Investing in real estate is in vogue these days. Everyday, I come across more and more investors who are looking to get started in building up their own real estate empires. That’s a wonderful thing, and I’m totally for that!
Unfortunately, buying in today’s market isn’t quite as easy as it was just two years ago. Or even last year, for that matter. Purchase prices have been increasing steadily… along with interest rates. That’s a double whammy! Add in the fact that there are less and less short-sales and foreclosures out there, and the odds of a novice investor jumping in and landing a smoking deal are slim to none.
The pros will ALWAYS find their deals… in any market, and in any environment. That’s why they are the experts in the field. Many of these professionals have access to networks and capital that the rest of us can only dream of.
If you are just starting out, odds are good that you are simply trying to locate something worthwhile off the MLS. Or, if you are trying to purchase out-of-state because your local market returns leave a lot to be desired, you’re probably looking at using a turnkey company.
In any event, you probably want to invest in a rental property to help generate semi-passive income. When times are good and the market is rising, you have to remember to be extra careful. As the old saying goes, “when others are greedy, you need to be extra fearful.”
These days, I am very fearful. Here are some things you can do to help mitigate risks in a surging real estate market:
Refuse to Overpay
In my own local market (Bay Area), we’ve witnessed a buying frenzy these past three years. Investors have been going crazy, bidding up prices on EVERY home, no matter how undesirable the living conditions are. These investors seem to be so hell bent on winning a bid that they will pay ANYTHING!
Please don’t lose perspective, in spite of what other people around you may be doing. A lot of these investors (foreign) have tons of cash to play with. To them, overpaying for a home is no big deal because they have plenty of $$$ to spare.
If you are still stuck in the rat race, I’m guessing the same does NOT apply to you. As part of your due diligence, always make sure to run your own numbers analysis to determine whether or not it makes sense to bid up a property.
Here is an example of the going rate for a 2/1.5 townhouse in Santa Clara (this is the listing price as of March 17, 2014. When all is said and done, don’t be surprised if there is in fact someone who “overpays” even more for this property:
Here’s what the numbers would look like if you won at listing price:
There you have it! Once you factor in 8% for Property Management, 5% for vacancy, and 10% for maintenance, the cash flow numbers don’t look so pretty. In fact, the numbers are NEGATIVE, so you should probably be worried. 😉
When looking at investments, I always run a Doomsday Scenario — If the market crashes, assume that the investment property loses half its value instantaneously. That means that you cannot head to the exits… Further, assume that you lose your job because layoffs will be running rampant in a downed economy. Can you still make ends meet? In the above scenario, if you are -$500/month in cash flow, that would be impossible. When the market tanks, you should probably even assume that the monthly rent you charge will have to be reduced.
The above investment property would get you in trouble real quick. The only folks who will invest in such a property are again the ones that have too much cash sitting on the sidelines… These people can afford to take risks… They are most likely playing the appreciation (speculation) game.
But if you don’t have tons of cash to just toss around for fun, don’t speculate. Instead, ignore what everyone else is doing around you. Don’t fall into the hype. If the numbers don’t work, move on and find another investment property where the numbers do work. If you still insist on playing with fire, though, don’t be surprised if you get burned.
Put More Money Down
Let’s say that you ONLY want to invest in prime real estate. That is, you won’t settle for C neighborhoods, and you NEED your properties to be located in fabulous locations.
The above example fits that bill. The property is located in Santa Clara, in the heart of Silicon Valley. You could literally post a Craigslist ad in the “for rent” section and have 10+ offers that very night.
There’s a reason why properties in Silicon Valley are so overpriced. The demand to live here is exceptionally high! Job growth/prospects are among the best in the country.
But like most things in life, you can’t have it all. Silicon Valley will get you almost everything, except cash flow. However, if you are willing to sacrifice cash flow today for the opportunity to own prime real estate, you can do so while still reducing your risk.
The above example shows that the cash flow numbers don’t work for a traditional 25% downpayment. Again, if you are willing to accept reduced returns on your capital, you can make the cash flow numbers work by putting down a larger downpayment.
Let’s run the numbers again with 60% downpayment:
If you are investing in real estate to maximize your cash-on-cash returns, a 1.34% yield (today) probably doesn’t get you very excited. But if you want to invest for the long-term and speculate on appreciation while removing the potential for risks found in a Doomsday Scenario, putting in more capital upfront may be what you need to do. This way, even if the Doomsday Scenario were to manifest, you would be sufficiently cash flow positive to weather the storm.
There have been many successful real estate investors who have amassed tremendous wealth through long-term appreciation gains. Some are even willing to go cash flow negative for the first 5-10 years (I’m not one of them)… These investors do so because they believe that if they buy in the very best locations, the rents will either eventually catch up (very likely if you go with 15 or 30 year fixed mortgage), or they will be able to sell for a tidy profit somewhere down the line. This strategy can be seen as more risky, so you should only consider it if you are absolutely convinced that you are buying into the right location.
If you come across any investors who bought up houses in San Francisco 10-20 years ago, I’m guessing the odds are quite high that these folks are retired today… and very happy with their investment decision. 🙂
Now, is $265.74/month in cash flow really the best use for your $238,800 of investment capital? That’s for you to decide…
Keep the Appraisal Contingency
If you are scared of overpaying for a property, keep the appraisal contingency. With the appraisal contingency intact, you will always have the right to walk away from a deal, or renegotiate the purchase price with the seller.
When I purchased Rental Property #1, I made sure to keep the appraisal contingency in place. I realized that we were in an upmarket, and the probability of the property appraising were pretty low. As it turned out, I was right. The purchase price was $8000 above the appraised value ($315,000), so I told the seller I would walk away if they didn’t come down in price (I was bluffing).
When you get that far in the closing process, chances are high that the seller will want to close the deal with you ASAP. In other words, they won’t want to start the entire selling process all over again (especially when loans are involved), so as a buyer, you are actually in a better position of power than you might realize.
In my case, the seller was desperate to sell since she wasn’t from California and had already stayed around longer than she wanted. I used that to my advantage and it helped me secure a better deal. I’m very thankful I elected to keep the appraisal contingency, even though many others around me were waving it to make their offers look more competitive.
In a seller’s market, people do some crazy, irrational things. You have to keep your senses even if those around you lose theirs…
Invest In a Better Cash Flow Market
As the first example showed, cash flow in the Bay Area when using a conventional 25% downpayment is almost nowhere to be found these days.
Rather than fret about it, I’ve decided to move on and tap into other markets around the country that do offer the reward of positive cash flow.
Here are the numbers for Rental Property #5, which I won in February of this year:
The cash flow numbers for Rental Property #5 look a lot better than they do for the Santa Clara example above, don’t they? In fact, I could buy two of these Chicago properties for roughly the same downpayment… Instead of cash flowing -$500/month, I would realize over $1000/month… If passive income is the name of the game, then in today’s market, Chicago has the Bay Area beat, no question.
An a real estate investor, I believe in the following for an upmarket:
“When times are good, avoid the coasts. Instead, give the Midwest a toast!”
When housing prices start to appreciate, they almost always surge most rapidly in the highly volatile (expensive) areas. It really didn’t take long for the Bay Area to go from bust back to boom. I would say that 2011-2012 was the absolute bottom, and now that we’re in 2014, housing prices have basically recovered back to the 2006 peaks, and in many cases, even exceeded those numbers (all-time high now).
So, buying in high-priced regions no longer makes sense from a cash flow point of view. Why not move on and infiltrate markets that haven’t rebounded as fast?
My ultimate strategy is to actually make use of the vast deltas that exists between different markets… For instance, my Bay Area properties have appreciated about 40% since 2012… In an expensive market, 40% is a huge amount of capital gains (say from $315,000 to $441,000). But in a cheaper location, a 40% gain on a $90,000 house still only raises it to $126,000. So, why not take the extra ammunition gained in an expensive area and re-invest it into a cheaper market?
Buy low and sell high. A 1031 exchange will let you tap into any appreciation equity without the consequences of having to pay taxes. This will do wonders in helping you maximize on cash flow returns.
Negotiate Purchase Price or Concessions
Always remember that buying a rental property involves two parties — buyer and seller. Any piece of real estate is negotiable. Even in a seller’s market, you should have room to talk down the purchase price. If the seller you are considering working with won’t budge, you can always move on and try someone else.
In the end, the return on investment must work for you. If you can’t negotiate on purchase price, try getting the seller to throw in some concessions. If your inspection reveals out-of-date mechanicals (e.g. water heater, roof, furnace), get the seller to either replace it with a brand new one, or return back closing costs for future replacements.
When it comes to turnkey properties, I’ve often tried (and succeeded) in getting the seller to throw in perks such as: 1 year rent protection guarantee, 1 year maintenance guarantee, seller paid closing costs, seller paid for insurance policy for 1 year, etc.
It doesn’t hurt to ask. But if you don’t try, you won’t gain an inch. Especially in a seller’s market…
Shop Around and Be Patient
If you are having trouble finding good deals, sometimes the best move is the one you don’t make. When the numbers don’t work, it may be a better idea to shop around (different markets, or different strategies such as MLS, turnkey, distressed, etc.), or to simply remain patient, instead.
You should never feel like you have to make an immediate move. Real estate is cyclical in nature, and what goes up will eventually come back down again. It always does.
If you aren’t having much luck finding solid properties on the MLS, or through a turnkey seller, you might need to sit tight and wait for a distressed opportunity to come along. Having ample cash will make it easier for you to get in on these type of deals. If you can locate a seller desperate to sell, and provided you have the cash needed to close quickly, your odds of finding a good deal are high, even in an upmarket.
Also, remember that owning property is very different from owning stocks. Rental property is very illiquid, and can be rather difficult to sell. Sometimes it takes months to unload a property… and you will be out a lot of money in closing costs. Selling isn’t trivial at all, and you will owe a lot more than just the $4.95 transaction fee your stock broker would charge you. So, it’s very important you take your time to ensure you buy right, the first time around.
Real estate investing in an upmarket inherently involves more risk. The cash-on-cash returns, or return on investment (ROI) are not as high as in a downmarket. You have a lot less margin for error, so it becomes much more important to buy right. In a seller’s market, it is routine for properties to sell for above their appraised value. People get greedy, and can become highly irrational! Just like with stocks, when times are good, you will always have the speculative buyers who enter the fray, inflating prices even further uphill. It’s all fun and games until the music stops… then it isn’t. Bottom line, if the cash flow or ROI do not make sense to you, don’t buy. Always perform your due diligence, and take your time in thoroughly evaluating an investment opportunity. If you utilize the strategies above, you can reduce your risks in a rising market. For these reasons, you won’t see me investing in any Bay Area properties anytime soon… that is, until the next market correction.