If only it were possible to consistently buy at the bottoms and sell at tops. Oh, what a life! But back to reality. How important is timing in real estate? It’s very important! But is it a sensible strategy? Not likely. Timing the real estate market means forecasting correctly. That means understanding value drivers, assigning probabilistic rates on potential scenarios, and guessing market sentiment, among others. And of course, you have to act on it.
That’s a lengthy way of saying it’s very hard. Some respected investors think it’s a waste of time. This is their approach.
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Real estate cycles
Although the overall trend for the real estate market has been upward, it still fluctuates and the mediocre years mean a positive yielding property can still be a bad investment (because of the opportunity cost).
It’s pretty easy to see why some would want to time the market. For them, the risks of selling low and buying high are worth the chance to earn substantially from buying low and selling high.
Unfortunately, timing the market is highly unlikely, and most end up losing or earning subpar over the long run.
Timing vs time in the real estate market
As a matter of fact, it’s such a rare instance that it’s newsworthy. When you see people in the news predict the stock market, consider (1) they’re one out of millions and (2) they’ve probably had a long list of poor decisions in the past.
The best alternative for a majority of investors, including myself, is to:
Focus on time in the market. Not timing the market.
Over the long haul, real estate has proven to be an asset class with positive returns. There’s no guarantee, of course, as with any other investment. But being in the market for a long time increases our chances.
So if there’s no guarantee and if timing the market is irrelevant, how then do we determine which real estate properties to buy, and when? We do this by setting rules for ourselves, ignoring the noise, and adjusting our criteria only when it’s absolutely necessary.
The buying criteria
Smart investors set their investment criteria before anything. Now, this could mean different things for different investors and is a whole separate discussion, but the important thing is your values fit your criteria and is a strategy you can stand by.
If you’re a flipper (buy-and-sell strategy), then your criteria will most likely be different from a buy-and-hold investor.
Know your criteria
For example, I like to focus on cash-on-cash returns while adding my risk buffers. Specifically, a cash-on-cash return is the net cash proceeds you get from your total cash investment. So if, say, I buy an apartment with a 20% down payment of 500,000, and my annual net cash flow is 60,000, then the cash-on-cash return is 12% (60,000 / 500,000).
Again, your criteria may differ. Some focus on price appreciation, return on equity, and so on. What’s important is consistency with your criteria and the rationale to back it up.
Include a margin of error
The next step is to include a margin of error, or what Warren Buffett calls the margin of safety.
Staying with the previous example, the 50,000 assumed annual cash flow is under a set of assumptions and a particular scenario. Those could be assumed vacancy rates, rental rates, economic growth, etc. When we include a margin of safety, we’re accounting for the possibility that our assumptions are wrong.
Let’s say the absolute worst-case scenario leaves you with a cash-on-cash return of 40,000, or an 8% return.
Investment decision
If 8% is an acceptable return based on your criteria, then it’s a buy decision. Now, remember, this is the absolute worst-case you can think of.
It is worth noting that there are no absolute rules on setting the margin of error. I could say not to be overly pessimistic as that precludes you from buying anything, including good deals. If I set the required cash-on-cash return at 100%, then I’m severely limiting my options.
But then again there are black swan events such as COVID. (Black swan theory was developed by Nassim Nicholas Tabel in his book, The Black Swan: The Impact of the Highly Improbable.)
Investing is still about taking on probabilities. We act based on expectations and live with the results if we know our actions are based on criteria and principles we support.
Conclusion
Timing the real estate market is tempting but futile. We fall in love with the fallacy because the potential gains are huge and too hard to ignore. But know that even the great investors of our time get it wrong and forecasting is a fantasy. (As a former consultant, I should know.)
Thinking, Fast and Slow points out why forecasting seems easy.
The idea that the future is unpredictable is undermined every day by the ease with which the past is explained.
Daniel Kahneman
Past events are easy to explain, but really that’s just hindsight.
Our focus should be on our investment criteria and margin of safety, and then buy when those make sense. When we consider that it makes money even in a down market, then the upside is just gravy.
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