Are you thinking about buying a home today? Then you need to also envision a scenario where you buy a home at the top or near the top of the market and a deeper recession hits.
If there is a downturn, will you be able to afford the monthly payments? If a bear market comes again, can you continue to pay the ongoing insurance and maintenance expenses as well?
Affording a home isn't just about coming up with the downpayment, it's also about whether you can comfortably keep on paying the ongoing expenses for years.
The housing market was strong until the Fed started aggressively jacking up interest rates in 2022. With higher mortgage rates, demand has waned and sellers want to hold onto their sub-3% mortgage rates. In other words, there is a housing market standoff, where prices are slowly declining in some parts of the country.
Inventory is still low, but unless mortgage rates decline again, we could easily see a 5% – 20% decline in home prices by the end of 2023. In hot pandemic markets like Phoenix, Austin, Miami, and Memphis, they could easily correct by 15% – 20%.
Downward home price cycles often take two-to-three years to play out.
Good To Assume The Worst In The Housing Market
If you lose your primary source of income, usually your job, will you also be able to afford your home? Buying a home with mortgage debt is a big decision. Therefore, please treat a home purchase with the utmost respect and buy with discipline.
Everything was feeling pretty incredible in 2006 and 2007. Then the housing market crashed and burned for the next three years as people borrowed too much and banks lent too much.
Plenty of homeowners didn't know what hit them. As a result, thousands of homeowners lost their homes to foreclosure and short sale.
It is exactly when times are great when we all need to think about downside risk.
What If You Buy A Home At The Top Of The Market?
One way to tell whether buying a home right now is a good time or not is seeing what the stock market is doing. The stock market reflects earnings expectations 6 – 12 months in advance.
2022 saw a 19.6% decline in the S&P 500, but 2023 is so far up 16% year-to-date.
You can investigate further and look at sectors in which your location has large exposure. For example, check out tech sector performance as it relates to the San Francisco Bay Area. Or take a look at bank sector performance as it relates to NYC. Tech performed incredibly well in 2020. Meanwhile, banks and other old economy stocks are performing well this year.
Stocks correct swiftly, while real estate corrects slowly until everybody knows real estate is weakening. Then liquidity dries up and the floor drops out. If the stock market is correcting, it's time to pay closer attention to any investment you make, especially with leverage. So far, the stock market is holding strong.
Real Estate Moves In Cycles
What we do know about the real estate market is that it moves in cycles due to the desire for economic profits, i.e. new construction to meet new demand.
Peak new construction tends to occur past peak demand, which ultimately leads to temporary oversupply and lower prices. This is what we call: boom and bust. This bust phase usually lasts between 1-3 years before a price floor is found.
In 2023/204, we are in a peculiar situation because input costs to build new homes have risen. Further, there is a shortage of home construction labor. Home builders want to build, but they can't build fast enough. But mortgage rates have surged, so affordability is limiting buyers.
The utility of a home is way up since we’re spending more time at home. Add on local government regulations to build new units, and supply is severely lagging demand at the moment. But the supply of new housing is coming to some heartland cities where land is plentiful. Therefore, stay observant of the supply and demand dynamics.
Classic Home Buying Cycle
Below is a chart that shows Market Cycle Quadrants. Back in 2006-2007, we were in Phase III – Hypersupply. In 2022+, it feels like we are at the end of Phase II – Expansion. This expansion phase should last for a year or two. But again, nobody knows for sure.
What I do know is that the supply of homes continues to be very limited, which is one of the key reasons why housing prices will likely stay buoyant, albeit at a slower pace.
There is a “life goes on” home-buying cycle that is embedded in the market. Millions of people put off their home buying during the pandemic, but marriages, babies, and divorce continued to happen.
Now millions more are waiting for mortgage rates to come down. But life goes on and this pent-up demand will eventually be unleashed as people are getting older and sick of waiting.
Reinvest In An Earlier Part Of The Housing Cycle
Real estate investors can look at the chart above and rationally make an argument it would be wise to shift exposure from late phase markets to early phase markets to earn more money and protect against downside risk.
If you believe in such logic, then you should believe in my thesis of investing in heartland real estate. Heartland real estate is considered in the earlier phase of the real estate market cycle than coastal city real estate. There will likely be a long-term demographic shift towards lower-cost areas of the country thanks to technology and the greater acceptance of working from home.
Personally, I reinvested $550,000 of my San Francisco home sale proceeds into a real estate crowdfunding fund across the Midwest and South. The goal was to diversify and earn income 100% passively.
At the same time, there will likely be a revival in big city real estate as people rush back to places like New York. At the end of the day, you want to be where the jobs and the people in power are.
Going remote is fine, but at the margin, you will lose out on more career advancement opportunities compared to the people who are regularly seeing their bosses in person.
My favorite private investment platform is Fundrise. Fundrise has over $3.5 billion in various funds they created to invest in residential and industrial property in the Sunbelt region. I've personally invested $810,000 in private real estate funds to invest in lower-cost areas of the country with higher yields
Buying At The Top Of The Market – How You'll Feel
Let's say you go ahead and buy property with leverage at the top of the cycle. Even though things look good now, some random black swan event crushes the housing market. Or maybe the Fed raises the Fed Funds rate too much, too quickly.
What happens to your mind and to your money if you buy property at the top of the market?
I've got first hand experience since I bought my Lake Tahoe vacation property in 2007, only one year after the peak. I bought the property for 12% less than the previous owner, but then the property's value continued to decline by up to 50% two years later! Condotel mortgages dried up, and I was left sulking. But I still own the vacation property today and it is only a small portion of my net worth now.
Here's what happens if you buy property at the top of the latest real estate cycle.
1) You go into denial at first.
You will stand behind your decision to buy at the very beginning. Even if you see a neighboring home on the market sit for longer or drop its asking price, you will justify your purchase by saying your home has a better layout or nicer amenities. You will tell yourself that you bought your home mainly for a better lifestyle first.
After about a year, the elation of owning your home fades a little bit. It's similar to the fading elation of buying a new car with a loan. You are thrilled for the first six months, but that thrill dies down while the car payments stay the same. You'll go online to see the valuation of imperfect comparable home sales to justify your purchase.
2) You begin to accept your mistake.
Between 12 – 24 months post purchase, you start realizing that maybe you didn't make the best purchase after all. You may start telling yourself, “In the long run, things will be fine,” in order to feel better. But the more you look at homes that sell for less, the more you beat yourself up about your purchase.
You start doing calculations on how much you could have saved on the downpayment or on the monthly cash flow if you had just been a little bit pickier or a little more patient. You look at the nicer homes you could have bought with what you paid and kick yourself a little bit. Finally, you tell yourself, “It's just money at the end of the day.“
3) You start to think worst-case scenarios.
Due to leverage, a 10% decline in the value of your home is a 50% decline in your 20% downpayment. Once the momentum to sell begins in real estate, it starts getting scary, especially if you own a condo in a large building. Think about real estate as a super tanker that's hard to stop in either direction.
During a worst case scenario, you start calculating how long you can keep the house before you run out of savings if you lose your job. You also calculate how low the house can go before it no longer makes sense to keep paying the mortgage.
During the worst stage of a correction, you may really begin to freak out because you will know friends who have been laid off. You start wondering whether you'll be next. You cannot help but worry about the housing market ruining your life, especially if you're over 40.
During the Global Financial Crisis my company went through seven rounds of layoffs. My best friend at the time lost his job and just had his first son. I did my best to get my firm to hire him, but it didn't work out. Although I didn't have kids at the time, I did have a $1.1+ million mortgage on my primary residence.
4) You start to cut out all excess fat from your budget.
The great thing about being rational is that during difficult times, all extraneous expenses get slashed and savings rates go up. Before the pandemic began, the average U.S. saving rate was around 6%. Then it exploded to 32% in April 2020. We Americans can save more if we want to!
As your property loses value, you might try and get a second job or work a side hustle. Fear of financial ruin in 2009 is what got me to start Financial Samurai. I needed a cathartic outlet to release my fear. I needed something to do just in case I was one of the thousands of people who got fired from the finance industry that year.
During the financial crisis, I didn't buy anything. I also hustled harder to build relationships with clients who were my only leverage to keeping my job. Instead of buying groceries, I took as many clients out for lunch and dinner to not only build better relationships, but to save on food!
Yes, I took leftovers home to feed my wife as well. My clients were also worried about losing their jobs and also wanted to save money. When you go through a crisis with someone and survive, your relationship thrives in good times.
5) You either stick with the game plan, or stick it to the bank.
If things get really bad where you're underwater on your home, you will need to make a crucial decision. You will decide to either stay current on your mortgage or stop making payments.
If you decide to break your contract with the bank, you must realize which states are non-recourse states so they don't come after your other assets. By short-selling or foreclosing on your home, not only do you ruin your credit and dignity, you also hurt your neighbors who decided to keep paying.
But in America, it's often every man and woman for himself. You can foreclose on your home like one financial pro did in 2011. He subsequently got hired by The New York Times to write about money advice and even wrote a book about how to improve your finances!
This is one of many examples as to why I'm so bullish on America. It doesn't matter what mistakes you've made or who you are, you can always come back.
Nothing Happens If You Decide To Keep Paying Your Mortgage
If you decide to keep paying your mortgage, then usually life goes on as planned. After all, real estate markets tend to recover over time. Few people go into buying the most expensive thing in their lifetimes without a long-term plan. The average homeownership duration is also about 10 years today.
If you buy a home at the top of the market, you're just annoyed you paid full price for something when it went on sale just a couple months later past the return policy.
The key is to try and refinance your mortgage before your equity gets wiped out. Most banks won't let you refinance to the best rate, even if you have stellar credit, if your loan-to-value ratio is greater than 80%. In other words, you need to have at least 20% equity to refinance.
Therefore, if you start seeing the housing market turn south, one of your first moves should be to call your bank or check online to refinance. Personally, I like Credible. They've got a great group of lenders competing for your business so you can get the lowest rate. You can get a free, no-obligation quote in minutes.
Further, if you ever lose your job, you will become dead to banks. The vast majority of banks will not let unemployed people refinance or take out a new mortgage.
If You Stop Paying Your Mortgage
If you decide to foreclose or do a short-sale, then you simply lose 100% of your downpayment. You also hurt your credit score by the following amount according to FICO.
- 30 days late: 40 to 110 points
- 90 days late: 70 to 135 points
- Foreclosure, short sale or deed-in-lieu: 85 to 160
- Bankruptcy: 130 to 240
A foreclosure will be on your record for 7 years on average plus 180 days from the last time the account was paid as agreed. Your credit score will gradually improve over these seven years, but may not fully recover until the foreclosure is off your record.
Those who’ve been through foreclosure and want to do conventional financing in the future will have to pay a higher interest rate (approximately 1 and a half to 2%) unless they put a sizable downpayment on their new property (more than 20% down).
If the real estate market seems frothy, please follow my 30/30/3 rule for home buying. If you do, you significantly increase your chances of being able to afford your home in a recession.
Just Have To Hold Onto Your Real Estate
Buying real estate at the top of the market stinks. But it's not the end of the world if you hold on. Over time, the property should account for a smaller and smaller portion of your net worth. The property should also recover its value as well.
If you responsibly bought your property to enjoy, then enjoy it! Today, the Lake Tahoe property I bought near the top of the market is a place where my family will spend the summers and winters. This is what I have always dreamed of doing when I first bought it as an unmarried man with no children. Surprisingly, I also discovered that owning a vacation condo at a resort is preferable to owning a mansion vacation property
When my wife and I pass, I hope our children will have their own families to take up to the mountains one day. Maybe they'll even have a picture of us on the mantle smiling over them.
You Don't Have To Go All-In On Real Estate
Investing is difficult. When things are bad, it's hard to invest because you think things could always get worse. When things are good, as they are now, you don't want to look foolish buying just in case the cycle turns.
If you want to invest in real estate, you don't have to take out a mortgage and buy property. That's like going all-in. Instead, you can buy a publicly-traded REIT, a real estate ETF, or a private eREIT for real estate exposure. None of these real estate investments require leverage.
After buying a “forever home” in 2020, I'm no longer looking to buy another primary residence for a while. However, given I think the housing market will continue doing well for several years, I'm investing in real estate more surgically through private real estate funds and real estate ETFs.
Top Real Estate Investing Platforms
Fundrise is my favorite private real estate investing platforms with over $3.5 billion managed from over 400,000 clients. Investors can surgically invest in one of their real estate funds with as little as $10. Fundrise primarily focuses on single-family rentals.
My second favorite real estate investing platform is CrowdStreet. CrowdStreet focuses primarily on individual real estate opportunities in 18-hour cities. 18-hour cities tend to have higher growth, lower valuations, and potentially more upside. CrowdStreet sometimes offers specialized funds as well.
As I get older, I want to spend less time managing rental properties and more time doing what I want. As a result, I've invested $810,000 in real estate crowdfunding across 18 deals and funds to earn more passive income.
It's important for me to diversify away from my expensive San Francisco real estate holdings into the heartland of America. I don't think we're at the top of the market yet. But having a well-diversified real estate portfolio is always smart.
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