Is It Time To Tap Out?
Quoted from a real estate blog: “I bought this duplex 3 years ago for $600k, and now it’s worth $980k! I love real estate! I want to do it again and again! I heard I can just cash-out refi and buy another property and keep doing that. This is GREAT!”
The person that wrote it is a card-carrying member of the AA; Accidental Appreciation Club.
There are a few weak points in this plan for a “rinse and repeat” strategy:
- No valid reason to buy except to gamble on appreciation
- Negative cash flow
- Herd mentality: buy high, sell low. “I can’t miss out on this real estate stuff—Suzy at the salon made $250K on her investment—I gotta get into this!”
- It all goes along great… until it doesn’t. Then what?
OK, I can pretty well hear the screams of “you’re so negative!” coming from some of the readers of this post. So I’ll explain my rationale for stating what is (for seasoned investors) the obvious:
A Tsunami of newbie ‘investors’
Happens every time the top is near—everyone wants to be in the game, but few have the knowledge, experience or financing to do it as they do on HGTV. Results: mixed. Sometimes they get lucky and join AA. Sometimes they are not-so-lucky and scrape along. And sometimes the soufflé just collapses. POOF. It’s a low percentage of people entering real estate investing that become successful at it for the long term. That’s not negative, it’s just the truth.
Sucking Out Every Dime of Equity
Which is greater, the fear of loss or the desire for gain? Usually, fear trumps all. But in this instance, both fear and desire are linking up to create a monster: “I am afraid to lose out on this deal/I really want to make money in real estate just like on TV!” So, as a member of AA, let’s pull out EVERY SINGLE DIME of equity in this big ‘payday’ we now have and go do it again. Everyone knows that if you leave any money in the property, you are underutilizing your capital and thereby losing out on the almost certain gains you will achieve from leverage. Remember this if nothing else: leverage is a two-edged sword. Want to know how to find the world’s best deals? Wait about 10 minutes after the bubble pops—the playing field will be pretty clear.
Ready, Fire, Aim!
Many ‘investors’ start getting trigger-happy at the end of cycles. They think they are playing with “The House’s” money. Nope, it’s the investor’s money, but a gambler is what a gambler does. It’s just so easy to follow the crowd—look over there—that guy just made $XXXK. If he can do it, why can’t I?” “I gotta jump into this pool quick!” Nope, not being negative, I’ve learned it’s best to check the depth of the water before diving in.
The FED, Interest Rates and Inversion
What happens in real estate when the cost of borrowing increases? Does the market value increase or decrease? Hint: it’s an inverse relationship—the higher the interest, the lower the market value, or at least a much lower rate of appreciation. The FEDERAL RESERVE BANK, which has absolutely nothing to do with the Federal Government, can crush our real estate market as well as our entire economy with interest rate increases. And there is absolutely NOTHING you can do to prevent that from happening.
Further, let’s look at the short-term/long term interest rate INVERSION. Normally the U.S. yield curve for government debt is upward sloping. As bonds mature further into the future so the interest rate typically increases. With inversion that relationship goes into reverse. When the yield curve is inverted, you earn less interest on a long-term bond, than on the short-term one. History shows the longer that inversion persists, the greater the chance for recession, and the longer and deeper that recession will be. The interest rates have been inverted for months!
So What To Do?
Plato once said, “you never go broke taking a profit”. Actually, I really don’t know if it was Plato, but they still are wise words. We all need to take a deep breath and realize that real estate investing is a marathon, not a sprint. Want to construct a building? Start with a good foundation. Get into long-term buy/hold properties that actually pay you to own them. Take care of your tenants because they are the engine that will power your money machine. Make each and every property you invest in stand on its own; don’t reallocate funds from high-performing property A to subsidize low-performing property B. Make B work for you, or cut it loose and move on to the next.
Real Estate Now and Forever
This business has been very good to me. I’ve been fascinated with it since I was a kid, and have never lost my passion for it. I also love helping other people along their real estate journey. Please feel free to PM me with any questions, comments or just to talk about strategy.
Absolutely - I saw a Facebook thread in a Financial Independence group just today about buying a condo in New Jersey, planning to lose money on a monthly basis, just to speculate on potential appreciation down the road.
The main area where I'm not clear what you mean is the Fed. Every day it seems like we get new speculation on where the Fed is going to go, and what interest rates are going to do. I'm not convinced anybody really knows what the Fed is going to do or where interest rates are going to go and when.
Thanks for the comment. To be clear, I mentioned the Fed to point to one more piece of a puzzle going askew. We have no way of telling what, if anything, they will do. We can only guess what it might be, and what the unintended consequences might entail. It's the element of uncertainty that must be recognized and respected.
No single factor should be able to topple the house. But when multiple forces start to align we disregard the signs at our own peril. (Wow, that sounded a bit ominous, but it's not meant that way. It's the natural order of cycles. Accept it will happen, plan and be prepared.)
@Marc Winter I like your "accidental appreciation club" comment. Sadly most people in this club are delusional and believe it was their skill that created the appreciation.
It is all about being honest. Know when you got lucky or unlucky. Know when it is time to take your chips off the table.
These high appreciation markets are also the ones that get hit the hardest in a down turn. I am not saying it is happening tomorrow or even in the next year, but economies do cycle. The future is hard to predict because it is always changing.