Using Real Estate to Hedge Against the Coming Bear Market

As an investor, volatility is unsettling.

But volatility is expected in markets. That uneasiness is what pumps up returns, causes growth, and ultimately, pays off. Now, with the stock market seemingly at the end of the longest bull market in history, what strategies can smart investors use to still make money?

The answers might surprise you.

Traditionally, investors have leaned on bonds when bear markets loom. In the Great Recession that began in 2007 with the real estate crisis, the S&P sold off nearly 40% while bonds like Barclays Aggregate Bond Index were part of a 5.2% increase during that period. The painful downside of those bond indexes is the low, but theoretically stable, returns and the challenges posed by inflation.

Now, in the last quarter of 2018, we’re seeing interest rates and inflation creeping up, so savvy investors are looking for smart strategies that can pay higher returns than bonds while offering the same security.

Only one investment market is hitting those demands and that is, surprisingly enough, residential real estate. While this has long been a strategy for some investors in bear markets, their reasons have often been based on little or no data. Knowing that investors have long viewed real estate as a safe harbor we decided it was important to look at the numbers to determine whether that strategy is actually smart.

There were quite a few surprises.

First of all, in every bear market in the United States since 1960 – eight of them in all – the only times that home prices went down was during the real estate crisis of 2007-2008. Since that bear market was created by real estate, it’s no wonder that home prices dropped. Traditionally though, the Case-Schiller Home Price Index has shown a 4.1% increase year after year – roughly one percent higher than the average Consumer Price Index of 3.1%.

An interesting sidebar to this data is that even in the highest periods of inflation in modern times – like the 1980-1982 bear market and 1973-1974 bear market – home prices continued to rise.

Now, the hardest part about drawing correlations between home prices and the stock market is that Case-Schiller doesn’t account for rental returns on a property. Another challenge is the fact that residential real estate takes longer and costs more to liquidate, whereas stocks can be purchased with the click of a button. In the 2017 Dalbar study about investor behavior, they concluded that equity investors under perform stock indexes by 2.9% annually over a 20-year period due to attempts at market timing. It’s likely that if investors were able to buy and sell individual real estate properties on a public exchange without high transaction costs, there would likely be much higher volatility in returns.

Why is that?

One reason stands out: The fact that real estate does take longer to buy or sell often means the due diligence prior to the transaction is far more in-depth than those used for stock, or even bond, purchases. Additionally, many real estate investors, rather than take a loss on a residential investment, will hold that investment longer than necessary to ensure some degree of profitability. The result of such a strategy is that real estate may have an artificial floor built into the data. Since the Schiller-Case data is based on actual sales, a real estate downturn and lower housing demand won’t show up in the data unless a sale is actually made.

The real reason for the under performance of those equity investors is likely emotional. It’s far easier to “click” and sell out of the losing stock (or a winning stock) than it is to sell out of an asset like an investment property.

So can real estate investment truly offset a bear market?

Yes, and even more so when certain specific criteria are met.

First, simply buying properties in a bear market is not a strategy. No matter what is going on with Wall Street, people will need places to live. Identifying where the targeted demographics are moving, living, and working will allow investors to realize far higher returns in some markets than others. Investors must do their research to identify the best markets.

Examples of this are found in every state – Denver, Austin, Atlanta, and even the so-called “flyover” states, with markets in places like Des Moines showing sharper increases than surrounding cities. Finding a property in a location with good growth potential and a high level of income relative to price is increasingly important whenever there are market peaks.

Another tactic for improving returns on real estate investment is to create an advantage over other investors. For some, that edge is financing – paying cash for a property instead of more traditional methods. For others, it is about understanding growth in certain markets and investing when prices are still low and demand is high… and no other investors are aware of the trend.

Those trends are the most critical asset to an investor. Due to the size and scope of the United States’ residential market, there is always a place to invest and make money. Even in the throes of the 2007-2008 crisis, the areas immediately around Washington D. C. saw rising rents and booming home prices due to government agencies growing. At the same time, in many other areas of the country, home prices fell again and again for a period of nearly two years.

So does it make sense to divest of your stocks and bonds in preparation for a bear market? Absolutely not! Corrections in markets are going to happen – in fact, there have been 29 corrections (defined as a decline of 10%) or bear markets (declines of over 20%) since 1960. The truth of the matter is that anything that increases is likely to have a decrease. A smart investment strategy has always been diversification and patience. By using real estate as a larger percentage of an overall portfolio, though, investors can realize significant returns in bear markets. The key is understanding the markets you choose to invest in. Demographics and growth are extremely important for intelligent investment in real estate, along with expert guidance to project trends for future earnings.

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