How Market Downturns Affect Pricing Beliefs for Real Estate Investing
Market downturns often cause fear, uncertainty, and confusion.
This impacts the pricing of real estate assets. But how each side of the transaction reacts to these downturns — these changing market conditions — is different. As a real estate investor, it is crucial for you to understand these differences and realize how this impacts your deals.
Basically, we have three key players in a real estate transaction:
- The Buyers
- The Sellers
- The Brokers
Each one of these individuals will react differently to changing market conditions.
As you know, the market goes up on an escalator, and goes down on an elevator. And then it recovers. We’ll call this FMV — Fair Market Value. This is the actual value of the asset.
This market cycle can take place over six months or it can take place over a number of years. It depends on the market and the situation. But what remains constant is the fact that real estate is a cyclical asset. In other words, what happened before will happen again.
When you examine graphs and charts of past recessions, downturns, or market cycles, they all look very similar — even though their drivers and causes may be different. The impact on pricing and rents all look very similar — up on an escalator, down in an elevator, and then you hit the recovery phase where it surpasses the previous peak.
So how do buyers, sellers, and brokers react to changing market conditions when it comes to pricing? Let’s talk about buyers first.
The 3 Key Players in the Real Estate Transaction
1. The Buyers
Buyers are extremely adept at noticing changes in the market. As soon as the market comes over the peak and prices start coming down, buyers will be on it like a fat kid on chocolate. They will know exactly what’s going on, and they will start putting in offers accordingly.
Buyers are very good at picking up changes in the market because they’re shopping for assets. They know what’s going on.
So whenever we have a shift in the market and the fair market value starts going down, buyers will start leaving the market with their offers. Buyers will know what’s going on because they are the first people to pick up on this. So they’ll start leading the market with their offers.
2. The Sellers
Sellers, on the other hand, work on a different schedule. They’re often the second people to figure out what’s going on in the market.
For sellers — even though buyers are starting to offer down where the market is going — the value of their asset usually stays at the peak longer than the actual reality. That’s why whenever the market reacts quickly, buyers will start adjusting their pricing. But for sellers, you’ll notice that their assets will stay for a whole lot longer at the previous peak’s price. Why?
Because sellers are slower to react than buyers. They’re not actively in the market, shopping for new deals. They just want to sell their assets for the most amount of money. This is why you’ll see listings sitting around even when the market is going down.
Buyers will often bypass these properties because they know the seller has not reacted. They are not adjusting to the change in the market.
And as a buyer, if you know a seller is still three months behind in their pricing (because they haven’t really fully grasped what’s going on), why would you offer and negotiate with that seller when you can move on to another seller that has picked up more quickly, realized that the market has shifted, and who is willing to offer different terms or better pricing for the asset?
So sellers end up chasing the market if they don’t understand what’s going on with pricing. Let’s say a seller has now figured out that the market is shifting. So fair market value is down. A seller, because they may be behind the eight ball, will adjust the pricing down from the previous peak, but it will only go halfway down.
Yes, they have reduced their price. But it’s still not enough. So what happens is that sellers have to chase the market. So if you’re a seller in a downturn area and need to sell your asset, you can’t price your property where the market is today, because it’s a declining market.
You have to price your asset where the market is going to be, not where it currently is.
So the successful seller will actually price their asset below market because they’re thinking ahead. That way, they’re not chasing it by reducing the price multiple times. What ends up happening is they actually have to underprice the market by a more significant amount just to get buyers interested. Those buyers have already looked at the earlier prices and have passed on it because it’s not priced realistically.
3. The Brokers
If you’re working with a good broker who understands what’s going on, they will pick up on it. But generally speaking, a broker is looking to get the highest amount for that property possible, just like with the seller — their interests are aligned.
So oftentimes, when the market starts to shift, but a broker is not on their market data, not seeing the shift, or not appreciating the fact that the market is shifting more than a small correction, their pricing suggestions to that seller may stay more in line with the seller’s expectations.
So they end up chasing the market down and then selling the asset for less than what they should have if they just priced it a little under and went where the market was going to be, not where the market is.
You Cannot Time the Market
The one thing we have to understand about buying in a market downturn is it’s impossible to figure out exactly where the bottom is. And if somebody tells you that they know exactly how to predict where the bottom of a market is, they either have a working crystal ball, which I’ve never seen, or they’re full of shit — it’s either one of the two.
Nobody can successfully predict the bottom of a market. It just doesn’t happen. It’s okay to look back after the fact and look at the graphs and understand what’s going on, but the only time we really know when the true bottom is, is after we start to recover. Then we can look back and say, “Hey, on this day or at this time, this month, this is exactly where the bottom was.”
When you’re in the bottom, you can’t tell. It’s impossible to tell. So if somebody’s telling you that they know exactly how to time a real estate market, I would take it with a grain of salt, because that’s not accurate.
How to Be Proactive in a Market Downturn
When we’re buying, one of the advantages we have in a market downturn is terms and price. As real estate investors, we know that it’s not always just about the price of the asset, it’s also about the terms.
So as the market starts coming down, we’re going to see better terms for our purchases under better pricing. We also know as real estate investors that the market is cyclical. So as long as we’re making educated decisions about the assets we’re buying — with strong fundamentals, conservative underwriting — it’s okay to buy in the downturn.
So since it’s impossible to know where the absolute bottom is, what we need to do in this phase is have conservative underwriting, strong cash flow, and a very solid value add improvement plan. Whether that means that you implement the whole value add strategy right here, or you implement some of them and then wait until the market recovers before adding the rest, that’s going to be dependent on the property.
Lenders — A Fourth Perspective?
How do lenders look at properties in this market cycle? I think most of us would agree that lenders tend to be even more conservative than buyers in market downturns. Because obviously, lenders want to reduce their risk. So they’ll really tighten up their lending standards.
The Bottom Line
This is a broad overview of pricing in downturns. As real estate investors, it’s really important to understand what’s going on in each side of the transaction, because this impacts your deals. If you’re going in as a buyer negotiating with the seller who hasn’t picked up on the market shift yet, you’re going to change how you approach that offer, and vice versa.
Maybe you’re a seller and you see buyers starting to change their negotiation strategies and the types of offers they’re putting in, you’ll want to understand what’s going through the buyer’s mind because you need to sell your asset and you still want to maximize your value.
So if you missed the maximum value, and you need to make sure you price your asset where the market’s going to be, so you don’t get caught chasing.