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!
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:
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:
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:
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.
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.