Remember the 2001-2006 years, when everyone was buying houses? Conventional wisdom at the time said you should buy before prices got much higher. Housing values skyrocketed and loans were given away like candy on Halloween.
Everyone was making money—until they weren’t.
By 2009, the music had stopped and the same people who were excited about buying were starting to get a little worried about holding. By 2010, those “smart” people were looking pretty stupid. Foreclosures dominated the marketplace, for sale signs sprung up everywhere, and the economy went from soaring on the wings of eagles to a pure nosedive into peril.
Now it’s 2018, and things are starting to look a little familiar in some markets. Where I live in the San Francisco Bay area, homes have been consistently selling over asking price for years—until now. An increase in interest rates caught buyers off guard, and many have checked out of the game until they can stomach the new normal of rates over 5%.
While the Bay Area market may have cooled, many markets across the country are still rising in price faster than rents can support. It’s so bad in some places that the local investors are left shaking their heads at how much an out-of-state investor is willing to pay for traditionally conservative value neighborhoods.
So, what should you do? Should you buy now before prices rise, or wait to see if there’s going to be another crash coming? Are we in 2012, when prices had just begun rising again—or is it more like 2005, when they were at their peak?
If you want to make the best decision, you have to consider all the facts. Before I make a black or white suggestion, let’s take a second to consider several market factors, strategies, and possibilities. There just may be a way to invest now and still be primed to take advantage if the market crashes later. I always recommend looking for ways to have our cake and eat it too when possible.
Are We at the Top of the Market?
When we say the word “bubble,” we are typically referring to an unrealistic, unsustainable value in an asset class we can’t reasonably expect to continue. In 2005, home values weren’t based on affordability; they were based on horrible loans that allowed people to borrow much more than they could afford. When those loans reset, nobody could pay them, and the market was flooded with foreclosures.
Today’s market is different. My day job is as a real estate agent, and so far, I haven’t seen any of these dangerous, adjustable loans that were prevalent during the last bubble. The majority of today’s loans have fixed rates, 30-year terms, and are based on a reasonable portion of the buyer’s income. Of course, home prices have risen since 2006, but so have wages! People often complain about how expensive housing is, but when is the last time you heard someone complain their job is paying them too much? Wages have increased right alongside home prices. If we are going to complain about real estate prices, we have to be fair and acknowledge wage increases as well.
So, are we in a bubble? In some areas, possibly. Does that mean we are headed for a crash like 2010? In order for a housing collapse, we’d need to see something more like overall recession.
What could cause this?
- A hit to the job market (tech bubble collapsing)
- A spike in interest rates to slow the economy (monitored and controlled by the Fed)
- A national disaster like a war (beyond any of our predicting or control)
If this happens, many asset classes are going to take a hit, not just real estate values. It may feel “safe” to avoid the real estate market, but where are you putting your money instead? The stock market? Bitcoin?
Are those assets guaranteed to be protected if the economy recedes? Don’t be lazy and assume just because home prices seem high it automatically means we headed to a repeat of 2005. It’s not that simple.
What If I Invest Now and the Market Crashes Later?
This seems to be every investor’s worst fear, and let me tell you, it’s slightly annoying to hear all the time.
If you invest too early and the market crashes later, you’ll be kicking yourself when homes are cheaper. If you wait for the market to crash and it doesn’t, you could spend years not making any financial progress. I’ve heard people saying the market is about to collapse for five years now. Meanwhile, it’s just trucking forward and growing each year. There is really no value in using the market as your excuse not to buy unless there are clear, objective, and sensible signs the economy is unhealthy and heading towards a correction.
Related: How I Landed a Solid 4-Plex in Denver, One of the Hottest Markets in the Country
This question also assumes real estate markets are the same across the country. They’re not. A “crash” in one area doesn’t always mean there will be a crash in another. Some markets are driven by specific economic factors that aren’t affected by the rest of the country. Example? Texas. In 2009-2010, when much of the rest of the country (CA, AZ, NV, FL, to name a few locales) was losing value, Texas went by relatively unscathed. The same goes for parts of the Midwest and South that tend to operate independently of coastal markets.
So what’s the solution? Should you buy now or buy later? Wait for a market correction or focus on a great deal instead? The trick is understanding why it is you’re afraid to buy now and miss out later. If you’re asking me it can be summed up in two words…
Opportunity cost is an economic term that refers to the price you pay when you miss out on one option in order to commit to another. In this case, buying house A can be a problem if you miss out on house B. If house B ends up being better (as in, you bought it after the market crashed and paid less), your opportunity cost would be the money you lost that you could have made if you’d waited for house B.
Think of it this way. Let’s say you have an opportunity to go work overtime at your job and make $200 or go to a concert that costs $100. Most people who go to the concert think it’s setting them back $100. That’s because they’re not factoring in opportunity cost. The reality is that concert is seeing you back $300—$100 for the ticket and $200 in lost wages you could have made while working. That $200 is your opportunity cost.
Many haven’t heard it called “opportunity cost” before, but they instinctively understand if they make one choice, they miss out on a better choice later. This creates the dreaded analysis paralysis that holds so many investors back. So how do you beat it? The BRRRR method.
What is the BRRRR Method?
BRRRR is an acronym that stands for “buy, rehab, rent, refinance, repeat.” It is the order by which you conduct the various stages in the “investment cycle” (my phrase) when you buy a rental property. When you BRRRR correctly, you can end up buying an investment property with zero money down. This often ends up resulting in a cash-flowing property that’s been fully rehabbed and sometimes puts more cash in your pocket than you put in.
How is this possible?
When you buy a house traditionally, you put a hefty down payment into it, then include money for closing costs and the rehab. The total of this money you’ve invested makes up your investment basis. This is used to calculate your ROI (return on investment). With the traditional model (non-BRRRR), there is always a heavy opportunity cost. If you put $35K down, pay $5K for closing costs, and have a $10K rehab, that’s $50K of your money you cannot invest anywhere else.
In this case, if the market crashes, you don’t have that $50K to invest in the down market, so your opportunity cost is high, as you miss out on the killer deal you could have got had you waited. This is the reasoning behind the “fear of missing out” that keeps investors from getting started investing in real estate. So, how do you overcome this? My solution is to remove the opportunity cost. If you can buy a property and recover the capital you used to buy it, what stops you from buying the next one too?
BRRRR-ing successfully is the way to accomplish this. In a hypothetical BRRRR deal, you would buy a fixer-upper property for $60K that needs $40K of rehab work. Throw in the same $5K for closing costs, and you end up with a total of $105K, all in.
At a loan-to-value (LTV) ratio of 75%, if the property appraises for $135K once it’s rehabbed and rented out, you can refinance and recover $101,250 of the money you put in. This means you only leave $3,750 in the property, significantly less than the $50K you would have invested in the traditional model.
It’s not too difficult to save another $3,750—and it’s definitely significantly easier than saving $50,000. This means you’ll have all that money to put into the next house when the market crashes. If you do this effectively, you can pull out even more money than you put in, growing your capital and the ability to invest in future properties.
Voila! No more opportunity cost.
How Do I Know Which Market to Invest in?
While no one has a crystal ball to tell you where the market will crash and when, there are some pretty standard metrics you can use to hedge your bet against a crash.
You want to avoid any area that is dependent on one employer or economic driver. Detroit is a great example. When the auto industry failed, so did all the home values. With no one able to find work, all the rentals went vacant (and so did everything else). Other examples would be North Dakota (oil dependent), an area known only for tourism, or a coastal village in Alaska that is completely dependent on fishing.
C-Class or Better Neighborhoods
Real estate investors tend to evaluate neighborhoods like school grades. A-class properties are the best spots in town, B-class is where the upper-middle class lives, C-class neighborhoods are your average areas with lots of renters, and D-class properties are problematic with high crime and high vacancy rates.
You want to avoid anything less than a C-class neighborhood. By investing in nicer neighborhoods in economically diverse markets, you avoid the worst of the negative factors when a market turns, and you’ll be able to ride out the storm. For more information on how a property is classified, ask a local top-producing real estate agent or property manager.
If your property cash flows (brings in more income than it costs to own), it doesn’t really matter what happens to the value. If prices drop, that doesn’t impact you unless you sell. Experienced investors buy properties that produce income—and only experience price appreciation as icing on the cake.
Related: 6 Deal-Breakers that Disqualify a Market for Real Estate Investment
Look for properties in areas that meet the 1% rule. If a property will rent for 1% of the purchase price every month (a $100,000 that rents for around $1,000 a month), it is very likely to cash flow positively. If you focus on buying in areas like this and avoid bad neighborhoods and non-diversified economies, it won’t matter what the market does. Your investment will be safe.
If you’d like more information about these concepts, check out my book Long Distance Real Estate Investing: How to Buy, Rehab, and Manage out of State Rental Property. Don’t wait to buy real estate—buy real estate and wait!
In Long-Distance Real Estate Investing, real estate investor and police officer David Greene shows you exactly how he’s built a multi-million dollar portfolio on blue collar wages buying out of state rental property without ever even seeing it. Check out this read, available today!
How do you view current markets? Will you be buying up rentals in your locale?
Let’s chat below!