Are you prepared for the next major economic changes? It might be deep deflation like the Great Depression of the 1930s. It could be high inflation like the 1970s and early 1980s. Or it may be unknown events that we have never seen before.
I’m not being a doom and gloom predictor here. My skepticism radar goes on high alert when I hear people make specific predictions. I haven’t seen a lot of evidence that anyone can predict the what, when, or how of specific future economic changes.
But that’s doesn’t mean you can’t and shouldn’t prepare for bad economic scenarios to come. Preparation, unlike prediction, acknowledges the uncertainty of the future. And it keeps you flexible and anti-fragile so that you can address whatever might come.
The foundation of my own investment preparation is a strategy I borrowed from an investor named Jack Miller. It’s called the three-legged stool. The rest of this article will explain the basics of how the three-legged stool works and why it’s useful for real estate investors.
What Is the Three-Legged Stool?
Balancing on one or two points isn’t easy. Just ask anyone learning to ride a pogo stick or a bike!
But balancing on three or more points is quite different. The three legs of a simple wooden stool give it a very stable foundation.
The investing version of this three-legged stool is a concept I learned from Jack Miller. Jack is now deceased, but he was one of the sharpest (and funniest) real estate investors and teachers I’ve ever known. You can still find his education on amazon and at cashflowdepot.com.
Jack was concerned about uncertain economic challenges during his multi-decade real estate investing career. So, he developed the three-legged stool strategy as a way to divide his investment holdings into different “buckets.” Each of these buckets had advantages that would help hedge against the three economic challenges he worried about most:
Leg 1: Inflation Hedge
Leg 2: Deflation Hedge
Leg 3: Uncertainty Hedge
I’ll unpack and explain each one below.
Leg #1 – Deflation Hedge
The first leg of the stool is a deflation hedge. These investments would do better if the overall economy (or your local market) experiences a dramatic drop in values (i.e. a depression or deflationary cycle). The investments that fit this category are free and clear (no debt) income generators, which include:
- Rental houses in the middle price range of the market with solid leases (i.e. high credit tenants)
- Variable rate private mortgage notes secured by excellent real estate
Median Priced Rental Houses
Rental houses in the middle price range of a market have the most available renters and buyers. This means they are more in demand.
Luxury housing, on the other hand, faces high vacancies when their tenants lose their jobs or try to cut costs during a bad economy. And low-end housing, while still affordable, can experience high turnover rates because tenants in this price range typically have little financial cushion for bad times.
The lack of debt would give you flexibility to renegotiate terms, lower rents, or execute trades in exchange for rent (ie: handyman services for rent).
You may have noticed on this blog that I’m a big fan of getting at least a portion of your real estate portfolio free and clear of debt. In addition to simplicity and increased cash flow, this reduction of deflation risk is one of the primary reasons.
Variable Rate Private Mortgages Notes
Variable rate mortgage notes are loans that are secured by real estate. Basically you become the lender for other property owners.
The variable rate means the interest rate could rise or fall depending on the overall market. But you could accomplish the same thing by only loaning money over short periods of time. If the borrower has to pay you off in 1-5 years, you’re essentially forcing them to borrow at the interest rate at that time. You, as the lender, stay in control.
Leg #2 – Inflation Hedge
The second leg of the stool is an inflation hedge. These investments should do a good job of keeping pace with rising prices in an inflationary cycle. The investments that might do best in this environment are:
- Highly leveraged, demand property encumbered by non-recourse, fixed-rate, assumable loans
- Variable rate private mortgage notes indexed to the inflation rate by way of variable interest, short terms, and/or shared appreciation clauses
- (my addition) Publicly traded stocks (my preference – low-cost index funds)
Highly Leveraged, Demand Property
Why highly leveraged real estate? Because with rapid inflation, the dollars you use to pay back debt in the future will be worth much less than in the past. It’s like you are only paying back $.50 when someone originally lent you $1.00. This is very profitable for you as the borrower (but not the lender).
But not any leverage will do.
Fixed rate mortgages keep your largest expense, interest, the same even while your rental income goes up. This can create huge cash flow spreads over time. So, you want to avoid borrowing with short-term balloons or adjustable rates.
And if possible, borrow only non-recourse, assumable debt that gives you more flexibility and protection as the borrower. In case you are wondering, the primary place to get this attractive type of financing isn’t from traditional sources like banks. Instead, you’ll need to explore seller financing and private lending.
Also only borrow against demand real estate. This type of property gives you the best chance of raising rents to keep pace with overall inflation. Demand just means something that most customers want, which for my portfolio usually means well-located single family houses or smaller multi-family properties in established neighborhoods.
Mortgage Notes Indexed to Inflation
If you do plan to loan money and own private mortgage notes during inflationary cycles, make sure they have short terms or that the interest you earn is pegged somehow to rising prices with adjustable rates. This is why conservative banks insist upon short-term balloons and adjustable interest rates. As a lender (unlike as a borrower), you may want to do the same.
Publicly Traded Stocks
Owning a stock means you own a piece of a business. And owning an index fund (like VFINX, Vanguard’s index fund of the largest 500 U.S. companies) means you own a piece of those 500 U.S. businesses.
In the past, the collective effort and intelligence of the largest businesses in the U.S. have beat inflation by a large margin over the long run. This doesn’t mean owning stocks will beat inflation during any given shorter period, but it’s certainly promising as a long-term strategy.
And for those heavy into real estate (like me), increasing your share of stocks provides more safety through diversification. I personally do this through my retirement accounts (IRA and Roth IRA).
Leg #3 – Uncertainty Hedge
Finally, a third leg of the stool should give you flexibility in any fast-changing or unpredictable circumstances. Ideally these investments should be extremely liquid. And if possible, they should not correlate with investments in the other buckets (i.e. if one goes down, the other goes up). Investments that fit this category are:
- Cash in FDIC insured savings, money market, or certificate of deposit accounts
- Highly discounted, high yield mortgages notes
- Gold or precious metals
- Mid-term bonds (to highly rated borrowers)
Cash in FDIC Accounts
Cash in a government insured account is extremely liquid. You can write a check or withdraw the funds as needed. This can be handy in uncertain environments when you need money for problems or opportunities.
Of course the challenge with cash is that it produces little or no returns. So, you want to balance this allocation with other investments that can produce a higher return.
Highly Discounted, High-Yield Mortgage Notes
In the real estate business, some investors buy or create discounted mortgage notes. This means, for example, they invest $60,000 in a note worth $100,000.
In uncertain environments, these discounted notes could be traded or cashed in rapidly at a discount. And while waiting, they still produce nice income yields that you can live on or reinvest.
If you’re interested in learning more about buying or creating discounted notes, you can get the basics with my article on BiggerPockets – “The Beginner’s Guide to Building Wealth With Private Notes”.
Gold or Precious Metals
This is not my area of expertise. But conservative investors whom I respect, like Darrow Kirkpatrick at CanIRetireYet.com, allocate a portion (currently about 5%) of their portfolio to precious metals like gold. You can see his entire portfolio here.
According to Darrow in “Should I Buy Gold?“:
“Many advisors label gold as a poor investment, or not an “investment” at all, because it produces no income. But that’s a narrow view in my opinion. The fact is that gold has historically been one of the asset classes least correlated to stock prices. When stocks have gone down, gold has gone up, and vice-versa.”
So, for Darrow and many other investors, gold is a hedge against the volatility of other investments in his portfolio. And this is especially useful in times of great uncertainty.
Mid-Term Bonds to Highly Rated Borrowers
This is another category that I don’t have much experience with. For most investors, it means investing in 5 or 10-year U.S. Treasury bonds. The logic is that U.S. Treasury bonds have a very low risk of default, so they act as a hedge to economic uncertainty. Mid-term U.S. Treasury bonds are also very liquid and produce a small interest rate, so they share qualities with CD accounts.
Three Legs = Solid Foundation During Unpredictable Weather
In the future, both economic storms and sunny weather will come and go. But it’s hard to know when or how the weather will change. Therefore, the only logical approach is to prepare for everything.
That’s what the three-legged stool has been about. It’s one way to remain prepared and flexible for an uncertain economic future.
If a depression or deflationary cycle comes, you’ll have part of your portfolio still producing income while other highly leveraged investors lose their properties to bank foreclosures.
If high inflation comes, your largest cost (interest) will be fixed. This creates a growing, profitable spread between rising rent and your fixed mortgage payment.
And whatever uncertain events come, you’ll have the liquidity to pivot and change quickly. This will help you to avoid problems and seize opportunities.
What do you think about the three-legged stool strategy? Are you concerned about any specific future economic challenges? How do you plan to hedge your investments to compensate for that concern? I’d love to hear from you in the comments below.
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