In my last several columns, I have been discussing how to understand and read economic and real estate cycles with the goal of better timing your acquisitions and disposition. The acquisition goal is to enter the market after it has bottomed out and on the way back up. You can eliminate 80 percent of a market’s risk by not trying to buy at the bottom and sell at the top. Therefore, your goals should not be to attempt to get every dollar of profit available in each cycle, but instead substantially reduce risk by waiting for the next cycle to confirm itself (a growth of 20 percent off its previous low). Likewise, when it is time to sell, do not try to wait to be the last seller to get top dollar before the pending bust, but instead sell at approximately 20 percent from where you expect the next high should end.
Based on this concept, let us focus on the crucial transition period and market dynamics of any real estate economy as it moves from a severe recession back into a boom period. If we have plotted the market value of real estate prior to a recession, we can see that the market first became very illiquid and then gave way to a downhill slide of the values themselves. The initial drop can easily average 1 to 2 percent per month in actual market value reductions. During the next years, the value can continue to slide from 30 to 60 percent, depending on the type of realty (apartments, land, residential, office buildings, etc.).
It is most important, however, not to be fooled into thinking that this pattern for the rate of decline will serve as an example of how a market will respond in an upcoming expansion. For example, there is a natural inclination to assume that, if the market first became illiquid and then declined at a rate of 1-2 percent per month, it will take an equal 40-60 month period just for prices to return to the previous market’s values.
I would like to illustrate the fallacy of this assumption by using an analogy concerning duck hunting. Successfully buying real estate during a feverish boom period is very much like going duck hunting. Success in either requires a special combination of knowledge, skill and luck.
If you analyze the process of duck hunting, you can see that the hunter needs to follow specific procedures and rules before he can have a good chance of succeeding. They have to scout the flyways where the ducks fly; have a blind built in the right location; buy and set out decoys; buy camouflaged clothing (ducks have excellent eyesight); perfect using a duck call; and train a dog to retrieve the fallen ducks.
Those who have been through this entire procedure know all too well that doing all this does not guarantee that you are going to have a successful hunt. To the contrary, even after everything has been done properly, most hunts yield meager results. The simple reason is that duck hunting is as difficult as trying to find a good real estate buy in a booming market period. Fortunately, during the other end of the economic cycle, a recession, this is simply not the case.
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During a recession, most real estate investors are hurt economically. Their banks usually will have cut them off, and their personal cash flows will have been severely curtailed. Since the market is completely illiquid, all they can do is hope and pray for the turnaround.
However, one by one, as their money runs out, they are forced to sell, quite often at a substantial loss. As one person is forced to sell for, let’s say, 20 percent less than he paid during the boom, that price quickly becomes the “current” market value. As a result, all other investors are immediately expected to sell at a similar price if they want to succeed. As the situation becomes more desperate, the market continues its fall. The healthy property owners will refuse to sell at a loss and prepare to hold their property until a more favorable market returns.
The longer the recession continues, the further the “current” market” value declines. In addition, since now only the most desperate are selling, the buyers quickly become expert “bargain hunters.”
This scenario is like hunting wounded ducks. A wounded duck is grounded on a pond and cannot fly away; the hunter knows that the duck has no way of escaping. Hunting wounded ducks requires absolutely no skill or preparation. You do not need to have a blind, buy decoys, use camouflage or duck calls. You really do not even need a dog because, once shot, a dead duck is usually blown to shore by the wind. You simply walk around the pond and shoot the wounded ducks.
This is very similar to buying real estate in the pit of a recession. The deeper the recession goes, the more wounded ducks there are. The healthy ducks will not go near a pond if a hunter is fully exposed and shooting wounded ducks; just like healthy property owners won’t sell their properties at the ridiculously discounted “current” market values. If a particular location gains a reputation for having an abundance of wounded ducks, the word quickly gets around to the other hunters and they all flock to the place that offers the “easy pickin’s.”
This analogy has been given to help illustrate what will occur during the transition period that then follows a recessionary economy moving back into a boom. Using our duck-hunting illustration, we can track the market as it returns to normal conditions.
Once the market begins to expand due to strong economic occurrences, it will take some time for the news to get around. As more and more investors enter the market, activity begins to occur. However, since there are still wounded ducks on the pond (financially desperate sellers), there will be a short slaughter period to remove them, and the price things sell for during this period are usually even more.
The next occurrences are extremely critical and are responsible for developing the fever that will become the upcoming boom. Once the wounded ducks are cleared, the market almost immediately return to the pre-bust prices. This is because the healthy property owners who had previously refused to sell at the distressed market prices now become the true market. Since there are no longer any desperate sellers, the only ones remaining are the healthy ones. Obviously, if they were refusing to sell at distressed prices during the depressed market, they are not going to lower their prices now that the market is fully strong.
This creates an amazing result in an entire market. In a very condensed period, market value returns to the previous highs of the pre-bust days. This rapid escalation in values produces very real profits for the bargain hunters who wisely bought at the right time. Their profits and the rapid growth in property values become front-page headline news, which immediately attracts others who are interested in similar opportunities.
This process begins escalating and is responsible for creating and sustaining the forthcoming boom. At this point, we are back to duck hunting as normal, which requires all the efforts and paraphernalia previously described.
Unfortunately, most investors will miss this important transition period, expecting things to take as long to reverse as they did to occur in the first place. However, unfortunately, most investors are usually following the herd only to arrive after all the easy ducks have been shot.
The best time to enter the market is after the turn around has been defined and prices have started back up. At this point, there should still be plenty of wounded ducks to whom recession is still very real.
Being a successful contrarian real estate investor means learning to implement the things I have covered over the last several columns. My hope is that these columns have opened your eyes to important principles normally ignored by most real estate investors.