Averages VS Realities

Averages Vs Reality

Have you ever heard the story of the man who was 6' tall and tried to cross a river that was 5' deep on average? His friends warned him that it wasn't safe but he was sure that he'd be fine since he was a full foot taller than the average depth. Somewhat unsurprisingly, when he tried to cross, he drowned because the average depth doesn't ever have to be the actual depth. This slightly tongue-in-cheek story is analogous to the real estate investing world in many ways.

Over the long run, historical averages for growth in the stock market, real estate, etc will likely remain steady. But in the short term, we're dealing with an unprecedented pandemic that has caused a massive reduction in economic activity and asset valuations. As we were wading our way through the river that was 5 foot deep on average, we stepped over a cliff into a deeper section where we will likely drown if not properly prepared. On a macroeconomic level, everything regresses to the mean and is fairly predictable, at the micro level, anything is possible and unpredictable shocks to the market are normal. If you're not prepared you may not stay in business long enough to see the good times again. This is why it's imperative that you follow the basic tenets of real estate investing by buying at a discount, capitalizing your business properly and ensuring your properties cash flow after ALL expenses!

Buy at a discount

We've all heard the old saying "you make money in real estate when you buy". This can be done by finding a property where simple renovations/changes in operations increase the ARV well past what you paid or even by finding an asset that's distressed to the point that you can buy for pennies on the dollar without renovations (Undervalued vs Value Add). Regardless of which approach you take, buying at a discount is one of the basic keys to being successful as an investor (in any asset). If you talk to anyone that's run a profitable business through the ups and downs of the market they'll likely tell you that this is the most important rule of real estate investing. Buying below market value creates immediate equity which helps to hedge against unexpected drops in value. If you're able to buy a $100,000 property for $80,000 in cash and the market drops 20%, you're not underwater and likely won't have to sell. Even if you do end up selling you won't incur nearly as much of a loss as that extra $20,000 was your reward for buying right. On the other hand, if you purchased that same property at full market value of $100,000 in cash and the market drops 20% then you've suddenly lost $20,000 of your starting capital and may lose the asset entirely.

Many people look at historical averages and expect 3% appreciation in property value each year forever. But think back to our analogy of the 6 foot tall man, the same concept is applicable here. If you happened to buy a rental house at market value in early 2007 expecting continued appreciation you were sure in for a nasty surprise. 13 years later we can say that on a macro level the consistent appreciation has held true, but if you had bought at market value you likely weren't able to hold the asset through the Great Recession. On the flip side, if you had purchased a house at a 20% discount in January 2007 it may have been unprofitable for several years but holding it would have been viable which would have allowed you to enjoy substantial appreciation throughout the 2010s. This is why purchasing below market value is so essential to being a successful investor, not only does it immediately add to your net worth but it also helps protect you against the unpredictability of the market.

Capitalize your business properly

I'm writing in late April and many states have begun easing the restrictions that have been in place for the last 6 weeks. On May 1st many businesses will begin to reopen and if there isn't another spike in Coronavirus cases then soon after restaurants and bars will follow and life will slowly return to normal. Ideally, unemployment will sink back to a reasonable level, tenants will pay rent and the moratorium on evictions will be lifted. Even in this best case scenario, there are many real estate investors who will fall behind on their mortgage payments and lose their properties because they have not capitalized their businesses properly. They've followed the late night infomercial "no money down" real estate investing gurus and purchased properties where they're entirely dependent on rents coming in each month to pay the mortgages and maintenance. No, you don't need substantial capital to start investing in real estate BUT somebody involved in the deal does. Real estate is a capital-intensive business, especially when you're first getting started. If you buy property without adequate reserves, what happens when tenants don't pay rent for several months? When your unit goes vacant? When a pipe bursts and you're looking at a $10,000 repair? Well, that's the point when the investor who was more prepared comes in and buys your property at a discount while you go broke.

The problem is (again) too many people are looking at averages as opposed to reality. When they run numbers on a potential rental property they budget a certain amount for vacancy/cap ex/repairs & maintenance expense and if the rents cover them and allow for additional cash flow they assume they should purchase the property. Yes, the property should cover all of these expenses and each month you should be setting money aside in anticipation for their arrival, but you must also have access to liquid capital for the immediate future! Perhaps only once a decade you'll have a large, unexpected expense where you have to come up with significant amount of cash, and if you average that amount over 10 years the rents cover it. But what happens when it hits in year 1? You won't have accrued enough reserves to cover it and if you don't have capital set aside for the unknown you could be in serious trouble. Again, in the long run the numbers will approach the mean, but if your business wasn't capitalized properly from day 1 your investing career may not last long enough for that to happen.

It has to cash flow

As discussed, there is always a chance that you will be hit with a large expense shortly after purchasing a property at which point you would need prior funds set aside. But over the long term, your investment needs to be able to support itself. The rents coming in each month need to cover PITI, vacancy, capital expenditures, repairs & maintenance, management and any other miscellaneous expenses incurred from owning the property while still leaving additional profit.

Just like buying at a discount, monthly cash flow is a hedge against the unexpected. Again, many people make the assumption that they'll at least experience average appreciation so if they're negative a few hundred dollars a month in their cash flow it's nothing compared to the upside of 3% appreciation a year, especially on more expensive properties. This is a dangerous game to play, as discussed in the earlier section on buying at a discount, 3% on average includes many troughs and valleys in the market and you never know when the market is about to fall off a cliff. If you have a property that costs you money each month to own AND loses a large portion of its value, how long do you think you're going to be able to hold it?

Don't assume best case scenario

At the end of the day, all of these hedges come down to not assuming best case scenario. Realizing that 5 foot deep on average could very well encompass several spots twice as deep. Too many people assume their rents/property values will increase every year, assume that vacancy rates will never increase, assume they won't get hit with a large expenditure in the first year or two, ad infinitum. One look at the current state of the world and it's clear why it's not especially prudent to assume that the average will be your consistent reality when investing in property (or any business endeavor). Everything regresses to the mean in the long run but in the near future anything is possible. If you want your business to last long enough to have a chance to benefit from average appreciation in rents & value, you have to buy below market value, buy from a position of financial strength and buy property that supports itself on its own!