Real Estate throughout Colorado is on a tear, setting records for price appreciation throughout the state. Unfortunately, eventually the market will run out of juice. Do you know the mushroom theory and how it can help you plan for the next cycle? I developed this theory after analyzing our portfolio after the 08 meltdown to determine what properties performed best during the crisis and which should you avoid.
First, put the magic mushroom down! I’m not talking about actually consuming a mushroom (nor did I consume one in the writing of this article!). I think most people would agree, the current real estate expansion is getting a little “long in the tooth” and at some point will correct and/or substantially slow down. How can this theory help you weather the next correction? What does real estate have to do with a mushroom?
What happens when the markets tank?
As a lender in the last recession, I learned some important lessons about what happens when the markets tank and s*** hits the fan. We are a private real estate lender and portfolio and service all our own loans and therefore we were forced into a front row seat in the last crisis. Like many lenders we lost money on certain transactions. I wanted to try to avoid this same scenario whenever there was a market downturn.
Many years later I’ve gone back and analyzed which transactions we got hurt on and which ones we did okay on to ensure we don’t repeat the same mistakes. When I look at our portfolio in the great real estate correction, there were clear trends that emerged. Certain property areas got hit considerably harder than others. Why did some areas fare well relative to other areas?
What trends emerged?
As I studied our losses in our lending portfolio there were three glaring trends that predicted losses. These trends are true for both commercial and residential areas.
- Consistency: the more consistent a neighborhood the better it fared during a downturn. I’m not saying all houses look alike, but the vast majority of houses were all well maintained and grouped at an average price point. Neighborhoods that had problems had outliers that were considerably lower than others. On the commercial side this was also a key indicator of success. Properties in uniform areas performed considerably better. For example, a building in an industrial park with many like properties did better than a property not in an actual industrial park but surrounded by different commercial property types.
- Closer to core fared better: Even with Covid, over the long term, properties closer to the city core in good areas typically fared better and came back much quicker than other areas. There is a desire in many areas for city living, this will return after Covid settles down. There is considerably more downside risk in farther outlying areas as they will lose their desirability once the dust finally settles. What I saw in the last recession is that the closer in areas came back much stronger than the far outlying suburban areas due to demand and lack of new inventory.
- Euphoria (up and coming): Towards the end of the cycle it seems like every neighborhood is the next “it” neighborhood with speculation abound. These areas are much less solid than more established areas and therefore are at considerably greater risk during a downturn.
What is the mushroom theory?
A mushroom can predict the trends above. Look at the shape of a mushroom, its colors, and consumption.
- Shape: A mushroom is much stronger towards the middle as opposed to the outlying parts of the circle. The closer you are to the center, the better you will be in the next cycle. This relates directly to the “closer to the core” rule.
- Consistency: certain parts of the mushroom are much more consistent in shape/texture than others. As you get farther out on the top of the mushroom the colors change, pieces fall off the sides, etc… Stick to the consistent areas to excel in the next correction
- Eating too many mushrooms 😊: As we get towards the end of the cycle, there are always people that try and consume too much towards the end of the cycle and get into “marginal” areas. It is always the final mushroom that can make you sick. Make sure you manage your consumption towards the end of the cycle and not bet on marginal areas that could turn the other direction. Moderation is key to success this late in the game!
Just as the snow is starting to fall, the real estate cycle could be looking to be making a change as well. Abiding by the mushroom theory is critical at this junction in our economic cycle. Now is the time to be a little more cautious to ensure you can weather the next storm. By following the three simple steps that I developed during the last crisis you can position your portfolio for the economic transition on the horizon. Remember the most important rule, just because everyone else is happy eating mushrooms today, doesn’t mean they will not get sick tomorrow.
I need your help!
Don’t worry, I’m not asking you to wire money to your long-lost cousin that is going to give you a million dollars if you just send them your bank account! I do need your help though, please like and share our articles it would be greatly appreciated.
Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in the Colorado Real Estate Journal, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, Illinois, and Florida. They are recognized in the industry as the leader in hard money lending with no upfront fees or any other games. Learn more about Hard Money Lending through our free Hard Money Guide. To get started on a loan all they need is their simple one page application (no upfront fees or other games).