(Usual disclaimer: I’m an investor, not a financial advisor. Consult your own financial advisor before making any investment decisions).
 

May 2018 update: here's a newer, step-by-step guide on how I pick deals today.

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A lot of new investors ask me “What are you invested in?” My answer usually surprises them. “I don’t recommend most of them.” It’s not because they did poorly: 2016 was a record year. It’s because the environment going forward is so completely different than it was a few years ago. Blindly copying what I did in 2014 would be very risky right now.  (March 2018 update: Here's everything that's inside my current real estate portfolio, including positions and returns: Peek inside my 7 figure real estate portfolio).

Several things have caused this. First, the biggest and most unfortunate trend in real estate crowdfunding in 2016 has been the deterioration in the quality of the investments on many sites. And often the higher risk is accompanied with lower returns which is a double whammy for a potential new investor.

The futures for some of the former top platforms has become uncertain. Venture funding for fintech has dried up (due to a financial scandal at Lending Club, dropping revenues at OnDeck  and mass layoffs at Prosper and others). In the real estate crowdfunding industry itself, one leading site (Fundrise) completely abandoned its original business model. Others (like Patch of Land, and perhaps another prominent site) have experienced mass layoffs.

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And meanwhile, the real estate cycle is like a horde of zombies constantly banging on the gate. The gate is still holding, but each day that goes by brings us closer to the end of the cycle when the monsters break-in and run amok.

Predicting exactly when that’ll happen is tricky. The current consensus is for a real estate recession to hit around the end of 2017/-2018 timeframe. While that’s difficult to predict, it’s a no-brainer to predict that a downturn is going to be coming. And there’s a higher than normal chance that it will happen in the next 2 to 5 years.

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So how do you invest in this kind of environment? In part 1 of this article, I’ll talk about the investments that I avoid. In part 2, I’ll talk about the types of investments I consider.

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Why buy snow cones when winter is coming?

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Here’s what I absolutely DON’T WANT to invest in.

Most investments don't make much money until they sell. So anything that targets an exit in 2 to 5 years immediately gets a red flag because of a likely recession.

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When the next recession hits, vacancies will increase, cutting into the bottom line. Also, rents will drop (perhaps with the exception of mobile homes). So I immediately cross off my list any investment that targets an exit in 2 to 5 years and needs income to stay at today’s rate to make an acceptable return.

Also, there’s a 50-50 chance (based on the past several recessions) that prices may drop dramatically and stay that way for a long time. If that happens, it will also become very difficult to sell due to decreased volume and difficult credit conditions. Personally I believe the next recession will be mild and this won’t happen. But since I’m conservative, and principal preservation is my #1 goal, why should I take a chance with it? So I’ve crossed off my list every investment that targets an exit in 2 to 5 years that counts on current pricing continuing at today’s level. There are plenty of other alternatives, so better safe than sorry.

At the asset level, I also avoid the most popular investment type I see these days: Class A apartments. In the past these were safe investments, so everyone and their brother is doing these now. But all of this activity has caused overbuilding in many city centers. Already, there are signs of dropping occupancy and rents. When the recession hits, these disappointments now will turn into major pain for investors who are caught on the wrong foot.

I also avoid investments looking to reposition class B/C into class A for the same reasons. (This is when an investor purchases a cheaper B/C and then improves it to sell it as a Class A) This is less risky than a brand-new class A construction, but is still subject to the same income and price pressures. It’s like a game of musical chairs: everything is fine as long as the music keeps playing. But we know it will stop, and when it does many people won’t be able to find a seat.

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What’s left after this? It may seem like not much. However, I still do see several opportunities in the current environment. To learn more, see part 2 of this article: Investing Quick and Slow.

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