Though it may seem like a strange notion, I spend time planning for the next financial crisis every single day. As CEO of a financial technology company, it is arguably the most important part of my job. At Fundrise, we tend to follow the advice of the great value investor Seth Klarman, who has said, “Take care of the downside, and the upside will take care of itself.”
It may be unclear when the next recession will come or what will trigger it, but the fact of its approach is inevitable. Denying it will only make it that much more difficult to handle once it arrives.
Make no mistake, winter is coming.
Rather than spend time debating it or trying to predict the future’s particular details, we instead focus on how to best prepare while the market’s summer sun is still shining.
Same tune, different decade
My father has often told me:
You know the market has hit bottom when no one can imagine it going back up, and you know the market has hit the top when no one can imagine it going back down.
As unbelievable as it seems, you see this same fallacy occur over and over again. With every bull market, investors experience amnesia, wiping from their memory the pains and tough lessons learned from the previous cycle. It takes a deep form of self delusion to think that things won’t eventually revert to the mean…in both good and bad scenarios.
But today, the widely accepted belief is that the US economy is healthy. After all, the Fed stated recently that the “great recession” was officially over — unemployment is at an all time low, while consumer sentiment is at an all time high, along with the stock market, housing prices, and practically everything else.
However, there’s also been a broad change in sentiment across the investment industry, which has become increasingly concerning to me. Ever since the 2008 crisis, most investment professionals have been waiting for the other shoe to drop. The narrative was that everyone had learned their lesson (this time) and was going to be prepared for the next crisis. Every quarter of positive earnings and growth was met with a healthy skepticism…there was no way we would let our collective memories be so short-term or allow our institutions to relapse.
That’s what people claimed, at least.
Now, a familiar tune is creeping back into the industry as investment professionals embrace the current bull market more and more. To see a case study of the current trend, take a look at samples from the past five years of annual Investment Outlooks from analysts at the $5 trillion asset manager Blackrock [emphasis added]:
Blackrock 2012 Investment Outlook:
“What lies ahead in 2012 for financial markets? A time when emerging economies and asset prices finally come into their own? A descent into an investment nuclear winter? ...We see an increasing divergence between faster-growing emerging markets and the debt-ridden developed world. The “real” economies and asset prices will likely decouple, helped by emerging markets having the room and cash to stimulate growth… The US economy and Japan muddle through.”
Blackrock 2014 Investment Outlook:
“The other market at risk: US equities. Many investors are reluctant longs, and US stocks look rich by most valuation metrics. Corporate profits are at a record share of output, with the wage share at a low. This speaks to troubling trends of growing inequality and weak wage growth – and brings into question the sustainability of these margins. If they were to fall to historical averages, earnings would take a hit – and equities could head south. A red-hot new issue market and the return of venture capital are putting high valuations on (expected) growth. This rhymes with increased investor exuberance – rational or otherwise.”
Blackrock 2017 Mid-Year Investment Outlook:
“The current U.S. economic cycle has been unusually long, sparking fears that it may die of old age. We have a different take. Looking at the quantity of recovery rather than the time it has taken reveals an economy with ample slack to power on. Its remaining lifespan may be clocked in years, not quarters.”
After years of caution, Blackrock’s analysts now forecast that there is “room to run” — and maybe they’re right. Ultimately, no one knows. The more interesting phenomenon, in my opinion, is that their forecast is now more optimistic than at any point since the last financial crisis, even as we enter into what is one of the longest sustained periods of economic growth in the last 50+ years.
It’s not easy to maintain and stand by bear predictions, especially after 8 years of experiencing a rising market. And by no means do I fault Blackrock’s earlier caution. I was similarly concerned about the underlying health of the US economy, high stock prices, and the Federal Reserve’s experimental policy of Quantitative Easing. And to date, we’ve both been wrong. Over the last 7 years the market has continued to rise, even as the Shiller Price-to-Earnings Ratio (PE) has increased from about 20 to 30 (note, the historic mean is 16.78).
But this new found confidence in the market is the same bellwether I witnessed in 1999 and 2006, and, for us, it signals the need to prepare for the possibility of the next black swan.
An ounce of prevention
The thing about black swans is that by definition they can’t be predicted. So rather than try to build an investment strategy around forecasting the market’s ups and downs, or waiting to find a life raft only when things get choppy, we subscribe to the idea that you should set out to build an ark that can weather a storm, assuming that one will hit, eventually.
To do so, we seek to make sound investments with strong fundamentals. We focus on the intrinsic value of the real estate, which to us means buying properties at-or-below replacement cost and investing in geographies with high barriers to entry. We believe strongly that if we invest in locations with stable or rising demand and own properties at a lower cost basis than the competition, over time our investments should experience stronger than average performance.
One of the fundamentals we consider in any prospective investment is the margin of safety. This is a classic value investing technique and a principle that is easy to see in practice in our debt strategy. For example, if an investment has 15%-25% equity subordinate to our capital, then, by definition, we have a buffer against economic shocks, meaning the value of the property could decrease by roughly that amount without our principal experiencing any losses.
Our investments in workforce housing — also known as Class B apartments — are another example of this strategy. Class B apartments are generally older properties that usually rent for 25%-50% less than newly built apartments. In an economic downturn, Class B apartments usually maintain higher occupancy rates than their Class A counterparts because people tend to move from newer, more expensive apartments to more affordable, older apartments as a way to lower their monthly rent payments. This provides Class B apartments with a level of resiliency in a recession that shinier Class A properties don’t always see.
What to expect when the unexpected occurs
At Fundrise we invest in real property because of the many benefits that come with owning it — higher yields, higher potential returns, and generally greater stability — but those benefits also come with a tradeoff, primarily liquidity. By its nature, real estate is an illiquid, long-term investment with a natural duration to be measured in years or decades. Properties grow in value as macro growth trends play out around them. Selling a property before you’ve given it sufficient time to benefit from this growth is a good way to underperform. More importantly, to do so during a financial crisis is not only foolhardy but can result in painful losses.
Yet in a financial crisis, people tend to be overcome by fear and forget the fundamentals of a long-term investment strategy. In that circumstance, we expect that some investors may ask for liquidity. Unknowingly or not, they would be demanding us to sell an investment in order to generate the cash required to provide that liquidity. This type of forced selling in a financial crisis is like paying the surge pricing for an Uber after midnight on New Year’s Eve — it’s almost certain that you aren’t getting a fair price.
Not only is forced selling clearly a poor investment practice, it also hurts fellow investors who are not seeking liquidity; it forces them to lock in lower returns by selling an investment into a down market rather than having the patience to ride out the storm.
We want to be clear to every investor that forced selling is not something you should expect from us. We have designed our governance specifically to prevent this scenario. We’ve built an investment model to perform over the long run, not trade in the short term — and we will act in accordance to what is in the best long-term interest of our investors as a whole.
Although none of us want to see another financial crisis, that doesn’t mean that we should blind ourselves to the inevitable — or not take strides to be ready when it comes. In fact, whenever the next downturn does occur, the stability of our assets combined with our broad base of investors may in fact create new opportunities to buy, not sell.
As Nathan Rothschild famously said, “Buy when there’s blood in the streets, even if the blood is your own.”