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How To Protect Your Investments During A Down Market

November 23, 2022

chrisseveney

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CWS 227 | Down Market

 

With the lasting impact of the pandemic, wars waging left and right, and divided politics creating rifts across the country, we are expected to experience a recession anytime soon. In this unpredictable down market, the first thing you need to do is protect your investments. Lauren Wells and Chris Seveney share their insights about facing an impending recession and how to keep your finances secure in an unpredictable economic environment. They discuss how today’s crisis compares to the 2007-2008 crash, the importance of securitized assets, what COVID value means, and how to navigate fluctuating housing prices.

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How To Protect Your Investments During A Down Market

In this episode, we are going to talk about protecting your investment in a down market. Specifically starting with how this recession that we’re heading into or in will compare to 2007 or 2008. What is Seveney doing to take advantage of the current economic environment and climate? What are we hearing from the industry? What am I hearing from investors? Now that I’ve spoken a bunch, Chris, how are you?

I’m doing well.

To start this episode, let’s talk about the two things we could kick it off with. Let’s start with the biggest thing I’m being asked. We’re hearing from both the industry and I’m hearing a lot on my calls that many people are forecasting or anticipating a decline in housing prices and evaluations, which it’s impossible to predict. None of us have this crystal ball. What are we seeing? What are we expecting? How are we addressing it at Seveney when it comes to the assets that we’re investing in?

A few things when people ask me that question come to mind and a lot of people will gravitate towards 2007 and 2008, which is the most recent downturn. I was also part of the 2000 and 2001 timeframe where I was several years out of college but what was similar with that is that was a tech bubble that popped. You’re starting to see that occur. On the tech side of things, there are a lot of layoffs. Interest rates were higher back then. Also, there were differences in loan originations, which we’re seeing a lot of that drive.

The difference in 2022 versus 2007 is we did have that ramp-up in home prices as well as we did with COVID. We don’t have that crystal ball but we all should be wise enough to realize housing can’t sustain the current growth that it’s at. There’s probably going to be some softening in the housing market. One of the interesting things being an engineer and analytics guy, I go back and look at the downturns. You do some research too. Back in 2007 and 2008, do you recall what the overall price depreciation was during that time?

Yes. We’ve been talking about this. We’re always tracking the market in relation to where it’s been in the past. The funny part is when we talked about this, I’m talking about how when I speak with investors. Before I looked into the actual number, I was like, “Yes.” If housing prices were to drop 30%, 40% or 50%, which is what I feel like when I speak with investors, what they’re thinking is, “It’s going to hit the fan.”

That’s what we’re going to see. Housing prices are going to slash by 50% but when you look back at 2007 and 2008, the max was 15%. Is that what we saw when we were looking at this? It puts that into perspective. It seems like everything was so drastic and it was. It did impact a lot of people. Don’t get me wrong but a very big difference when thinking a house that’s valued at $500,000 is going to drop to $250,000.

The other component was it wasn’t overnight. It was a very slow progression. That’s one of the interesting things about housing pricing. We’ll talk about what we do with notes. One thing, I’ll throw a little snippet out. We typically will hold a note for around two years. The last 2007 and 2008 lasted until 2011 and 2012, which was a four-year turn.

People thought it was a lot sharper because, in certain markets, they did get hit harder. That was overall. Also, the massive amount of job layoffs that were going on during that time. In 2022, the job market is still very strong. Certain sectors are going through some challenges. That’s an interesting thing. A lot of people are predicting 30% or 40%. How do you protect against that? To protect against anything like that is challenging.

For us, if we started the foundation, we’re always looking to protect investor equity. That is rule number one. I don’t care what you’re investing in. The sponsor should always be focused on protecting that investor’s equity. In mortgage notes, one of the benefits is you’re backed by real estate. It is a secured asset. That is what we invest in compared to other assets. Anyone that turns on the TV and looks at the term FTX will know what that means.

CWS 227 | Down Market

Down Market: One of the benefits of mortgage notes is being backed by real estate because it is a secured asset.

 

One of the interesting things too was in 2001. I’ll hop back a little bit. I was out of college. I had $5,000. I’m like, “I’m going to invest in WorldCom.” WorldCom, you probably don’t even know who they are. They were Comcast or files where they bought in all the AT&T and the bell companies. They were the next telecommunications company. They went belly up.

My $5,000 investment turned into nothing overnight. Ever since that happened to me, I’m like, “Okay real estate,” or a majority of it because I can physically see real estate. I can hold it proverbially like we own the note but it’s secured by something. One of the first points I’d like to make is during a downturn, investing in something that has some asset behind it is something I’d recommend.

This came up in an email that I received about what if values drop. We’re not buying the actual property. We are buying the note behind it and attached to it. We’re buying that at a discount. I’m sure, Chris, you want to walk through an example of how that works. We’re not only looking at buying a property that has equity in it or buying notes that have a loan balance where there’s equity in the property but we’re also getting a discount on top of that.

We try to stay around 75% loan-to-value when we’re looking at what we purchase. Also, taking again that discount off of that. Even if the housing price values were to drop, we’re pretty buffered in and insulated from that. Nothing is guaranteed as we will say numerous times but I feel like something to take into account. We’re not buying an actual single-family home for 70% and if it drops a little bit, we’re like, “We’re close.” We’re buying the loan behind it and at a discount.

I like to use the term investment to value. I’ll give you two situations of what would you rather be in. Would you rather originate a brand-new loan to somebody that is purchasing a $150,000 home at 20% down? You’re giving them $120,000 at 7% and collecting roughly, let’s say $800 a month. That’s option one, which is somebody going out and getting a mortgage. Would you rather buy a loan from somebody that originated in 2016 with those same terms? The loan balance might be $115, $110, $1,000 and $15,000 but also you’re buying it at $75,000.

Let’s say the property’s worth $150,000 in both situations. Your investment to value is 50%. Our investment is 75%. Take it another step. I’ll mention numbers. If we hold it for 2 years, 8% to investors is $6,000. It’s $12,000 over the 2 years we hold it. $87,000 is what we’d have to exit that asset at to get the investors their money on a $150,000 investment. That still is 58%. There’s over 40% coverage on that. Going back to my other situation where if you’re either private lending because a lot of people do private lending, all of a sudden, you do get that 15% drop. Your risk profile is very different now than it is on that loan compared to buying something that had some seasoning even if it is non-performing.

That brings up another point when I’m speaking with people or listening to what people in the market are saying. We have to remember that we’re more focused on our portfolio and assets that originated pre-COVID. During COVID, we saw tremendous values skyrocket. If you were to take that away, we’re not buying notes that originated during COVID.

The ones we’re looking at could have originated in 2010 or 2011. Even if you were to take away the COVID value, I call it, you still have equity. We’re not worried about this value that we’ve seen over the past years going away because most of the notes that we’re acquiring originated long before COVID came around.

Another component of that is if housing pricing does start to fall. Listening to the Fed, one of the comments made is they’d rather break things because they have the tools to fix them than be able to fix something that’s not broken. Unemployment will probably rise so they do want to cut some of the jobs as well as soften housing. Typically, we’re at all-time lows on distressed debt.

If distress debt goes up, it’s a supply-demand business. That loan that we are paying $75,000 for might go down to $60,000. The pricing will also vary based on market conditions and more inventory. Our prices soften. Buying it at a discount gives us more flexibility in most situations. When we go to work out something with the borrower because we have a lower cost basis, it gives us a little bit more flexibility to still work the numbers to get the return that we target.

A perfect example that I’ll illustrate again is if there’s a $120,000 loan. I was paying $1,000 a month. We bought it at $75,000 but then turned around and bought it at $60,000. We’d get the same yield having the borrower modify the loan at $800 a month versus $1,000 a month. It gives us an extra $200 a month. That’s for us to negotiate but it does give us that added flexibility. If inventory goes up, our pricing also goes down like in the housing market. These things soften. There’s more inventory on the market and you can get better deals.

You stole my thunder there. It mirrors the market when values go up, costs to acquiring competition get harder, values come down and our acquisition prices get less and there’s more inventory. To that point, because we’re seeing all this inventory come across our desk. One thing that Seveney does when we’re evaluating assets is factor in pricing decline into our acquisition and bids.

Looking ahead, if there is a decline in value, we’re taking that into account upon our initial bid on that asset. There’s no, “This is our hardened set rule. This is our criteria. We stick to it.” We are constantly evolving our bid prices in relation to what we’re seeing on the market and what’s happening in the market with value. That is something that we’re taking into account and bringing to our bids.

It’s very dynamic. We’re very fluid with it because if I’m looking at a property in my area of Washington DC, pricing is very different than it is in Phoenix. Phoenix is undergoing a rapid increase of properties on the market. There are a lot of eye buyers in that market so pricing has started to shoot down in Phoenix. If there’s an asset in Phoenix compared to Washington DC, we would look at that very differently on where we anticipate the pricing to be in 24 months. We call it price damage. We are including some price appreciation or decline over the next years within our analytics.

You summed up what I was going to say. You touched upon this in a little bit but talk about how this is different from the 2007 and 2008 recessions, from what caused it to how it will impact real estate specifically.

In 2007 and 2008, there were a lot of discussions. There’s never just one factor that causes any type of recession of that size. Back then, there were a lot of bad loans and fraud going on in the mortgage space which led to people being qualified for loans that shouldn’t have. I remember I was looking at a beautiful house in 2006.

They were running numbers. It was an interest-only loan. Our payment would’ve started at $3,000 a month but then would’ve jumped to $5,500 a month. I’m sitting here and they qualified us for a loan. I’m like, “My take-home pay at the time wasn’t $5,500 a month. How can I afford this?” “Don’t worry. You’ll be able to afford it. You can refinance after a year.” It’s what they tell you. I’m sitting there like, “I can’t afford this $600,000 mortgage or whatever it was.”

Unfortunately, I understood that and a lot of people didn’t. They were taking those words. That was more broad-based on real estate. Every downturn has its issues or causes. We’ve got wars overseas, supply chain issues and COVID but things are different because you also have to work from home, which is much different than it was years ago. People are being more flexible about where they can live. That’s changing the dynamics of things. You’ve got the CFPB. Since they got implemented, it’s a lot tighter on restrictions.

Part of it is you can compare things to learn from them but at the end of the day, my focus is on what’s going on now, what are we forecasting or looking to see and how are we structuring our business to be able to be profitable and take advantage of some of the things that we see coming down the path in front of us.

For me, when I look at that, it was like bad lending practices induced. People were not qualified to be owning the homes they owned, which led to 2007 and 2008. The CFPB came in and made much. For people who don’t know that is the Consumer Financial Protection Bureau. It plays a lot more regulations and restrictions around who could invest in notes, who could be lending, what it means to be a lender and certain guidelines and restrictions. That’s why we have licensed services in every state that we work with to make sure that our investor’s equity is protected and we’re following everything to a T.

CWS 227 | Down Market

Down Market: The Consumer Financial Protection Bureau placed more regulations and restrictions on who can invest in notes and who can lend. That’s why there are licensed services in every state.

 

In 2022 though, it’s not that the loans or the notes that we’re acquiring are necessarily people who couldn’t afford them. It was more of a situational change for them, whether that was health, divorce or job issue. At some point, they were qualified to afford the home. It’s more about what changed in their situation and how can Seveney step in. We do have such a price discount on what we’re acquiring a loan for. How can we work with them? How can we get this loan reperforming?

One thing I wanted to touch on is, “We hold notes for anywhere from 18 to 24 months.” That’s not saying that’s how long it takes to get this borrower back on track. I wanted to clarify that. Typically, it does not take nearly that long. The goal is to get it to perform and season the loan to be able to then sell it as a performing loan.

That was a good point about the 18 to 24 months. There’s one thing that I know you get asked a lot and I get asked a lot as well. Both of us also are investors in different things, real estate, whatever the case may be. What are some of the things people are doing? That’s another question besides there’s a Seveney fund. We’re not giving “financial advice.” We’re talking about some of the things that we may be doing with our portfolio based on some of the things that we see. We are very tight-knit in the mortgage market and housing. I live and breathe everything between that in reading SCC offerings and other things that I like to do that you realize. What are some of the things that you look for?

You and I are going to have very different answers to this. Similar answers along with what we look for.

I’m a lot older. You just don’t want to say that.

I didn’t want to say it but I’ll say it. It’s good. Essentially, number one, looking at investing in things that are secured, where you have secured assets that are not over-leverage. That’s specific to real estate funds or any syndication that are not over-leveraged secured assets, top two things. As a whole, it’s the conversations I’m having with a lot of people who come from that tech-heavily invested in the stock.

They’re looking and trying to get out of that and realizing that they do want to get into something more secure and not necessarily at the whim of up and down and taking a hit hard. A lot of people are my peers and contemporaries. I come from the Silicon Valley tech startup world. That is my background before real estate. They’re all looking to diversify and get into more real estate-backed or secured assets as far as investments go.

A few things that I’m looking for and things I’m not looking to invest in. I’ll share both. I’ve got some real estate rentals in my portfolio, which is keeping those. They’re cashflowing and doing well. Notes, we love it as well. I’ve never gotten into crypto and I don’t intend on it at this point. It’s something that to me isn’t tangible. A few things that I’ve invested in the past I’m taking a harder look at. One is multifamily syndication.

To clarify, taking a harder look at it as in being more cautious?

More cautious about my personal investment, my wife and me. I’m being cautious because I spent many years working in that space. The deals are pretty much coming to a halt because interest rates are above cap rates. Previously, if an interest rate was at 3% or 4% and your cap rate is at 5%, you’d leverage it and it would enhance your returns. When your interest rate is above the cap rates, it hinders your returns.

The other thing with multifamily that has me slightly concerned is a lot of those exit strategies are based on a five-year refinance. You want to look at where those refinances could be. You and I have had this discussion and I’ll let you give your opinion on where you think interest rates will be but some people think, “In six months, interest rates will be back down to 3%.”

I would love that but the reality is I don’t think that’s happening. I’ll let you voice your opinion. It goes back to rental rates. Rent continues to go up but eventually, there’s that breaking point where it gets too unaffordable. When you look at inflation, it is still roaring at 7.5%. I heard a great analogy of, “Great, it went down but you’re still going 150 miles on the highway when it’s 65. It went from 180 to 150 but you’re still speeding.”

You got to remember that a good component of that is wages. To bring that down, if wages come down there are already 24 million people that can’t afford that same house months ago. There’s a lot to digest with that but it’s one of those things where I’m looking on the multifamily side. It’s 1 asset versus a fund with 20 of them. It’s something that’s looking to be acquired now. Make sure you understand the fundamentals and the numbers behind them. The ones that I’ve seen are a little too aggressive on some of the exit rates.

I’d say something else when you’re looking at investment strategy during a downturn. It is much more research. We’ve done 3 or 4 episodes on this on the strategy, previous funds and current investments. If you are reading this for the first time and haven’t read our show, we highly recommend checking it out. We’ve gone through questions you should be ready to ask your sponsor. Chris has answered all those questions and then the top questions I get asked when speaking with current or potential investors on the phone. Feel free to check out those episodes. We talk all about that.

To echo all the things you said, you talk about interest rates. I see people investing with ARM loans and thinking, “I’ll refinance 6 six months, 1 year or 2 years.” It gives me a little bit of anxiety. Six years is the average it takes. I don’t have a crystal ball. I can’t predict what’s going to happen in the future. We are in this great market for so long so I feel like it’s going to take probably 5 to 10 years to come back down. It’s only based on experience and what I’ve seen the market do before.

The market has been going strong for a while now. It would probably take five to ten years before coming back down. Click To Tweet

It’s interesting because it’s like a story with time and price. It’s like fishing. Every year, that fish you caught got 6 inches bigger. Housing is the same thing. Everyone’s like, “My house lost 50%.” It probably didn’t back then. Also, people are like, “Inflation went from here down to here in two years.” You go back and look at the figures again. It was 70% to 80% or something like that where it went from 7 double digits to getting back below 3%. Even when it got up to 5% in 1992, it still took 4 years to get below 3%. If they want to target 2%, that’s a whole other animal.

They have the means to get there. It’ll be interesting because they had quality leasing decades ago. In 2022, they’re doing the QT. It’s the first time it’s ever been done. A lot is going into the mix with the markets and so forth. At the end of the day, it’s so unpredictable because we’re in a global economy. There’s so much that can be impacted based globally as well as internally within what the federal government can and can’t do.

One thing also to consider is coming back to that strategy. We’re not giving financial advice. It’s that disclaimer out there. I’m not a financial advisor but we realized that the returns of the past decades have been astronomical. Especially the last few years when it came to real estate specifically. You could essentially put your money in any real estate investment start of 2020.

CWS 227 | Down Market

Down Market: The returns of the past decade have been astronomical, especially in real estate. But that will differ from 2021 onwards, and you must adjust your expectations.

 

All stock essentially.

You could set your money on something. At the start of 2020 and the end of 2021, you’re like, “I am a genius. I have made the best investments.” Not necessarily the case. We’re going to see a lot of people realize that but adjust your expectations. I speak with investors. Some of them I get on the phone with and they say they’re looking for a 15% or 20% return. I have others who say, “How can you offer 8%?” It’s also knowing realistically what you can expect in this market for the assets you’re investing in if you’re not taking that on yourself. If you’re doing this yourself, it’s very different.

One of the things we pride ourselves on is understanding risk and being able to measure it. When people talk about, “This person’s offering 20%,” or whatever people throw out there, you have to understand there’s always some risk associated with that return that parallels that. As I’ve spoken a million times to this as a note investor and real estate investor, we look to target, I’m going to use the baseball analogy, singles and doubles.

If you’re in football, we run 7 to 12-yard out patterns. Once in a while, do we go for a home run? Sometimes we get them but rarely do we ever strike out because that’s not what we look for. I know some people especially back in the day were buying second mortgages that were 100% underwater. What that meant is the house was worth $500,000. The first mortgage was $600 and was sold for $100,000. They would buy 100 of them. They pay $0.5 for them hoping that one person would cut them a check.

Some of them would get that one person that would cut them the check that paid for all those other loans and everything else but it’s almost like buying a scratch ticket. It is what that was. To me, I view that more as gambling. As a note investor, we like to look at the strategy. We used some game theory involved with trying to understand the borrower. That’s where we talk about that 3D picture, which you can talk about a little more. One thing that we strive ourself and pride ourselves on is understanding the risk that’s involved in the type of investments that we’re looking at.

Be very realistic. I always say under promise, over deliver. People mention this before, “I was on BiggerPockets researching Chris. I was googling Chris and who Chris is. It seems like he has.” People have nothing but great things to say. Part of that is we are very transparent and realistic about what is possible and are always underpromising and overdelivering on our communication, returns and the investor experience overall. Not to toot our own horn but it’s something you do a good job of.

Thank you.

The purpose of this episode was to talk about the market and all the things we’re hearing. A lot of it is around values dropping because that mostly correlates to what we do. There was that concern. Hopefully, we’ve addressed that.

It goes back to weathering the storm that a lot of people are seeing, buckling down the hatches and focusing on the business. One thing that is also about us is we’re also very strategic. We’re not trying to dip our toes in many different things or shifting businesses. A lot of people sometimes will get into the game of chase and start chasing things or chasing returns. That’s not something that we do with our business. We are very focused on what we target when we look at our buy box. Is it adjusting? It is. Adjust things but we’ll pivot on some items.

We’re not going to go and start buying seconds is essentially what you’re saying. We’re not going to try to reinvent.

All of a sudden, credit card debt is at $1 trillion and you can go buy credit card debt. There are loans in Greece. I see people chasing loans in Greece. Car loans, I see people chasing that. I see people wanting to get into short-term rentals because that’s the next biggest component. We’re very strategic in regard to our business plan, which we had to be anyways with the offering that we had to submit. What are your final thoughts, Lauren?

My final thought would be to whom you’re investing. Someone I was speaking with said this. Maybe it sounds cheesy but I agree with him. Whom you invest with is as important as the asset you’re investing in. The people, their experience and your experience working with them. I’d say getting to know the team behind the assets you’re investing in is important. That would be one piece of advice I have. Making sure that you are investing in securitized assets.

The people you invest with are as important as the asset you're investing in. Click To Tweet

Specifically, I would not be putting in a ton of money if we’re looking at portfolios as a whole. I would not necessarily be moving too much of my money out of the stock market. Granted, I have a little bit more time than you, Chris. I wouldn’t be looking at short-term rentals or fix and flips. I would be looking at what is going to be like a stable bread and butter income, generating investment over the next several years. Those are my final thoughts.

I’ll add a few things. This is my personal opinion looking back. I’m not trying to chase returns in 2022 or things with very high returns because those are going to pose a much higher risk, especially if credit starts tightening, something securitized or a lot of cash, companies with cash and provide a service or have cashflow. It is very important as well to look at the underlying company in itself because a lot of companies over the last several years have also been propped up by VC firms as an example. Can they survive on their own? What’s that management look like?

Are these companies taking additional leverage outside? That’s important too. If you’re comfortable with it, that’s fine. I would not be.

That’s one thing. We’re running a little late that we didn’t touch upon it but we should. With our fund, when people talk, “Do you leverage,” we are the bank so we don’t secure or obtain additional leverage with our funds.

Can you explain an example for people who might not understand what that means?

We’ll go back to traditional real estate. I’m going to use banks for example. No representation of these banks but let’s say you’re buying a $500,000 property with 20% down. You’re putting $100,000 down. You’re getting a $400,000 mortgage from Wells Fargo. You owe Wells Fargo $400,000. It goes back to if pricing does come down, you’re at the mercy of the bank, essentially if you can’t make payments or you borrowed that money. You still owe that money out there. That’s traditional in real estate. We are Wells Fargo. We don’t have loans from Wells Fargo, PNC, TD or pick a bank. We have our shareholders that are the investment.

If something does tighten or we do take a property back, it’s not like, “We have to liquidate this because we have a bank calling us.” We can hold it and turn it into a rental. We could turn around and sell that property. We could turn around and sell it with seller financing. We could sell the note. Many different components allow us to not have the leverage be able to be much more flexible. You can say that in five words.

I asked you on purpose because someone sent me a private message about that. I wanted to make sure that concept was broken down a little bit but that’s a whole other. We have a whole other episode about debt and leverage. Go back and read that episode if you want to learn more about that. Do you have any other final thoughts?

With real estate, most people get themselves in trouble because they’re over-leveraged. That’s where you see most investors get themselves in trouble because they’ve over-leveraged and they can’t afford the payments or values decrease. They’re chasing their dollar and it runs out. That’s something I want to mention about leverage as well.

If anyone is interested in learning more about our offering, I’d be happy to get on a call with you. Feel free to email me directly at Invest@7EInvestments.com or give me a call. We can talk about our offering, which offers 8% annually, paid in monthly dividends and is open to accredited and non-accredited investors. The minimum investment is $500 with bonus shares starting at $25,000.

If you’re interested, want to connect about the offering, notes specifically or anything of that, feel free to reach out to me directly. With that being said, thank you so much for joining us on this episode. If you enjoyed the show, please share it with a friend, subscribe or leave us a review. Until the next episode. Thanks, folks.

Thank you.

 

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