How to find out the next RE crash & a exit strategy.

Question

Andrew Johnson · Answer

Joe J. The scenarios are really apples and oranges.  I think (many may disagree) that looking at a personal residence is an entirely different ball of wax.  For the personal residence my primary concern is: "Can I easily make the mortgage payment?"  We will say that's based on a standard W2 job for the sake or argument.  I'm not depending on my primary residence for cash-flow and since I live there I'd also argue that appreciation doesn't help matters.  Why?  To take advantage of the appreciation I'd have to sell and then buy in a lower-cost market.  I can't buy down the street but that similar property has appreciated as well.  But I digress.  Income properties (read: investments) are completely different.  If the market crashes and I have to lower rents by 20% (I don't know why that is always my hypothetical number) then my cash-flow decreases.  Odds are if you did a 20% down mortgage (or 25% down for an investment property) that it would hard (or impossible) to still have a positive cash-flow if rents dropped by 20%.  So then you have two options:

1.) Take your medicine and sell the property.  You will likely a.) be paying to sell, b.) be losing your principal and c.) in the scenario above you'll also have to pay out of pocket just to exit the property.

2.) You don't sell the property but you have to come out-of-pocket a small amount each month.  You rationalize it to yourself that it's a better option than selling and that you're at least having the renter pay down some of the mortgage principal.

But with option 2.) you went from thinking you will make 5% a year to losing 5% a year.  It's a decent sized swing.  That $20K down payment is now (on a cash-flow basis) literally costing you money and slowly eats away at that $30K that you didn't put down on the property.  Put down $50K and you're still (likely) cash-flow positive, but at a lower ROI.  Going back to comparing that to a primary residence is where you get apples and oranges.  For a primary residence, if you still have your job, you just bought at the wrong time.  You still make the monthly payments and after the downside cycles through you'll be in a good spot.  I'm not buying my principal residence to rent out, I'm not looking for ROI, I'm looking for a place to raise my family.  Completely different objectives when making the purchase.

Of course, these are all with hypothetical numbers, scenarios, and don't really mimic real life.  At least not too closely.

Tyler Parish · Answer

I don't think you can time the market.

If you put down more as @Andrew Johnson had mentioned, you may decide to keep the cash flowing property in the market decline and wait a later date to sell, maybe when there is a recovery. Sometimes people get emotional when they see they've lost money and decide to sell and take a loss because they are worried of where it will dip to.

I would follow Andrews 7 steps, I think that's great advice. Also, if you buy houses in different areas, cities, states, you can think of it as risk mitigation.

If you continue to think of the market crashing you will stop yourself from buying anything. Buy good quality homes, near good schools and hold on to them. If they make you money monthly you will be able to hold until the next cycle.

Andrew Johnson · Answer

Joe J. If you want to have some real fun start playing with numbers and looking at trying to time the market with both a crash as well as rising interest rates.  What if the property purchase price drops by 10% but interest rates are at 6% instead of 5%?  What if the purchase price drops 20% but interest rates are at 7%?  That kind of analysis will apply to both primary residence of investment properties.  I'm not saying that price drops will 100% be driven by interest rate hikes but I think interest rate hikes are more certain (in the near term) than a housing crash.  But, hey, I'm not an economist so what do I know?  My point is that there's more than one variable to consider if you're looking at a buy-now vs. buy-later scenario.  Not to mention it's a huge digression for the original question related to exit strategies!

Tyler Parish · Answer

@Andrew Johnson I agree, interest rates, cutting rent, market crash. If you keep some money in the bank and the market drops, buy a deal while everyone is losing their places. Get one that cash flows. That may be able to carry you and your other house through the cycle.

You can be so creative with real estate and it has so many variables. Just be flexible and be able to react. That's what we should focus on!

Joe J. · Answer

@Andrew Johnson

Agreed that it is apples and oranges.  I guess that is why I am far less inclined to buy another rental in my market at these prices, but am more willing to buy a home to live in.  Thanks for your feedback!

Brent Coombs · Answer

@Joe Jung, if/when those price drops occur, will your JOB still be safe? (It's a fair question, because if nobody's losing their jobs, why will house prices be falling?)

Of course, if your job IS safe, why would you need an exit strategy? Just ride it out. Most people who came undone in 2008-09 after paying too much the years before, are now back in the black again, providing they've just kept paying their mortgage.

My main recommendation is always: wherever the market cycle is, look for BARGAINS only!...

Joe J. · Answer

@Andrew Johnson

Thanks for the response.  Let me clarify the scenario I was thinking in my head for someone with $50k cash looking to purchase a $100k home for their primary residence.  Let's assume for example sake that the market declines 20%.

Scenario A: Purchase home for $100k using 20% down leaving you with $30k left over and an $80k loan.  After market declines home is worth $80k so you have zero equity (with the exception of the principle payments made).  If you needed to sell and it costs 10% of home value for transactional costs, then you would have to pay out of pocket $8k (10% of $80k).  This amount would reduce your left over cash from $30k to $22k.

Scenario B: Purchase home for $100k using 50% down.  Assuming the same events as scenario B, you would still be left with $22k proceeds.

I feel the only difference would be that in scenario B your cash is locked in a mortgage and if the market declines more than 20%, you're stuck with taking the full loss.  With scenario A you could potentially do a short sale, foreclose or take a steep loss if you ended up underwater.  Although those steps aren't ideal, they would provide more options.

This is of course from the perspective that the buyer is guessing a high probability the market will decline.

I ask this because I am currently looking for a primary residence to purchase and only intend to put in no more than 20% although I could put in more.  I definitely appreciate different perspectives though.  Full disclosure: my timing is terrible so maybe this is all a moot point.

Andrew Johnson · Answer

Joe J. You would at least have the ability to exit (read: sell) if you had to for some reason.  It costs to sell and if the property has gone down in value you likely will have to come out-of-pocket.  If you don't have that money you literally won't be able to sell and satisfy the mortgage.  So you retain the ability to exit (if you needed to) rather have finding yourself stuck.  And you'd also have a slightly smaller mortgage payment which helps you maintain a positive cash-flow (or just break even) if you have to drop rents in response to a crash.

Take that same $50K and use it as 25% down on 2 $100K properties and the market drops by 10%.  If you need to exit you sell for $90K, it costs you ~10% to sell, you're left with $81K to satisfy a $75K mortgage.  It works.  The market drops by 20% and you're upside down: $72K to satisfy a $75K mortgage.  If (because of a crash) you don't have $6K to spare you can't sell.

Plus if you have 50% down and a much lower mortgage you can more easily "ride out" a crash.  But your risk (using your hypothetical) is that you have $30K that isn't leveraged.

Again, if you think a crash is coming, don't buy now!  But a higher down payment is one way to mitigate risk.

Joe J. · Answer

@Tyler Parish

I absolutely agree about being flexible.  I've always been narrowly focused on acquiring long-term buy/hold in my backyard but the cash on cash is incredibly hard to justify today.  I'm starting to expand my horizons to different investment vehicles and different markets.

How to find out the next RE crash & a exit strategy.

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