Real Estate Investing: The Exit Strategy

by FI Fighter on July 24, 2014

in Real Estate Thoughts

exit

There’s an old saying — “A rising tide lifts all boats.” In an upmarket (like the one we are currently experiencing right now), almost every single investor looks like a genius. You can literally put your money into any real estate purchase, and your investment will keep on going up!

Who knew flipping could be so easy? Just buy, hold… don’t fix a thing, and you can easily sell it back to the marketplace a few months later for huge gains!

Genius!

It’s all fun and games, right? Well, yes, until the market inevitably decides to correct itself again (like always!), causing your investment to come crashing back down to earth (reality). Ouch!

So, the time to worry isn’t after the unavoidable market crash… it’s while you’re doing your analysis work, prior to purchasing. If you want to protect your downside, you must carefully consider your exit strategy. What will you do when the going gets tough? Will your investments be able to weather the storm?

Can I Hold?

When doing any analysis work for potential rental property prospects, I always assume the following doomsday scenario:

A market crash ensues! My rental property is now worth half of what I paid for. I am potentially underwater and may owe more in loans than the home is worth! Further, my employer is downsizing and has decided to let me go. I am now unemployed and out of a job… Can I still make ends meet with my rental property investment?

I realize that there are many investors out there who invest in real estate primarily for appreciation/flipping (a proven strategy that has made many people filthy rich!)… The trouble with investing for appreciation, however, is that most properties that have strong potential do not cash flow very well… That, and it’s also extremely difficult (if not impossible) to accurately time the market, over and over again…

This is an oversimplified statement, but in general, most homes that have potent appreciation potential are also located in the best neighborhoods (Class A and Class B), where the top-notch school districts are found.

Unfortunately, rents don’t scale with purchase prices, and those same desirable homes generate the least (or negative) cash flow for a typical downpayment of 20 to 30%. Quite simply, too many wealthy homeowners will want to live here and are more than willing to pay a premium to do so!

For instance, if I was looking to purchase another rental in the Bay Area that had future appreciation potential, I might target the following townhouse deal today:

Santa_Clara_Prop

With conventional financing, I would find myself cash flow negative, right off the bat. In an upmarket, this probably wouldn’t be too bad because I would most likely have a day job to cover the spread, and the short-term appreciation would make me feel really, really smart! 😉

However, the only real exit strategy I would have with this type of rental would be to sell during that same upmarket. If the bull run were to suddenly halt, that same “instant equity” would vaporize in an instant. Without positive cash flow to tide me over, I could easily find myself in a most precarious situation!

Quite frankly, because there is no margin of safety (positive cash flow) for this type of investment, this is the primary reason why I am no longer investing in the Bay Area today… sadly.

*Of course, if you are paying all cash (or putting down a more sizable downpayment), then that’s a whole different story!

So, when in doubt, don’t purchase any rental properties that do not cash flow from Day 1! I haven’t purchased a rental property in a few months, but here is the cash flow analysis I used for Rental Property #5:

chicago_returns

As you can see, Rental Property #5 cash flows, even after setting aside 20% of the gross rents for reserves (vacancy and maintenance).

There are no hard and fast rules, but when I am purchasing out-of-state rentals for cash flow, I typically look for over 10% Cash-On-Cash Return (this includes allocation of funds for reserves).

Although owning rental properties will never be risk-free (especially when utilizing loans), if you buffer aside sufficient margin, you should be able to weather any economic storms that may arise during the life of the investment.

With enough margin in place, not only will you be able to withstand a sharp decline in home equity, but you should also be able to lower rent by a few hundred dollars each month and still have the property produce positive cash flow… That way, even in the worst of times (say you have to advertise below market rent to find a qualified renter), you should still be able to locate a good, paying tenant.

Can I Sell?

What’s the most desirable asset class when it comes to property?

Single family homes (SFH).

Most everyone wants to live in one, whether you’re a renter or homeowner. Single family homes are usually located out in the quiet suburbs, away from all the noise and crowds of the inner city, and close by to the nice school districts.

As such, single family homes will usually be priced at a premium (relative to other townhouses, condos, duplexes, etc.), and produce the least amount of cash flow.

However, if you can locate a SFH that cash flows sufficiently, it may be worthwhile to accept a lower ROI…

When it comes to exit strategy, SFHs will trump any other property type… They will always be the easiest to liquidate and sell!

Here are the numbers for Rental Property #1, a SFH:

Rental_1

The Cash-On-Cash Return of 6.82% is far from being high (no allocation for vacancy, maintenance, or PM either!), especially for a cash flow generating property. However, in this case, I was more than happy to sacrifice returns to get into a SFH in the Bay Area.

With Rental Property #1, I do not worry much about my exit strategy. It is located in a great location, features a large backyard, and is the type of property emotional homebuyers will gladly overpay for during the peak summer months. In a downmarket, such a property should also retain its value (less volatile than the cheaper investor grade townhouses, condos, etc.) and experience less overall fluctuation. Although no property is fully immune to the whims of Mr. Market, highly coveted properties, such as this one, will always retain a higher value since prospective homebuyers will always be knocking on the door, rain or shine.

So, although my properties in Chicago produce much higher Cash-On-Cash Returns, I would not be so quick to dismiss Rental Property #1 as being an inferior investment. Exit strategy is an extremely important component that must be factored in when doing any analysis work!

After SFHs, we have townhouses and condos which can also be relatively easy to sell, provided they are located in good enough locations. Once you start getting into multi-family units and apartments, the investments naturally become more illiquid; only other investors operate in this space.

For instance, Rental Property #3 and Rental Property #5 are 2-flats (duplexes) located in South Chicago. I invested in these properties primarily for cash flow. In this particular market in Chicago, most people rent, anyway, so the owners are pre-dominantly investors. Should I ever elect to sell either property in the future, most definitely, I would be selling back to another investor… More likely than not, any potential buyer would also be extremely savvy and know how to run proper cash flow numbers!

My exit strategy in Chicago is more hazy, and less certain than with my SFH and townhouse in the Bay Area. And like most things in life, there are no free lunches! These are some of the risks you take when trying to balance out ROI and exit strategy. Realistically speaking, I would not anticipate being able to sell the 2-flats back to the market for a tidy profit. No, there would be no emotional homebuyers swooping in to overpay for these properties…

Of course there’s nothing that precludes you from crafting your own portfolio — a few SFHs here, some 2-flats there, an apartment complex sprinkled on top, etc. Just make sure you factor in the sellability of your investment before you jump in with both feet!

Can I Deleverage?

Leverage is a double-edged sword that cuts sharply in either direction. When times are good, leverage can be your best friend and help catapult you to newfound riches. However, when times get rough, leverage acts more like a poison pill that slowly erodes away your wealth.

Always be careful when using leverage!!! Yes, I owe close to $800,000 in loans, but each one I took out was thought out beforehand. 😉

When factoring in for exit strategy, I consider many things, and an important one is the size of the loan.

Going back to my Bay Area property, Rental Property #1 produces the lowest Cash-On-Cash Return, and also carries the largest loan amount ($236,250) of all my properties. As mentioned previously, though, it’s also a SFH that’s located in a very desirable location. As such, I am more than comfortable taking on this sizable loan because I trust my exit strategy.

Ditto for Rental Property #2, which is a townhouse located in a Class A neighborhood. The loan was initially $232,000, but the unit cash flows decently, and should be easy to sell, if necessary.

With out-of-state investing, I also happen to own a SFH in Indianapolis, IN. The loan on Rental Property #4 started out at $64,500. In comparison to my Bay Area rentals, this loan is minuscule!

And that was precisely intended… At the time of purchase, I had no previous experience with owning rental properties in Indianapolis, and didn’t want to take on too much risk… So, I found a property that cash flowed over 10%, was a SFH located in a good neighborhood (easier to sell), and lastly, I took on a tiny loan.

The size of a loan is relative, of course, but I reasoned in my mind that this Indianapolis loan was nowhere near daunting, and one that I should be able to pay off in one fell swoop, should the need to do so ever arise.

Just my own strategy, but I elected to take on the largest loans in the market I trust the most (Bay Area)… I own more properties out-of-state, but the combined loans of all those properties equates to less than what I owe in the Bay Area.

Summary

When looking for potential rental property investments, many investors will fixate on ROI alone. Unfortunately, ROI does not tell the entire story, and it is also extremely important to consider your exit strategy when planning. We all want to hit a home run on every single one of our deals, but that isn’t always possible, so it’s prudent to also work out a gameplan to handle the downside of things. Further, any bear markets or corrections that occur in the future will always be beyond our control! So, we must plan carefully, and know in advance the course of action we will take… Will we continue to hold? Sell? Will it be possible for us to deleverage?

When times are good, an exit strategy might be the farthest thing on the mind of a prospective investor… However, careful planning of an exit strategy may one day prove to be the most important homework assignment we could have done during our analysis.

Happy investing!

{ 16 comments… read them below or add one }

1 No Nonsense LandlordNo Gravatar July 24, 2014 at 7:02 am

Any investor that buys with a negative cash flow, is not an investor, they are a speculatior…

Start looking at multifamily properties. You are competing with too many people that will pay a premium to live in the higher rent districts. Look for areas that an ‘average’ family can afford, and get in top quality renters.

There is no one answer. There are deals everwhere, but it depends on how much you can afford, and if you know how to structure the deals.

Reply

2 FI FighterNo Gravatar July 24, 2014 at 9:26 pm

Eric,

Yeah, count me out from buying cash flow negative properties… too much risk and speculation on prices going up…

Multi-families are great… I’ve been looking into some in the Bay Area, but those start at a cool $1MM+…

Maybe out of state is the answer? I do have a few 2-flats in Chicago…

I’m still building up cash right now, but your right, there are still deals out there… just gotta keep the eyes and ears open.

Cheers!

Reply

3 Ross LukemanNo Gravatar July 24, 2014 at 1:39 pm

This article was fantastic! Thanks for writing it.

Reply

4 FI FighterNo Gravatar July 24, 2014 at 9:27 pm

Ross,

Thanks!

Reply

5 jeffNo Gravatar July 24, 2014 at 2:13 pm

Interesting article, but I would like to point out that many people looking for real estate deals considering putting 20-30% down on a place to be “forcing” cash flow into the property via the down payment.

Otherwise, great article – I have been considering real estate, but the down payment is a pretty big barrier for me at the moment. I have considered pulling equity out of my primary residence (currently ~50% LTV) and using that, but dont really want to put the house at risk

Lets see if I get tossed in spam here too.

Reply

6 FI FighterNo Gravatar July 24, 2014 at 9:29 pm

Jeff,

No more spam filter! Sorry about that 😉

You have a point there about forcing cash flow with a downpayment… That is true, and in most cases, very necessary with real estate… Since most lenders require 20 to 30%, I went with those figures…

Even though the barrier to entry can be much to get into REI, the cash-on-cash returns can still make it attractive… In many parts of the country, it’s very possible and easy to locate 10%+.

All the best!

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7 Asset-GrinderNo Gravatar July 24, 2014 at 4:50 pm

Real estate is often a tough call to sell or hold. Generally if I have big gains I will take and run but if a property has a great income I would prefer to hold. Real estate is fickle with market timing so a few times I get nervous and cash out my gains when I have a chance. Unlike stocks Real estate is often not very liquidable and I have been caught with a lump in my throat with a million dollar plus property not selling. It aint pretty!

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8 FI FighterNo Gravatar July 24, 2014 at 9:30 pm

Asset-Grinder,

I don’t blame you for taking the big gains off the table… no one ever went broke from taking a profit! 🙂

I was debating that myself, but I like the long-term prospects of the Bay Area, so I’m planning on holding for now…

Real estate can be very illiquid, but if you own a desirable piece of property in a strong demand location, it can also be surprisingly easy to rent/sell. The hard part is finding returns in these parts…

Take care!

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9 A Frugal Family's JourneyNo Gravatar July 24, 2014 at 9:29 pm

Great article FI Fighter…very informative! Thanks for your insight.

We have not gotten into real estate but hope to eventually grab one or two prior to retirement as supplemental income…and possibly a away of keeping me busy. 🙂

AFFJ

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10 FI FighterNo Gravatar July 24, 2014 at 9:34 pm

AFFJ,

Thanks! Glad you found the article useful.

I’m a huge fan of diversification, and think real estate can complement any strategy. With that said, I think it’s important to consider more than just ROI… especially if someone is just starting out and doesn’t know for certain if REI is the right path for them. Planning an exit strategy that would allow for a swift exit might save a lot of headaches in the future.

All the best!

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11 Stefanie @ The Broke and Beautiful LifeNo Gravatar July 25, 2014 at 5:55 am

There seems to be a common misconception that real estate investing is simple because it’s a given that the property will appreciate, and if times are tough, there’s always the rental option. Operating on these assumptions without making the calculations and seeking to understand the reality of cash flow is dangerous.

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12 FI FighterNo Gravatar July 29, 2014 at 8:59 am

Stefanie,

Yes, definitely, a lot of people got burned and learned the hard way that appreciation is not always assured. It’s important to buy with cash flow margin in place, in the event the market does correct or pull back significantly.

The numbers are easy enough to run, unfortunately not everyone does it before buying.

All the best!

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13 JC @ Passive-Income-Pursuit.comNo Gravatar July 25, 2014 at 8:46 am

I just started looking at some rentals again and found a great opportunity. Unfortunately I missed out on that one since they had received/accepted an offer before I got a chance to look at the property. I know the pictures are easy to manipulate but the numbers looked good on the low end of rent and awesome on the high end. But there’s no way I’m making my first rental purchase unseen.

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14 FI FighterNo Gravatar July 29, 2014 at 9:00 am

JC,

Yeah, it’s tough trying to resell property, so it’s definitely worthwhile to do due diligence… Seeing the property yourself is an important part of that!

I also can’t imagine buying my first property sight unseen…

Hopefully another great opportunity presents itself in the future, and you’ll be in position to snag the deal.

All the best!

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15 No More WafflesNo Gravatar July 27, 2014 at 2:40 am

Interesting and informative analysis, especially for someone who isn’t used to housing prices depreciating. How much does your housing market go up and down on average in a bull and bear market?

In Belgium housing prices have never, ever gone down since the second world war for more than 1% and for more than two consecutive years. A lot of people therefore don’t take into consideration that their property might depreciate, even though I expect a market correction in the near future since the government cut back its home owner subsidies.

Thanks for sharing!
NMW

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16 FI FighterNo Gravatar July 29, 2014 at 9:03 am

NMW,

Bay Area housing is pretty robust, for the most part. After the subprime housing bust of 2008, almost all homes across the country witnessed a sharp decline in prices. In the Bay Area, I would say most homes were selling for 50% less than their peak values… Lots and lots of discounts available between 2009-2012.

Wow, that’s crazy! I can’t imagine a market in which prices only go up! How affordable is it to buy a home in Belgium?

Take care!

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