This will be a quick one.
Just had lunch with a friend and client who has been a broker for decades. We got to talking about what we both think is headed our way in the next several quarters. Basically, doom for real estate in a variety of ways as the Fed tries its best to kill the economy — particularly buying homes. We got to talking about comparisons of what we expect to see in 2023 vs. what we both saw in 2008.
One thing struck me about our conversation: we all recognize that real estate is a cyclical business. Things go up, then things go down. Markets get hot, then markets turn cold. It’s part of the industry and as old as the industry itself. Brokers and agents spend a few years making a fortune, then spend a few years losing it all.
What occurred to both of us is how most real estate people and certainly real estate companies are un-hedged. What do I mean?
I’ll illustrate with a story from 2010 or so. Obviously, I can’t use actual names, but I assure you this is a real story. Frankly many of you know people who were in exactly this position back in the bad old days of the Collapse.
A friend of mine was a very successful real estate broker married to a very successful mortgage broker. This kind of couple is extraordinarily common, because the nature of real estate tends to lead to meeting and hanging out with and ultimately getting together with other people in real estate. I’m a perfect example, since I met my wife Sunny (who is a recovering real estate broker, and still works in the industry) at a real estate conference.
From 2001 to 2006, this couple made an absolute fortune. The market was crazy hot, and both mortgages and home sales were going stratospheric. They basically doubled their income every year from 2001 to 2006. With the enormous amount of money they were making, they made significant investments into rental properties. Again, this is extremely common since real estate agents know the value of real estate as an investment asset.
The point is that during Good Times, things were amazingly great. Both the real estate business and the mortgage business made more money with each month, while their investments went up in value month over month, and they had strong rental demand. But when the Crash came, the entire family was wiped out.
Sales plummeted. Mortgage was frozen. Both spouses saw their income drop by nearly 90%. At the same time, their investment properties kept falling in value and renters started to miss payments. They ended up having to fire sale their investment properties, sell their vacation home, and suffered enormously for years. Rags to riches to rags, in about ten years.
This is an incredibly common story. Some brokers and agents working today remember those bad old days; many do not because they were not in the business in 2007-2011.
What my friend and I ended up discussing is that while we think many agents in 2022 are in the same position as those agents we knew in 2007, we are pretty confident that almost all brokerages are in that same position out of necessity.
That is, most brokerages over the past 20 years or so have seen their profits from brokerage get eroded to pennies… if not zero. For the past decade, every brokerage-focused session at every conference I’ve attended has been preaching “ancillary revenues” as the business model of choice. The basic idea is that you can operate the brokerage more or less as a loss leader business in order to feed leads and business to the actual profit centers: mortgage, title, escrow, insurance.
And over the past few years, brokerages have done very well with this ancillary-revenue based model. Sales were going up, prices were (and are) going up, volume is up, so all of the ancillary businesses have been doing very well indeed. These ancillary services became the profit center, with the brokerage staggering along at break-even (or at a loss), as long as the brokerage generated leads to mortgage, title, escrow, insurance, etc.
Trouble is, much like my agent friend’s family from back in the day, ancillary businesses are all connected to the housing market. If transactions are way down, then mortgages will be way down. Escrow will be way down. Title will be way down. It’s hard to sell homeowner’s insurance if there are fewer people becoming homeowners.
I think a phenomenon few of us discuss is the fact that most brokerages and even agent teams today have all of their eggs in one basket: real estate. That’s a fine basket during up-cycles, but it’s a bad basket during down-cycles. And it’s a horrible basket if the market collapses.
Back when I was still thinking about pursuing law as a career, my interest was in bankruptcy law. I find the area intellectually fascinating for a variety of reasons. For some reason I thought international cross-border bankruptcy law was super fun.
Thing is, there was one partner at the law firm I summered at who said something that stuck with me forever. At the time I was a summer associate in the mid-90s, the economy was booming. Bankruptcy department wasn’t doing much, and they weren’t billing a lot of hours. So I asked this partner, “What do you do when the economy is good?”
His answer: “Watch my investments grow.”
It was an eye-opening insight to a young twentysomething lawyer larva. When the economy is bad, bankruptcy lawyers are making money hand over fist as debtors and lenders both need bankruptcy lawyers. When the economy is good, those lawyers have investments that do very well. Either way, they were doing great. Not so much those lawyers in the high-flying M&A departments or Corporate Finance.
Bankruptcy Law is a near-perfect counter-cyclical hedge.
Most industries do not have such perfect counter-cyclical hedges. But it would be wise to think about counter-cyclical hedges.
Real Estate Counter-Cyclical Hedge
In my mind, there is a perfect counter-cyclical hedge in housing. It’s something I’ve been talking about for a while now, especially in live presentations.
If home sales are up, then the sales side of the business does very well, along with all of the ancillary businesses that benefit from higher transactions and higher sales volumes. You can carry property management along during a hot housing market.
If home sales are down… then rentals and property management does well as fewer buyers = more renters. Homelessness is not an option for housing. Purchase and rent are the primary options. If you have property management, then that division should get far busier to offset the losses in the sales side of things. If you don’t… well… all eggs, one basket, no?
It’s bizarre to me that so few brokerages have property management divisions or practices (some even have rules prohibiting agents from the practice). It’s odd to me that so many agents look at property management as they might shoveling manure: as something far beneath their dignity as professionals.
As the housing market reverses faster than most had imagined possible, and we are seeing double digit declines in sales transactions, most brokerages are going to get put under enormous pressure extremely quickly. If they had property management, they would have at least one counter-cyclical business that goes up as everything else comes down. If they do not… then everything simply comes down.
So… a few questions as I am curious.
Does your brokerage have property management? If so, how’s that doing now that the market has turned?
If your brokerage does not have property management… why not? What has kept that brokerage from building out the counter-cyclical hedge?
Am I missing something in thinking that rentals and property management are the ideal counter-cyclical hedge?
Let me know what you think in the comments.