What happens if rental property value goes down?

41 Replies

Hello Everyone,

This is my first post on BP, as I just made my account a few moments ago, so please excuse me if my forum post is not formatted correctly.

I am looking to buy my first rental property around July 2020, however I am a bit reluctant because there is one scenario that kind of scares me.

Let's say I buy a rental house for $275,000 in July 2020.

3 years go by and as I am paying principal and gain equity on the house, I have accumulated, say, $30,000 equity on the house (sorry if this is not a realistic number, just for sake of example)

But let's say that the housing market crashes or takes a dip from 2020-2023 and the value of this rental home dropped in this time period from $275,000 to $195,000.

What exactly would happen to my equity in the property because of the drop in market value of the house? Also, would I still be paying a mortgage worth $275,000 if I did a 30-year-fixed mortgage back in 2020? Is this a realistic scenario, and would it even effect me negatively if at the end of the day if I am simply just trying to cashflow each month from a rental?

I know it is seen as trivial to try and time the housing market, but a scenario like this kind of scares me because I am young and inexperienced. But my question is, is this even realistic, and if it is, would it even effect me if I am just trying to cashflow off rent each month?

Sorry in advance for my ignorance on the subject and thanks in advance for guidance and consideration.


You wouldn't just have no equity but negative equity, however unless rents take a dive too the property would still cash flow, even if not as much as other properties that would be available. This happened in the 08 recession to quite a few people but that was an extreme event, could it happen? Yes. Is it super likely probably not, but nobody has a crystal ball on markets.

@Aaron K,

Thanks for the response. As a newcomer to real estate investing with limited funds, do you suggest that I just bite the bullet and go in on a property that cashflows in July 2020? Or should I wait till I see a drop in market value for homes in my area? I want to make the most financially advantageous choice, and I understand that there may be a decent amount of risk.

@Zeeshan Mallick equity is the difference between what you owe (mortgage) and the value of the property at any given time. However the value of the property is only truly determined when you get an appraisal, such as when you buy the property or sell it. So, if you are buying a property to hold long-term because you want the monthly income then the house price dropping shouldn't be a huge concern (long-term housing prices have pretty much always gone up, historically). However, if you're wanting to buy a property and then sell it for a profit just a short time later, then this is a large concern. The problem is, no one can predict the housing market (people have been calling a recession for years) so trying to bank on appreciation as an investment strategy is fairly risky unless you're in certain areas (California for instance).

Originally posted by @Kevin S. :

@Zeeshan Mallick equity is the difference between what you owe (mortgage) and the value of the property at any given time. However the value of the property is only truly determined when you get an appraisal, such as when you buy the property or sell it. So, if you are buying a property to hold long-term because you want the monthly income then the house price dropping shouldn't be a huge concern (long-term housing prices have pretty much always gone up, historically). However, if you're wanting to buy a property and then sell it for a profit just a short time later, then this is a large concern. The problem is, no one can predict the housing market (people have been calling a recession for years) so trying to bank on appreciation as an investment strategy is fairly risky unless you're in certain areas (California for instance). 

Kevin, 

Thank you, that clears things up for me. Because I will be using this property simply for monthly cashflow it seems like the rise and drops should not concern me. Thanks for the info. It is just a bit scary as a new investor to get my feet wet because every dollar means a lot right now; but I need to do it.

 

@Zeeshan Mallick although you'll be the one to pay the mortgage technically, it will be with money that your tenants earned and paid in rent. The only time decreased equity hits you in the wallet is if you want or need to sell. Your mortgage is amortized from the moment you buy it. Other than property taxes and insurance that can change, the Principle and Interest payment is set for 30 years regardless of what the market does. You can, on day 1, see how much principle you'll have paid off after 10 years of paying the set payment. How much equity you have is in relation to the current day appraised value....which only matters if you plan to refi or sell. Your tenants don't care and your mortgage company doesn't care. They keep paying rent and you keep paying the mortgage on the terms you agreed to at closing.

You don't want to overpay, of course, but if you live in a relatively strong and stable market (population growth over time, good employment numbers), rents likely will not drastically decrease even if home values do for a brief correction period. Many who lost a fortune in the previous crash were buying for appreciation only, leveraging homes to 100% loan to value, and were either not cash flowing at all or even bleeding money each month (negative cash flow). They hoped appreciation would make up for it and it didn't, so their house of cards fell apart. Many others who had bought smart, kept some equity in each property, and stayed steady for years before the crash simply held on through it. Sure, their equity dropped from 08-13 or so, but their tenants continued paying their expenses, paying principle down, and earning some cash flow. Maybe they didn't increase rents as much, maybe they had an uptick in vacancy, but they didn't sell and so they never 'realized' that loss since they didn't have to sell during a low point. Now values have come back up and their principle balance on mortgages is lower than it was 10 years ago.

Nobody can guess what the market is going to do for sure in 3 years or 5 years. But I can almost certainly guarantee that anything you buy next summer will be worth significantly more than you pay in the year 2050 when you pay off the mortgage. Buy and hold investing is a long term strategy not effected much at all by short term market shifts that historically always come back around.

Outside of the mortgage payment, you want to make sure to take into account Vacancy, Repairs (Smaller items that come up over time), CapEx (Capital Expenditures...big items like roofs, HVAC systems, etc), property management fees. Even if you self manage, run your numbers as if you hire a property manager so that if you decide to some day you've already planned on it. There's lots of great information on the forums about each of these reserves and how to arrive at numbers based on risk tolerance and the property itself, but my point is that you want to be sure to be setting aside some of the rent every month for these as well as to pay the mortgage. If, after accounting for all of these expenses, you cash flow a couple hundred a month....then you are earning money while your tenants quite literally pay down the mortgage. Mortgage principle pay down and appreciation are just the icing on the cake.

There are some more complex strategies and calculations involved in determining when would be a good time to refinance out additional equity for more properties, sell and exchange for other properties eventually, etc.  However, at it's core, you're buying something with a small percentage down that your tenants will ultimately pay off for you over the course of 30 years.

A great book to read to grasp the long term benefits of buy and hold investing is Building Wealth One House at a Time by John W Schaub.  There are much more aggressive and lucrative methods to build wealth faster and acquire more properties more quickly, but at it's core that book  is eye opening to the power of 'slow and steady wins the race'.  
  

Originally posted by @Kevin S. :

@Zeeshan Mallick equity is the difference between what you owe (mortgage) and the value of the property at any given time. However the value of the property is only truly determined when you get an appraisal, such as when you buy the property or sell it. So, if you are buying a property to hold long-term because you want the monthly income then the house price dropping shouldn't be a huge concern (long-term housing prices have pretty much always gone up, historically). However, if you're wanting to buy a property and then sell it for a profit just a short time later, then this is a large concern. The problem is, no one can predict the housing market (people have been calling a recession for years) so trying to bank on appreciation as an investment strategy is fairly risky unless you're in certain areas (California for instance). 

Even California RE values have peaks and valleys.  If you are betting on short-term market appreciation in So Cal, I would classify that as fairly risky. However, if you perform a value add then you can somewhat insulated against most depreciation cycles.

Buy n hold should be looked at as a long term strategy. Other strategies are shorter in term. Timing the market is tough to do and not absolutely necessary if you are planning a long term hold. In the long term, So Cal RE has appreciated more than inflation for at least 60 years.

If you do buy n hold, plan on holding the RE a decade or longer.  It would be a very rare depreciation cycle that lasts a decade (very unlikely).

Good luck

As others mentioned, your mortgage does not change on a 30 year fix if your property value goes up or down, all that changes is your “equity”. Additionally, unless rental rates drop too, your cash flow doesn’t go down either so as long as you had positive cash flow from the start, you will continue that. Eventually in 30 years you own free and clear.

Don’t wait but buy smart and don’t over pay for current market values. Find deals as only deals will likely cash flow in up markets.

@Zeeshan Mallick I won’t give advice, but I will give you a real life example that goes with your question. I bought a condo for $105k in 2007. This was my primary residence at that time.

Then the market crashed. I actually bought a second condo, same property, same layout, everything, for $49k as a rental. If you’re reading between the lines that means that the unit I bought at $105k was also now worth $49k. I had negative equity in the original property.

However, when I rented out those properties the leases were $900 / month. My mortgage, including taxes and insurance was around $575. Plus HOA of $125 my costs before repairs were $700 vs. rental income of $900.

Basically, even though I now had negative equity, I was still at positive cash flow. Not that positive, but positive. It was still a fine investment.

The one I purchased for $49k has always been a MUCH better investment, but as others have pointed out we don’t have crystal balls. If I knew the market would tank again I would suggest waiting. But if something cash flows now it is likely to cash flow going forward.

And if it matters, those condos now go for $110k. I’m thinking about selling the one that I bought for $49k, but I’m not sure I can find a better investment.

As long as rents don't nosedive and they aren't covering the mortgage anymore, Capex and other expenses, you will be fine and you ride it out with no issues.

The loss of the house value only comes into play when you sell it..... you will only incur that loss IF you sell it when it is worth less than you paid for it... until then, its only on paper.....

@Zeeshan Mallick I wouldn't try to time the market, you'll most likely sit on the sidelines during a market climb or try to catch a falling knife on the way down, if you invest for the long term the short term ups and downs shouldn't bother you too much.

Property values dropping are only a problem if you sell. Dont sell. You know who got burnt in the housing collapse? People who sold. You know who got rich in the housing collapse? People who didn't sell.

@Corey Hawkinson

coming up on the end of the year we were just looking at the returns on all of our properties and comparing one to another. Bottom line, there really is no comparison. I bought a condo for 13k back in 2009 or 10, it paid for itself in less than 2 years. What I’m getting at is the returns on the properties I bought back then are SO much better than some of the more recent properties. If you’re starting out now you just have to try and find a good deal, but I wouldn’t necessarily 1031 out of great deal unless I had a great deal waiting for me

@Zeeshan Mallick   Unless you are planning on selling it, it doesn't matter.  House prices go up and down.  If you hold it long enough, you should come out ahead.  I bought a condo for $96K, about 5 years later it could have sold for $84K, but that didn't matter as I wasn't selling.  Sold it about 15 years later for $245K.  

Even if prices go down a bit and you need to sell, you will have been paying down your mortgage (or your tenant will).  And if it is your house, then your money went to pay your mortgage and ultimately some equity instead of paying rent.

As real estate investors who began with buying foreclosures in 2010, here's my take on it. So many people lost their homes in the crash that there were MORE RENTERS, keeping rents up despite the recession. When things got better, rents settled (not dropping, but not rising for a while), and the values of our properties increased. Of course we mostly bought foreclosures at first, so they never dropped much. We do not worry about recessions or crashes in real estate. We do worry about our state -Illinois- taxing people so much that they leave in ever greater numbers, which will lead to both lower rents and lower property values. But recessions, no.

@Matt Higgins That’s exactly why I haven’t sold yet. I can’t find anything that would provide better cash flow. Long explanation coming...

The only hypothetical situation for me to consider would be if the 1031 would set me up better in the long term. Here’s an overly simplified version of what I mean, but keep in mind that I’m watering down the numbers too much. I realize loan principal payments don’t work like what I’m showing but it’s just to compare:

The condo I currently own cash flows $500 per month. The loan is $30,000 amortized over 25 years. Let’s call that a pay down of $100 per month. Let’s assume no appreciation on the property value. That’s an equity increase (cash flow + principal pay down) of $600 per month.

1031 hypothetical option: I sell that condo for $110k, after closing costs and paying that $30k loan my net is $70k to put towards another property. I add in $30k from my savings to put $100k down on a 4-plex for $400k. Loan is $300k. Although I can't produce the $500 cash flow per unit, let's say I only make $100 per unit or $400 cash flow per month total. However, the loan amortized over 30 years pays down an average of $800 per month. So now my equity increase per month is $1,200 instead of the $600 I'm currently receiving.

On paper that puts me in a better position and 5 years from now I can do another 1031 on that into something bigger and truly be closer to financial freedom. With all this said, I’m not currently pursuing this option because I can’t quite justify the added complexity instead of just keeping the cash flow from the condo. But this is why I’m debating it. On paper, I should expand.

I have been investing for 15 years and have never purchased a property where there was a probability of large declines in value...even prior to the last recession.  And forcing appreciation with property improvements can provide additional risk mitigation.

Only buy properties that cashflow and then if market fall you can just hold them until it recovers and still profit nicely.

@Corey Hawkinson

I had a guy call our company today looking for us to find him a 4 plex in the metro and have us manage it for him. Talk about low inventory and high prices at the moment.

The returns always look better with more leverage. Maybe just pile into high risk corporate debt & junk bonds??

Kidding, we are in the same boat. Im not going to buy a property in 2020, market has been too hot for too long , enough is enough, and there’s no need to take on more leverage......but, I’m working on a great deal if I can get the city to change the zoning, and I sure would like to defer some taxes with another cost seg if possible, and I could probably pull out all of my investment and get ridiculously good financing on the backend. So ya...

The other scenario obviously is that vacancy goes up, rents go down, and your loan is up for renewal. I would say if the numbers make sense on 30 year fixed financing it might be worth the shot.

Zeeshan, as other have probably said, and I just haven't gone through the thread long enough, nor do I care to, so apologies aforehand to others if needs be; there is a difference between cash flow and equity. I suspect your real concern comes in two questions as-a-practical-matter;

First is - when does a market correction (which effects equity) overwhelm equity, and;

Second is -- when does a market correction affect cash flow?

Let me answer the second question first, as it is a market timer's question, and one should be wary of trying to time a market for an exit (maybe not so much for an entry, but I can hear the doubters and they have valid point). A market correction will affect cash flow only when it is strong enough to bring down rents. Rents are sticky (section 8, market inertia, transaction costs of moving, etc.), so the market has to move a lot before rents go down. That is you marketing decision. That is your R-I-S-K decision.

Just remember, nobody likes a coward.

As to the first question (which as you can see is related to the second question (as a philosypher (sp?) I knew once said:  "It is all one.')) -- How far down do you think  property values are going to go down in your area?


Finally, and here we cut to the chase -- why and how to you think that you can time the market to the point that you can cut out the capital acquisition costs without cutting the rents?

Answer those questions for yourself and you will answer your original question.

Here endesth the lesson.

Zeeshan, I can relate one of the comments you made in a response about getting into the market at a bad time.  I'm trying to break into the game and have the same concerns.  I'm wrestling with the fear of getting into a property at the top of the market in a marginal or bad deal, just for the sake of getting into the game and getting some real experience that isn't coming to me through my headphones or on paper.  Then if the market does tank, all my cash is tied up in a bad deal and I can't move on the good deals that start to show up.

I've heard many people say it is better to just get started, so that is what I want to do.  I'm looking at doing that with a partner so that I can minimize possible newbie mistakes.

As for the equity swings and being under water, if you are looking to hold it for the long term, who cares what happens to prices in 5-10yrs.  Think of this; if you do plan to sell it in 25-30 years, you will have a lot more experience under your belt, and timing the market will be much easier after living and investing through a couple market cycles.