JF1608: How To Recession Proof Your Real Estate Investing Business #SkillSetSunday with J Scott
You know the name by now, he’s an in demand speaker and a best selling author. J is back to add more value to our lives, as always, this time having a discussion on the state of the market, and how to survive regardless of which part of the market cycle we are in. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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J Scott Real Estate Background:
- Full-time entrepreneur and investor
- Since 2008, J has bought, built, rehabbed, sold, lent-on and held over $40M in property
- Author of 3 real estate books, including the best-selling, “The Book on Flipping Houses,” which has sold over 125,000 copies in 5 years
- Listen to his previous episodes:
- Based in: Washington D.C.
- Say hi to him at: http://www.123flip.com/ or https://www.biggerpockets.com/users/JasonScott
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Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff.
With us today, J Scott. How are you doing, J?
J Scott: Joe, glad to be here. Great to be back, thanks.
Joe Fairless: I am glad that you are here, and I welcome you back with open arms, because I always learn something during our conversations. I’ve seen you present at a couple conferences, and I know how much you hate presenting in public, but you are damn good at it, and you always teach the audience a whole lot of stuff… I won’t speak for the audience, you always teach ME a whole lot of stuff, and perhaps some others as well.
J Scott: I appreciate that.
Joe Fairless: A little bit about J, just as a refresher, Best Ever listeners. He’s been on the show a couple times… Episode #217 – this is not even close to episode #217; it was over 1,000 days ago when I first interviewed you on the show, and the title of the episode is “You only have one chance to make a good flippin’ impression.” A little play on words; you used to focus on fix and flipping, especially at the time. Now I think you’ve broadened your portfolio a lot since then.
Another episode, episode #1209, the interview on negotiating real estate, and that’s a Skillset Sunday episode that I highly recommend listening to, because he also — when I mentioned that I’ve heard J at a couple conferences, one of the conferences in Philadelphia, Dave van Horn put it on… Oh, no, actually that was my conference, the Best Ever Conference; you actually talked about negotiating, and some great tips there, and we talk about some of those tips in this interview.
And J is the author of three real estate books, including the best-selling book on flipping houses, which has over 125,000 copies sold in just five years. And in fact, he’s got a second edition of the book on flipping houses that has recently released, and a second edition of the book on estimating rehab costs that has recently released, so go check those out. Where is the best place to get those – Amazon, or Bigger Pockets?
J Scott: Both are great. You can buy them individually on Amazon, or if you want the set with some bonus materials, go to BiggerPockets.com, and they can sell you both books together with some additional bonus materials.
Joe Fairless: Since 2008, J has built, rehabbed, sold, lent on and held over 40 million dollars in property. Because today is Sunday, we’re going to have a special segment with J called Skillset Sunday. You know the drill, Best Ever listeners. This episode is going to be focused on a specific skill that you can hone – if you already have it, maybe you’ll get a little bit better – or acquire by the end of our conversation.
Here’s the skill – how to recession-proof your real estate business. J said he’s got some good ideas on how to do that, and I’m looking forward to this conversation. I do not know what those ideas are, so I’m looking forward to a lively conversation. With that being said, first can you just give the Best Ever listeners a quick recap of your background, just so we have some context?
J Scott: Yeah, absolutely, and I appreciate that introduction. I’ve been in the real estate industry for about ten years now, since 2008. My wife and I have a business together. We started out flipping houses, we did a couple hundred flips over the first five or six years of our career, and then we expanded into some smaller multifamily, we’ve done some lending, we’ve done some smaller rentals, we’ve done some note investing… We’ve done a little bit of everything, and I’m a big fan of — and I guess we’re gonna talk about it in this discussion, but I’m a really big fan of instead of trying to fight the market, basically going with the market and doing what the market is allowing us to do. We’re kind of doing a lot of different investing strategies, and we’re always looking for the path of least resistance and the low-hanging fruit when it comes to our investing.
Joe Fairless: I mentioned prior to us recording that I really appreciate your posts on Facebook about the economy, and I told you that most of the times I read something about what you post, I will then one day later read about it in the Wall Street Journal. Not the same day, not the day before, but one day later I’ll then read something about what you posted, in the Wall Street Journal. I’m like, “Wall Street Journal needs to hire you, to get some better intel, or some quicker intel”, or maybe you’re just faster to market because it’s a Facebook account, not an edited post, or edited article by the Wall Street Journal, so you do have speed-to-market on them. But that’s why we’re talking about the “Recession-proof your real estate” business topic. So how do we do that?
J Scott: I’m a big believer, like I said, in — basically, at any given point the market has stuff to offer, and the market has stuff that it’s not offering. And you can basically be one of two types of investor; there’s nothing wrong with either, I’m not making no judgment here. The first type of investor is someone like you – you’re actually a great example. There are people in this industry who are such a master of their craft, they’re so good and so knowledgeable and so well-connected and so experienced that no matter what the market has to throw at them, they can be successful. You can go out during probably the worst parts of a recession, or the best parts of an economic boom, whatever it is – you could go out and you could be successful buying multi-unit apartment complexes. And that’s what 1% of the real estate investing population can do; they’re just so good at what they do that no matter what the market is throwing at them, they can be successful.
Unfortunately, for the rest of us it doesn’t necessarily work that way. You could be a pretty good house flipper, but there are gonna be parts of the economic cycle where house flipping is just not gonna make sense for you or for anybody. You could be a really good landlord, but there’s gonna be parts of the economic cycle where acquiring rental properties just isn’t gonna make sense.
I’m a big fan of knowing where we are in the cycle, knowing what strategies and what tactics are working in each part of the cycle, and also being able to prepare and plan for the next part of the cycle, so that when it comes, you’re ready to kind of pivot your business and continue to make money.
We’ve noticed over the – and when I say “we”, I guess it’s you and me and a lot of investors out there that have been paying attention – last year or two the market has definitely changed. We’ve gone from what I like to call an expansion, in economic terms (the economy has been growing, GDP has been growing) to a point where we’ve kind of hit a peak in the market. So instead of every month there being fantastic economic news – obviously, unemployment is still great, GDP is still good, but instead of it going up month over month over month, what we’re starting to see is we’re seeing mixed economic news coming out. The stock market is up and down, and wage growth is kind of hit or miss, and there’s been some layoffs here and there… Things are still really healthy overall, but we’re starting to see signs of the economy cracking, we’re starting to see signs that in a month or a year or two years things may not be as good as they are now.
And if you follow macroeconomics and economic theory, what you’ll find is this isn’t uncommon; it’s perfectly natural for the market to go in cycles – it goes up, it goes down, it goes up, it goes down, and a typical cycle can last anywhere from 5 years, to 8 years… We’re now almost 11 years into the current cycle, and it’s perfectly natural for it to go up; so the fact that we’re getting to a point where it’s likely to turn down in the next several months or years isn’t a reflection of who’s in office, it isn’t a reflection of how businesses are doing, it’s just a reflection of that’s the way our economy works.
What I’ve been talking to a lot of people about over the last few months is 1) how we can modify our businesses for now, so that we’re reducing the risk should the market have a downturn, and second, how to prepare our businesses for the coming downturn, and what we can do now so that when the market turns, we’re prepared and we can still make money. Does that make sense?
Joe Fairless: That does make sense. So in order to talk specifics about how to modify our business now for reducing risks should the market have a downturn, and we can prepare to make money, do you need to have a specific type of business in order to use those, or do you have concepts that apply to any type of real estate business?
J Scott: Well, there are certain strategies that are gonna work better at this point in the market cycle. And sure, let’s talk some details. I started with house flipping, I still flip houses, a lot of people I know flip houses, and I imagine a lot of people that listen to this show flip houses… So if you’re flipping houses right now, a lot of these are common sense, but there are a lot of things that house flippers should be doing right now.
One is we’ve stopped doing big flips, we’ve stopped doing anything that’s gonna take more than six months. So between 2014 and 2017 we were doing some new construction, we were doing what we call pop tops, where we add a second story on houses, adding square footage… We’re not doing those anymore, because we’re not convinced that we necessarily have a 6 to 12-month runway before the market starts to turn down and prices start to decrease. So we’re pretty much sticking with projects that are under six months long, and preferably under three months long.
We’re making sure that any deal that we have has multiple exit strategies. From 2013 to 2017 we were pretty certain that if we took on a flip deal, we’d be able to sell it as a flip, so having a back-up strategy wasn’t particularly important. But these days having a secondary, or even a third or fourth or fifth strategy as a back-up should your flip not work out is really important. Maybe that back-up strategy is turning the property into a rental, maybe the back-up strategy is being able to do a lease option, or being able to do a wrap or subject to, depending on how you finance the property… But having a back-up plan – maybe it’s seller-financing the property to an owner-occupant who doesn’t have great credit – is important these days, because you could get to the end of your flip and you could find that the ARV is lower than what you expected, or because it’s taking so long to sell that your carrying costs are higher, maybe the rehab went over budget… So having a plan B, C and D these days is really important.
We’re avoiding leverage these days. One of the big risks when the market is potentially gonna turn is that if interest rates go up, or if the values of your property go down, you can’t necessarily repay your loans. It used to be that I’d have no problem taking out 100% loan-to-value loans against my flips, because I was pretty confident that I was gonna be able to sell for at least a little bit of profit. These days if I’m planning on making 15% return on my investment on a flip, and the market drops 20%, if I have 100% loan, I’m automatically underwater. So we’re avoiding large amounts of leverage.
Joe Fairless: Okay, so you said avoiding leverage, but then you said avoiding large amounts of leverage… So you’re still using leverage.
J Scott: Us personally, we are avoiding leverage altogether at this point in the market cycle. That said, I realize that a lot of people are not in the same position we are, and they can’t avoid using leverage completely. So to them I would recommend avoid large amounts of leverage. If you think that the biggest potential drop in the market is, let’s say, 20%, then don’t leverage your properties more than 80% loan-to-value, because if the properties then drop 20%, you’re right about even on your loan. So figure out from your perspective what’s the worst case scenario, and then factor that into your risk model.
Joe Fairless: With you avoiding any leverage, what are your thoughts of getting a long-term loan at relatively speaking a lower interest rate based on where we’re still at; that to me seems pretty conservative, but clearly you have a different approach to it, because you’re avoiding any leverage… So what are your thoughts about that?
J Scott: Keep in mind that I’m talking about flips right now, and if you want, after this we can jump into some of the strategies that we’re doing to prepare for the next phase…
Joe Fairless: [unintelligible [00:13:53].16] because you’re buying small multifamily too, so…
J Scott: Exactly, and my strategy is completely different for the buy and hold.
Joe Fairless: Okay, alright. Sorry. So this is only related to fix and flip.
J Scott: This is related to fix and flip, exactly.
Joe Fairless: Okay.
J Scott: Another thing we’re doing is we’re staying away from the higher-priced houses in our markets. What you’ll find is if you look at some historical data, when the market turns, the first type of house that typically sees a reduction in sales and in greater inventory are the highest-priced houses in any particular market. So if your average house price in your market is 200k, you probably don’t wanna be flipping the 600k, 700k, 800k houses, because when the market turns, that’s the buyer demographic that’s gonna slow down first. So we’re staying away from the really high-priced houses.
We’re also staying away from speculatory purchases. There were times when we would buy a flip thinking “We may make a little bit, we may make a lot. Let’s take a chance.” These days we wanna be absolutely certain of our numbers before we buy anything, because the speculation is where you get in trouble when the market changes.
Joe Fairless: Cool. And now how to prepare, so that you can still make money in a downturn?
J Scott: Yeah, if you wanna talk about things we’re doing to prepare – we’re moving a lot of our assets to cash. During a downturn, for anybody that wasn’t around in 2007-2010, what you’ll find is that when there’s a recession and things get bad, or even as things start to improve on the other side, cash is king. Credit gets really tight. These days anybody can get a loan — not anybody, but these days getting a loan on a rental property or even a flip isn’t that tough; there’s portfolio lenders out there, there’s hard money lenders out there, there’s private money out there… But what you’ll find is as soon as the market turns, the portfolio lenders go away, the hard money lenders tend to slow down, and private money lenders, your friends and family – they get scared to invest in things like real estate, so that goes away… So having cash is really the best way to keep your business moving forward during a downturn.
What I recommend to everybody is if you have any assets that you can easily liquidate, now’s a great time to do that. Second, I tell people if you have assets (real estate) that you’re not willing to hold for 3-5 years, now’s a great time to sell it, because if you’re not looking to sell it right now, in a year or two or three the value could be lower. You could be looking at 3-5 years before the value comes back to where it currently is. So if you’re not interested in holding for 3-5 years, seriously consider selling now.
I tell a lot of people, start working on building your credit. If you don’t have good credit right now, credit is extremely important when there’s a downturn. Lending requirements tighten up, you go from 680 credit scores being good enough to get a mortgage, to you have to have a 740 credit score. That’s just an example. But having good credit will really give you more options when the market turns.
Along the lines of credit, apply for lines of credit now. Even if you don’t use those lines of credit, if you can take out a HELOC, or a personal line of credit, or a business line of credit, having that cash available for when great deals come along and you can’t find private money or you can’t find hard money or you can’t find a bank to lend, having those lines of credit available now is really important… Because once the market changes, it’s gonna be a lot harder to qualify for those lines of credit.
If you have any short-term debt, now’s a great time to restructure it, because interest rates are going up, and as interest rates go up, it’s gonna be harder to refinance when a year or two or three from now your debt comes due. So negotiate with your lenders and if you have something that’s gonna come due or that’s going to balloon or that’s gonna have an interest rate that resets in a year or two or three, go to your lender now and say “Hey, can we restructure this into a five-year or a seven-year loan now?” so that you don’t have to worry about it in a couple of years when values are down and interest rates are up.
I’d say sell off any income properties that can’t handle a 10% decrease in rent or a 10% increase in vacancy. During the last downturn – and I know in a lot of markets rents stayed pretty strong, vacancy stayed pretty strong, but in some markets vacancies and rents dropped significantly in 2008-2009. So if you’re barely cash-flowing, if you can’t handle a 10% drop in rents, or you can’t handle a 10% drop in occupancy, consider selling off that property and look for something better, or just hold the cash.
What else…? Here’s a big mistake that I see a lot of investors make when the downturn starts – they don’t cut their losses; they’re scared to take a little bit of a loss, so they hold and hold and hold, and they chase the market down and they find that they end up taking a much bigger loss later. So what I like to say is if you happen to be in an area where the market turns and suddenly you’ve gone from making a little profit to breaking even, or losing a little bit of money, don’t be scared to cash-out and say “Okay, I’m gonna take a little bit of a loss, because what you could find is 6 or 12 or 24 months later that little loss could end up being a big loss.
Joe Fairless: You’re currently buying property that are not fix and flips, right?
J Scott: Correct.
Joe Fairless: So what is your approach with those properties that you’re purchasing and what types of properties are they?
J Scott: That’s a great question. If you look again at historical data, what you find is typically the A-class properties are the first to take a big hit on rents and occupancy when the market turns. A lot of people start losing jobs, they take paycuts, and people in A-class units find that they can’t necessarily afford those units, so they move down to B-class units. And people in B-class units move down to C-class units.
We’re staying away from what a lot of people call the A-class properties, the high-end properties, and we’re focusing a lot on the C-class properties. In fact, over the last year or two we’ve bought a bunch of D-class properties that we’re improving to C-class, because as the economy changes and as the market turns, there are gonna be a lot of people who can’t live where they’re currently living, but they still need a place to live, so they’ll down a class, or they’ll move down two classes.
I’m a big fan of B and C-class properties during a recession… And it’s not for me, but I know that there are a lot of landlords who focus on worse than C-class properties; what they’ve found during 2008 was that they were still able to make money. Remember, everybody needs a place to live, no matter how little money they make… So if you’re focused at the very bottom of the market, there’s a lot of headaches there, but you may find that those units are more recession-proof than some of the higher-end units you might be considering buying.
Joe Fairless: The D-class property that you’re improving to a C-class, how many units is that?
J Scott: We have a 38 and a 16 right now. These are mid-sized units.
Joe Fairless: The 38-unit property, what type of financing do you have?
J Scott: We originally bought that seller-financing, and then we refinanced into a portfolio loan with a local bank.
Joe Fairless: And what are the terms of that loan?
J Scott: We are paying seven years 6%, amortized over 20 or 25.
Joe Fairless: And in your mind a seven-year loan is conservative enough, knowing what you’ve mentioned earlier about your belief in a correction taking place soon?
J Scott: It is. If you look at the data historically, the market moves in cycles and you can kind of think of it as two different parts of the cycle; you have the expansion from when the recession ends until the next recession starts, and then you have the recession phase. And typically speaking, that expansion phase is about five times as long in general than the recession phase. So typically, what we see when the market turns is there’s a steep and a quick drop, but that tends not to last tremendously long. So if you have a loan that’s at least 3, 4, 5 years out, you’re probably gonna be in a decent position by the time that resets or the time that you have to refinance.
Also, remember, interest rates tend to go up towards the top of the cycle – that’s how the government controls inflation – but as you get towards the depths of the recession, things are really bad, the government is gonna lower interest rates to encourage spending, to get people to stop saving money… So typically, by the time the recession is done, which again, is a year or two after it starts, interest rates are down low again, or lower. So I’m perfectly comfortable with seven, and I think I’d be comfortable with five or even four from here.
Joe Fairless: Anything else you think we should talk about as it relates to building a recession-proof real estate company that we haven’t already talked about?
J Scott: For your typical fix and flippers or buy and hold folks, I think that covers the bulk of it. But if you’re a lender – it’s interesting, because I see a lot of lenders right now that are either big hard money lenders or smaller private lenders, and what I find is that a lot of these lenders are lowering their rates today because they’re so desperate to find deals. So they’re lowering their rates, they’re increasing their loan-to-value, so they’re taking more risk in terms of the amount of leverage they’re giving out… I do some private lending out of my IRA, and for me, I’m doing just the opposite – I’m actually raising my rates and I’m being more conservative on my loan-to-value.
Joe Fairless: What are your rates? What do you charge?
J Scott: Typically, I lend mostly to people that I know and trust, and on properties that I will look at and say “I’d be happy to own this property if something happens.” So typically I’ll lend at somewhere in the 10%-12% range, no points; maybe even a little bit cheaper than that if it’s a deal that I can almost root for them to fail on and I could take the property. Not that I ever root for my borrowers to fail… But if I’m really comfortable with the collateral, I might do a little bit less than 10%.
These days I’m starting to do 12% to 14% again, with a point, because I know that there’s additional risk. If the market turns, there are gonna be a lot of fix and flippers that are gonna get caught with their pants down when the market turns, and I know that there’s some buy and hold investors that they might be cash-flowing now, but they won’t necessarily be cash-flowing if rents drop 10%, or if occupancy drops 10%. So I’m being a lot more cautious with my lending now. I’m increasing rates… I’m focusing a lot more loans on buy and hold investors, because typically buy and hold properties, if bought well, are gonna be recession-proof. If your DSCR is high enough, you’re not gonna have to worry about a 10% drop in rents. So if I have to take back a buy and hold property, I’m less concerned than if I have to take back a flip that might be 5% or 10% or 20% underwater.
Joe Fairless: How can the Best Ever listeners get in touch with you and learn more about what you’ve got going on?
J Scott: Absolutely. Anybody that wants to get in touch with me, my e-mail address is firstname.lastname@example.org. You can check out my website at 123flip.com, you can follow me on Facebook, J Scott Investor, and if you wanna check out my books, it’s The Book On Flipping Houses, The Book On Estimating Rehab Costs and The Book On Negotiating Real Estate, all available on Amazon, and soon all to be available on BiggerPockets.com.
Joe Fairless: Those all sound like Friends episodes. Has someone told you that?
J Scott: Yes, THE Book On…
Joe Fairless: Yeah, yeah, The Show About… Well, J, thank you so much for being on the show… Helpful for any type of investor, but certainly fix and flippers. If you’re fix and flipping right now, do fix and flips that take less than six months, you have multiple exit strategies, you avoid large leverage – J avoids any leverage on the fix and flips right now – and avoid the higher price homes.
Similarly, for buy and hold portfolios, staying away from A-class properties. We don’t buy A-class properties for this reason. Also, having loans, you said, at least four years – agree there; our loans are at least five years. And ultimately, I also like buying cash-flowing properties that, regardless of what happens, if you’re making money and you can ride out the storm, where the loan does not become due, then you’re in a pretty good spot… And wrote about my three immutable laws of real estate investing, and they certainly overlap with what you’re saying here, because you mentioned earlier to be cash-heavy, and that’s definitely important during a correction.
Thanks so much for being on the show. I hope you have a best ever day, I really enjoyed it, and we’ll talk to you soon.
J Scott: Thanks so much, Joe.