Why Cash Flowing Rentals are Recession-Resistant

Real Estate, as we all know, was hit HARD during the last recession. Prices dropped in half or more in many areas taking the shirts of investors and homeowners alike. While I won't go into the much-studied causes, I bring it up because it is a relevant topic as we head into Year 11 of this most recent bull-run. 

Rental property investing is like the mini-van of the real estate world - it's not the sexiest, fastest, or largest car out there but people keep buying them because they get you where you need to go. In a market upswing, people are driven towards investment vehicles that produce outsized returns with less regard for the inherent underlying risks. As Warren Buffet puts it "Everyone's a genius in a bull market." In real estate, that looks like flipping, wholesaling, vacant land speculation, spec home development, and a number of other strategies that, while having their place, expose the investor more to market volatility than rental properties. 

The attraction of a massive payout for a short holding period is enough of a draw to encourage new investors to wade into these waters. I recently went to a real estate meeting in San Diego, CA where the agent talked about being able to grow wealth faster using negative cash flowing properties in expensive coastal areas that appreciated at a rapid rate. He would then pay himself by refinancing and pulling money out of these properties as they appreciated. This strategy works great as long as property values continue to rise. The minute they level off or drop, this source of funding is cut off and you are left with a negative cash flowing property that eats away at your net worth. 

This "bank on appreciation" approach encourages investors to be lazy. Deals are bought that may not actually be deals, but as long as property values keep rising, appreciation will save the bottom line. If a rehab goes long and way over budget, appreciation is there to soften the blow. Margins get slimmer, offers get higher, and in an appreciating world it all still works out. However, the second prices drop, the "it" hits the fan. 

Cash flow rental properties are not immune to a drop in home prices. Despite this, as long as your rents exceed the mortgage and all expenses, you can still make money from an underwater house, allowing you to hang on to it long enough to weather the storm. It's not the fastest vehicle to wealth, but it is the most forgiving. That is not excuse to buy a bad deal, but time atones for a multitude of mistakes. 

Another side benefit of rental properties is that, in an area that remains desirable, people will still need a place to live. The rents will not be hit nearly as hard as the home prices as long as jobs and opportunities stay in a given area during a market pullback. People that provide quality rental homes are a saving grace to individuals that lose their homes. I would never wish that ugliness on anyone, but in the event that it happens, I want to be there to provide a home because that is better than the alternative that they would face. 

I am not saying that everyone needs to be a rental property investor, nor are any of these other strategies inherently bad. But new investors need to be aware of what these risks are before jumping head in and betting the farm that a luxury flip in a coastal area will just "work out." Three things to keep in mind for those that do move forward with these strategies: 

1. Be extremely certain of your numbers - and build in a "worst case scenario" buffer.

2. Be picky about the locations that you invest - real estate is a very local industry, and some places will be hit harder than others if/when a price correction comes. 

3. Use leverage wisely - leverage produces outsized returns, but it also produces outsized losses. Short term/high interest loans are the most risky. Have multiple exit plans in case the primary plan fails. You do not want to be unable to sell a home because prices dropped while having to pay 12% on a hard money lone with a 1 year balloon payment looming...