The reality of market economies is one of boom and bust. As prosperous as the booms can be, that reality also implies that that the U.S. will experience another bust -- even in real estate. In fact, I'd argue that it's not a question of if. It's a question of when.
How can I be so confident, especially at a time when the country is still reeling from the hard lessons learned in the financial crisis and great recession? Because that exact scenario has happened time and again throughout U.S. history.
Our uncanny ability to repeat the same mistakes
Owning your own home is woven into the fabric of the American dream. It's as much cultural as it is a rational financial decision. Americans are, by and large, very comfortable taking on a mortgage and its associated risks, even though history has repeatedly shown that real estate is as susceptible to a crisis as any other investment class.
Homeowners will one day find themselves underwater on their mortgages. Foreclosures will spike. We'll likely have to learn the very same lessons from 2007-2009 all over again. The cycle has repeated itself countless times over history, both in general and specifically in real estate. In this case it's unfortunate, but history really does repeat itself.
A history of real estate crises in the U.S. and abroad
From 1929 to 1945, there were three recessions (including one depression) in the U.S. that saw greater declines in GDP than in the great recession from 2007 to 2009. In the 100 years prior to the great depression, there were at least 24.
This isn't to discredit the severity and pain experienced by Americans in this most recent crisis, but rather to show that economic decline is a fact of life in a market economy.
Modern history isn't without its own examples, even in real estate. Take the Secondary Banking Crisis of 1972 and 1973 in the United Kingdom. Driven by property speculation, financial institutions across the pond extended massive amounts of credit to finance these real estate purchases. Credit standards decreased, leverage increased.
Then, beginning in November of 1973, the bubble burst. The Yom Kippur war sent the cost of oil through the roof while at the same time the Bank of England began raising interest rates. Borrowers fell behind on their payments, banks ran out of liquidity, and ultimately the Bank of England was forced to provide huge sums of cash to keep the system afloat.
There are other examples still. A relatively short time later in the U.S., another real estate crisis was about to bubble over.
Throughout the 1980s the commercial and residential real estate market in the U.S. had grown stronger and stronger. By the late 80's and early 90's it was at a fever pitch. Naturally banks were happy to meet the new demands for real estate financing, again relaxing lending standards and happily writing checks to fund investors and speculators alike.
Then, almost like clockwork, the markets began to collapse under the pressure of the debt-fueled boom. On the commercial real estate side vacancy rates, rental prices, and asset values fell across the country. On the residential side, skyrocketing foreclosures and declining home values drove the savings & loan bank model into extinction. It cost $160 billion to stave off the crisis, including $132 billion from tax payers -- and that's in 1990 dollars.
Investing in an uncertain world
What's an investor to do then, knowing not only that the U.S. will certainly again fall into recession, but also that its a near certainty that there will again be a crisis in the real estate market?
In my view, this investor should continue investing with prudence and an eye toward risk management. He should use leverage cautiously, if at all, and diversify his holdings to protect his long term objectives from short term economic turmoil. Benjamin Graham, the value investing legend and mentor to Warren Buffett, said that investors "must be prepared in their thinking and in their policy for wide price movements in either direction."
Investors can protect themselves from these price movements in the stock market, real estate, or otherwise by focusing on value and by building a margin of safety in their investments. Regardless of the current phase of the economic cycle, investors should buy assets for less than their intrinsic value. The greater the discount, the more upside and the lower the downside in that investment.
Done properly, investors can turn the cycle of boom and bust on its head. The busts become the time to buy assets on the cheap, instead of a time of panic, fear, and financial pain.