What’s the real downside of a market crash?

22 Replies

Hey BP community! I own a few units in Cleveland and live in San Francisco. I was rather young for the 2008 crash so I don’t have the hands on experience in a down market. What is the realistic downside of a market crash when you own Real Estate? Is it that your tenant might lose their job and not be able to pay rent? Is it that you have a likelihood of losing your job personally (although I don’t know how this would affect existing real estate investments negatively)? May be a negative question but I’m curious how this plays out.

@Rich Rodman , one risk is tenant loses their job and can't pay rent. I'd argue the bigger downside is potentially wiping out large amounts of equity built up in your portfolio. If you purchased right from the beginning then this risk should be mitigated. But if you over-paid and also were banking on appreciation, this is where things could hurt you, particularly if you are looking to sell any of your properties and trade up for something bigger. If that scenario played out, you might be underwater (in the sense that the property is now worth less than what is remaining on the note)

@Rich Rodman , putting the equity/appreciation piece a side, then in a nutshell, yes. However in times of economic downturn, your pool of potential renters may actually increase because less people can qualify for purchasing homes, and there are more foreclosures (but people still need a place to live). Depending on the market, rental prices may drop if people fall on hard times, so if you do not adjust accordingly, you would definitely experience an increased vacancy rate. 

If you plan on holding your properties for the long-term and you have adequate cash reserves to handle any unexpected vacancies that may arise, then you'll make it through a short-term economic downturn just fine. People get into trouble when they over-leverage and don't have enough cash on hand to float those expenses.

Does all that make sense? If you have more specific questions or want to dive into more logistics feel free to PM me 

I mostly agree with Michael. Except one thing I don't worry about is my equity being wiped out because unless I try to sell the property during the crash or refinance it (dumb), how much equity I have in it doesn't matter.

More pertinent is really just the tenants. Maybe your tenant loses their job and you have to get a new tenant, but that's no different than any other vacancy. It's more of an issue if they keep missing payments and eventually have to be evicted...but that can happen any time, regardless of a crash.

The only major dangers I see are: a substantial decrease in rents and now your expenses are no longer covered (generally not a huge risk) or if you have an adjustable-rate mortgage (hopefully not). I do agree with Michael that your renter pool may increase because people can't qualify for loans as easily during the crash.

For the most part, I don't think the major risks are as related to a general market crash as much as they are the specific market the properties are located in. Like when the Michigan cities went bust years ago, all of a sudden rents decreased and tenants left the city leaving little tenant pool left, etc. That has a more direct impact on rental properties I think. General market crashes aren't as bad. Plus, during a crash everything goes on sale. Best time to buy more rental properties :)

Someones downside  is someone elses upside . If the marked drops you buy . Nothing is a loss untill you sell it . 

Bad parts of a down market:

1. You can have problems finding tenants (increased vacancy) and rents may decrease (decreased or negative cash flow). Don't always buy the argument that a down economy means more renters... In the last recession/depression households consolidated for the most part. Kids kept living with parents, roommates vs studio, etc.

2. Unless you have long term fixed debt (i.e. 30 yr fixed mortgages primarily for SFR), you face refinancing and interest rate risk. In the last recession/depression property values fell significantly which made refinancing a major problem. Many had more than their equity wiped out and had to come into a loan closing with cash..... LTVs also went down. Not good especially if you are leveraged and have multiple loans coming due. Increased rates can also through a wrench into a refi and your cash flow.

3. Many on here are think a downturn will be this panacea of opportunity. Its can be true to some extent (I am an optimist), but not as much as people think. When the market is in the toilet, buy side "good deals" are everywhere, but the use or exit opportunity for the property is typically non-existent. That is the opposite of this market. You have to be able to buy, hold, hold, hold, and sell/rent into a turning market. You need (1) access to equity capital (do not rely on being able to get debt... lenders will hate real estate again) and (2) the intestinal fortitude to pull the trigger when it seems like things could keep going down and (3) more cash than you think to hold hold hold....

There is only a downside if you do not have the reserves to carry your short falls. Reserves are mandatory when investing in income properties.

You will lose your equity if you are using real-estate to hoard cash. Unfortunately once lost you can not predict when you may have to sell and therefor a definite risk of loss exists.

Leverage has no impact on risk assuming adequate reserves based on that leverage.

@Rich Rodman , I have had the same question. I am a college student saving to do a house-hack soon. My Economics professor is predicting another downturn in the economy soon. For the seasoned investors, should I be worried? Should I wait to invest? How much equity should you have in an investment for it to be safe during a market downturn? Thank you

Downside:

  1. Loss of value
  2. High unemployment
  3. Increased vacancy
  4. Increased turnover
  5. Declining rents
  6. Inability to make mortgage payments
  7. Foreclosure
  8. Lending freezes
  9. Balloon payments come due

Defenses:

  1. Good locations
  2. Cash flow
  3. Add value
  4. Prudent debt
  5. Reserves

I think a lot of the downside for rentals depends on where they are located. If they're located somewhere that you can give a 30 day notice to vacate, you could be ok. There might be a lot of people in a race to the bottom with rents to try and fill the apartments though. If you live somewhere that can take 6-12 months to get someone evicted, good luck. That could happen back to back and you could have to float the property for a year or two. Make sure you have enough in reserves to cover your costs for at least a year for one or more units IMO. Best case, none of your tenants lose their job, you have a ton of money sitting in the bank and people panic again and offload their multis for crack head prices and you can get one or two more in cash.

You are from SF you should recall tenants in SFBA insist to pay less to stay. One example is the major employer is closing its operations. The exposure is negative cash flow.

The last Great Recession is owner had to use rent to pay for his own mortgage since he lived on high leverage and lost his job. They let go their renter(s). 

Property owners always need to have 6 months reserve.

@Rich Rodman

Rich: Thought I'd chime in with a quick note about tenant risk ...

On small properties (under 80+ units), tenant-specific risk can be substantial in an economic retraction. If vacancy or delinquency by a couple tenants will dramatically impact your returns, you're exposed. On larger assets (80+ units), you'll be much less exposed to tenant risk and your main downside risk will be a decrease in rental revenue or vacancy (if you refuse to decrease rents). Run some sensitivity analysis before you invest passively or buy a property to better gauge where you'll land in a pull-back.

@Brayden Stevens

Brayden: Don't let your economics professor encourage you to attempt timing the market. 99% of the time you'll loose. Keep a long term perspective, and you'll be able to ride all the bumps.

An economist would say loss of liquidity, unless it was a bad investment.

Large enough equity and reserves solve every issue except how long you have to hold the property before you can cash out.

Smart investors know down turns mean long turn opportunities.

It can throw a wrench in your pipeline. Lets say you are doing a BRRRR strategy, as things decline and you are waiting for seasoning you may not be able to refi once that has occurred.

The vulnerable neighborhoods have the potential to collapse in value, and rents.  

@Tyler Weaver I agree with Tyler. I’m already preparing for a correction. My marketing is going towards stable neighborhoods and I am solidifying my relationships now with my private and hard money lenders now so I have a solid backing. Once the correction happens I will have a good streamline of better deals and the labor/ general contractors will become cheaper ( I am also building relationships with my suppliers as well). When the market turns the hardest thing that is going to be hard to find is money. Negotiating will become a lot easier when things become uncertain.

@Rich Rodman  the biggest risk is fear. It will cause you to make irrational decisions. Nothing can fully prepare you for the mental stress, but having some cash reserves helps.

First you see stocks fall 25% or even 90% in some cases. Then you see massive layoffs, first your neighbor, then your family members, then YOU get laid off. For sale signs sit in yards for months as housing prices drop further and further. Vacant houses are looted for copper or appliances. All news in the media is dark and predictions say it will get WORSE. Your instinct tells you to run before it gets worse.

You may sit here today and think you will remain rational, but hardly anyone did. The result is people missed opportunities and made horrible mistakes, such as selling all their stocks at the bottom of the market or leaving a flip half done and walking away. It is the herd mentality. When the market is good, everyone wants to be a real estate investor, when it is bad, everyone sells and runs.

Fact - more millionaires were made from the great depression than from any other time in history, however the majority of people stood in handout lines for food because they didn't even have money to eat. You need to decide which type of person you are.

Originally posted by @Tyler Weaver :

It can throw a wrench in your pipeline. Lets say you are doing a BRRRR strategy, as things decline and you are waiting for seasoning you may not be able to refi once that has occurred.

The vulnerable neighborhoods have the potential to collapse in value, and rents.  

Worse yet, the BRRRR strategy is simply equity stripping. In a down turn it will lead to upside down loans and you are stuck with larger payments. People need to be careful those R's or one will be "Repossession".

@Rich Rodman Great advice by everyone. It all boils down to one thing: How long can you pay your mortgage + expenses in the worst-case scenario (tenant leaving or refusing to pay)?

@Joe Splitrock

The other side of that is what made almost as many millionaires were people who started investing in the 1980s. People waited and waited for it to drop and it did eventually but it was a heck of a lot later and not to that point. Not saying that is the scenario here but I tend to think that when everyone thinks something will happen it goes on longer than people think until most give up.  

It happened in the mortgage crisis and that probably had a lot more triggers than we have now. 

Originally posted by @Rich Rodman :
Hey BP community!

I own a few units in Cleveland and live in San Francisco. I was rather young for the 2008 crash so I don’t have the hands on experience in a down market.

What is the realistic downside of a market crash when you own Real Estate? Is it that your tenant might lose their job and not be able to pay rent? Is it that you have a likelihood of losing your job personally (although I don’t know how this would affect existing real estate investments negatively)?

May be a negative question but I’m curious how this plays out.

 The rents in your standard C-B class rental neighborhoods in Cleveland have not really moved too much from the days of the crash to where we are at today. So long as you don't need to cash out during a crash you should get through it realistically unscathed. In fact what you really want to do is start buying any and everything you can get your hands on if we enter another crash. Issue is that in a crash your access to mortgages is going to be dramatically smaller.

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