learn real investment analysis.
Right now it seems that property values are coming back, but real incomes haven’t risen, so it’s really driven by more demand due to people feeling greater job security than a few years ago, combined with still-tight supply.
I think what we’re going to see over the next few years is that builders will step up to the plate and do a lot of building, and if the economy continues to be “OK” I think the new inventory will be absorbed and we will see mild but steady increases in values.
However if wages actually start to rise then I would expect price increases to be more dramatic. That might be tempered a bit by higher interest rates but I don’t think it will be by much; I think real income increases will supersede any tempering effect from higher rates, and values will increase at a good pace.
Demographically—think millenial renters, people who had moved back in with their parents 7 years ago, etc.—I think the trend will swing back from renting to ownership, and group psychology about “rising house values” will kick in just as it did 10-15 years ago.
Yes, I do think investors should keep buying now, to get more boats in the water in case the water rises, but they should also completely disregard any potential appreciation. In other words, they need to be careful about getting caught up in a “real estate boom” psychology and avoid buying marginal or cash flow negative properties expecting future appreciation.
There are also some broader economic issues which represent some systemic risk, such as Russia-Ukraine, the Chinese economy, the European economy (and some of its weaker members like Greece), etc., and should not be ignored.
So I think we’re 1) one-third likely to have steady low growth in real estate values (U.S. economy continues to do reasonably well but there is little real wage growth), 2) one-third likely to have another boom (U.S. economy does very well and we see real wage growth for the first time in a long time), and 3) one-third likely to have the train derailed by external factors such as the world economy, some kind of war, etc.
In all of those scenarios, positively cash flowing properties will be good of course, but I also need to add that even if it seems like we’re going into scenario #2, do not over leverage. I still think there are geopolitical issues that make scenario #3 a non-negligible possibility, and being locked into high loan payments could be disastrous as broader economic malaise would make it hard to find tenants who can pay the rents.
So I think it is better to have fewer pieces on the board, and sacrifice some gains in scenario #2 (another big real estate boom), in order that the pieces on the board are safer due to good cash flow and lower loans-to-value, to protect against the less likely scenario of #3 just because #3 could blow an over-leveraged investor out of the water completely (think 2008).
As to whether we are at a market top now, I don’t think we’re at a market top at all. I think it’s far more likely we’re on the up slope from the market bottom of 2008-2009. The only question is how steep that slope is (scenario #1 or #2) and the risk of a sudden downturn (#3).
I think it’s most likely that we’re just at the beginning of another cycle of money flowing in to real estate, and if the economy continues to do OK or even improve significantly, we will see a LOT more money come into the market.
To me, we could be 3-5 years from seeing another real estate market top, depending on what else happens with the world economy, the stock market, world politics, etc.
I think this is definitely a time we should be buying, but also to be careful not to repeat the mistakes of the last decade with over-leveraging and buying properties with meager or even negative cash flow in anticipation of future appreciation.