Is It Safe to Invest in Real Estate Right Now? 7 Ways to Mitigate Your Risk
I began 2020 with the goal of increasing my portfolio holdings by over 30% and gaining hundreds of dollars of additional passive monthly cash flow. We are now nearly six months into the year and entering month three of the pandemic. Like many of you, I’m wondering if my annual goal is even relevant right now. Moreso, I’m wondering if it is even safe—or responsible—to invest?
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I sat with this question for a few days back in late March. I didn’t really have much else to do, since my daughter’s spring break was canceled, and I hadn’t realized I’d need to learn to cut hair yet.
I went back to basics and combed through my financial foundation plan for “cracks.” I even went through my financial growth plan to plug my money “leaks” that had crept in over time. My answer to this question (one that I know many of you are wrestling with) was that now can be a great time to invest in real estate—if you are doing so smartly and from a position of strength.
Let me help you bust the myth that now is a horrible time to buy and help you get the right mindset and plan in place to move forward and scale safely.
Your 7-Point Checklist for Investing
What you want to do is stack as many investing cards in your favor as possible. Get back to fundamentals, if you will.
First and foremost, ensure you are abiding by the four tenets of conservative investing (capital preservation, cash flow, appreciation, and tax benefits), as well as identifying solid growth markets that yield cash flow and are poised for modest appreciation.
However, as you move through the following months, there are a few additional considerations to include in your underwriting and due diligence process.
1. Lower ARV—Especially in a BRRRR Project
Go into this year calculating a 10-15% discount in ARV projections during the refinance phase of the project. That doesn't mean that prices will drop (they may even go up!). However, if you have stress-tested your financial model, acknowledge that the market could soften by the time you are ready to refinance your project, and leave a little capital in to complete the deal, you will have far fewer surprises.
2. Higher Vacancy During Your First Year
The current vacancy data from any property manager is from a pre-COVID environment. If you go into the first year underwriting 25-30% higher vacancy rates, screen your tenants for income and employment, and carry adequate reserves to weather this storm, you will be well-positioned to carry your investment through this tumultuous time.
3. Lower Market Rents
If you are putting a unit into service (say, with a BRRRR), you want to ensure you have room within your rents to remain competitive in the market. This isn’t the time to do an infinite return deal with only $10 cash flow (on a good day). Stress-test your rent underwriting to be 10-15% under the market rents.
This doesn’t mean rents will soften this much, but you will be able to sleep far better at night if you know that your business plan still works even if you have to bring down rents for a few months. You can also consider doing shorter leases with the lower rents and re-evaluate the market in six to nine months.
4. Lower Rent Growth
Vacancy is your No. 1 income killer. If you have an occupied unit, ask yourself if it makes sense for you to risk a turnover for a 2-3% rent increase.
For me, I have seven units turning this summer, all with great long-term tenants. It didn't make sense for me to risk a turn for $30/month by the time I factor in turn costs, lease-up fees, and the unknown financial situation of the next tenant. Therefore, we renewed three of the seven at their current rents (four others are pending for late summer) and will continue to evaluate this plan throughout the summer months.
5. Construction Budget
As we move through this market, think about keeping expenses low and more cash in your pocket. Cash on hand is vital for your business.
Can you pick up a property and hold off on the rehab for a year or two until everything stabilizes? Or can you do a smaller rehab to preserve cash and tackle larger items later?
For example, I have a unit that I planned to replace the HVAC in this summer, but it has two or three years of life left. Additionally, the new HVAC unit does not achieve a rent premium for me. Meanwhile, I have a second unit that needs carpet during a possible turn. Weighing the two CapEx items, I will complete the carpet replacement to capture my rent premium and delay the HVAC for a few months as I watch the rental market.
If you do decide to rehab, have a large contingency reserve to handle any cost overruns.
6. Expectations on Lending
If you need commercial lending to complete a BRRRR deal, it's well known that most commercial lenders aren't doling out loans currently. Those that are, are doing so cautiously with a much lower LTV and are lending to borrowers with up to 12 months of reserves and a proven track record.
Qualifying is not very feasible for a new BRRRR investor who is on their first deal and can’t even do a conventional refinance.
As a result, you may find yourself in a situation where you need to partner with someone more experienced to get access to commercial financing. If you have a rock-solid deal, there are plenty of investors who would partner up (50% of a deal is better than 0% of no deal).
7. Multiple Exits
Just like in a pre-COVID environment, think about purchasing deals where you have multiple exits. For example, could you do a traditional flip, flip to an investor, BRRRR, buy and hold, wholesale, JV partnership, corporate rental, etc.?
Underwriting your deal for multiple exit possibilities will give you ultimate flexibility as you move through the next year.
Pulling It All Together
It’s a myth—don’t believe that you can’t invest in this market (especially BRRRR investing).
Will it be easy? Probably not. But it is definitely doable.
To wrap up, here are the seven ways to stress-test underwriting expectations:
- Lower your ARV.
- Lower your market rents for one to two years.
- Lower your rent growth for one to two years.
- Increase your economic vacancy for year one.
- Increase your contingency for construction, or possibly postpone the scope of work.
- Increase the need for lending reserves, or possibly bring on a partner.
- Explore multiple exit strategies to mitigate your risk.
As for my 2020 goals, will I hit them? Maybe. I’m not so naive to think that I won’t have to adjust them.
But am I continuing to make steady and calculated progress toward them? Absolutely!
Arming myself with a plan to mitigate my investing risk during this time of uncertainty is key to my confidence to continue to invest and build toward my dreams. What’s your plan?
What adjustments are you making to mitigate risk right now?
Share your thoughts in the comments below.