It is impossible to escape the headlines.
Inflation is at a 40-year high. A recession is coming. A recession is here. What will America look like in the next year or two?
However, recessions are not new for the United States. Since World War II, the US has been through 12 recessions with an average economic contraction of 2.5%, an average unemployment rate increase of 3.8%, and an average duration of 10 months.
So where are we in the market cycle right now?
In my search for the answer, I realized that even the brightest economists do not agree on where we are in this market cycle or when a recession will hit. This means as investors we must learn the guiding principles for investing so we can navigate any market cycle…even perilous ones.
7 Principles to Invest By
When you study the greatest financial minds, you find that they rarely time the market, rather they subscribe to a set of investing principles so they allow them to make money in almost any market and spend as much time in the market as possible.
Most investors have heard of Warren Buffett and his two rules of investing.
“Rule #1: never lose money. Rule #2: Don’t forget rule #1.”
This means the first step to investing in any market cycle is to invest in hard assets where your capital invested cannot go to zero (this is THE main reason I love investing in real estate). As an extension of this principle, you want to invest in assets where you can control the value of the asset. This means investing in assets that are their value on net operating income or expected gross income not on the whims of the market. Additionally, any asset that you invest in must be well capitalized with capital expenditure and operational reserves to mitigate loss and to keep the need from selling in a down market unnecessarily.
Another principle of conservative investing is to invest in assets that have multiple streams of income that begin from day one of owning the asset rather than waiting for cashflow to kick in months later. When an asset has immediate cashflow, this indicates that the asset has an element of stability in today’s market. Another way to protect the cashflow is to ensure that the are several rental comps in the area that are higher than the subject property so you can be competitive in the market should you need to adjust rents. And like rule #1, around capital preservation, you want to ensure that the asset is well capitalized from day one to mitigate any sort of loss and to protect the current cash flow on the asset.
There are two types of equity growth: natural market growth and forced equity growth. Ideally, you want to invest in assets that takes advantage of both levers is possible. To tap into market growth potential, and since you personally cannot control it, you need to invest in assets that are in areas of the United States where the population is growing, jobs are growing, incomes are growing, jobs are diversified, poverty is coming down, and crime is coming down. You want to stack the investing cards in your favor. To take advantage of forced equity growth, you need to look for assets where you can raise the income on the asset, decrease the expenses associated with the asset, or add additional streams of income to the asset. The real power is when you can pull all three of those net operating income levers at the same time!
One pillar of conservative investing is to invest in assets that have tax benefits associated with them (the IRS is incentivizing investment to solve a problem). Again, this is another reason I love real estate. When you invest in real estate you can create paper losses through depreciation, including accelerated depreciation and bonus depreciation. These losses can help shelter taxation on income the asset generates.
Another tax benefit of investing in real estate is the 1031 exchange. One of the major benefits of doing the 1031 exchange is the ability to defer the tax on capital gains and to avoid depreciation recapture. The tax benefits of real estate are one of the most powerful builders of wealth.
However, how important are the tax benefits if you are investing through a SDIRA? Glad you asked! The SDIRA account itself already has tax advantages built in, so any depreciation will remain in the account itself and not pass through to you as the individual. Additionally, SDIRAs cannot participate in a 1031 exchange (they don’t need to save on tax). When you invest in real estate through an SDIRA, you really do not need the tax benefits anyway!
An inflation hedge is an investment where the decreased purchasing power of a currency results from the loss of its value due to rising prices either macro-economically or due to inflation. When you invest in a real estate asset, you can periodically increase your income that you are earning and pass through your expense increases to the end customer. For example, with multifamily properties you can adjust your income annually at lease renewal. For self-storage property you can adjust your income monthly. For express car washes and hotels, you could adjust your income daily if you like. Being able to respond to the market to protect your purchasing power is one of the most powerful aspects of any commercial real estate business.
Another pillar of conservative investing is understanding how to safely arbitrage the interest rate environment to use leverage safely to amplify wealth. In today’s rising interest rate environment, we are in the cycle where fixed rate debt that covers the term of the hold on any project is KING and short-term floating rate debt should be used with immense caution. If you come across an operator using floating rate debt, ensure that the debt has a cap and that the project has been underwritten to that cap for the duration of the hold. Since this type of debt is short-term, ensure the operator has also purchased extensions to the debt term upfront to cover the hold period, and has multiple avenues for a successful exit should their debt strategy fail.
Invest with Experts
Without a doubt, the most important conservative passive investing pillar in this market or any market is to invest with experts that you know love and trust. While most investors are drawn to deals with high returns, the success of any deal hinges on the operator’s execution. So be sure to invest with a team that has knowledge of the investment strategy, a track record of positive performance, the ability to secure credit and lending for high quality assets, the ability to reliably pool investor capital to close and manage the asset, and a professional team to source, acquire, operate, and reposition any deal in their portfolio on your behalf. Finding such an operator makes you not only feel confident that they can preserve your initial investment and execute their business plan, but you also get your time back… your most nonrenewable resource.
Is a Recession in the Future?
Some economists declare that the next recession will begin in Q4 2022 and last through 2023 predicting it to be a shallow yet prolonged contraction. Other economists challenge that the real recession will not realize for another 18-24 months.
So, what does 2023 and beyond hold for us? I truly do not know.
As a student of history, I believe that success leaves clues. And successful investors made money through all 12 modern recessions… and these seven principles of building wealth were the key to their investing confidence.
What are yours?
About the Author:
Whitney Elkins-Hutten is the Director of Investor Education at Passive Investing, a private equity firm with $1.3 billion in assets under management, including 3300 multifamily units, 6600 self-storage units, and 16 car washes. To date, PassiveInvesting.com has achieved an LP ARR of 29%, an LP IRR over 26%, and a 56%+ increase in asset valuation in three years or less.