5 Ways to Stay Afloat When an Eventual Real Estate Crash Happens

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Our world is massively leveraged. This is not only in total dollars, yen, yuan, or euros; but also in percentage of debt to income, tax revenue, and gross domestic product (GDP). I’m personally not a huge fan of massive financial leverage, but the point of this article isn’t to disparage central bankers around the world. The point is to understand the realities of the investment world that we are all operating in and attempt to prepare ourselves to prosper.

The key thing to understand about leverage is that it breeds volatility, both good and bad.

Let’s take a simple example of buying a home. Assume, for this example, that the cost of the average home in the United States is $100. A classic mortgage would have the home buyer putting down 20%, or $20, to purchase the home with the bank financing the other 80%, or $80. In this example, you have four times as much leverage as you do equity, but historically, home prices have gone up (or at least been less volatile) than many stocks or other investments.

In a scenario where prices went down 15%, the homeowner would still have some equity ($5). However, many people have taken out loans where they put down only 3% to 4%. This does a couple of things: first, it pumps returns when prices go up, but second, it deepens losses when prices go down. Let’s compare a homeowner who puts down 20% and one who puts down 3%.

If prices go up 10%, then things play out like below:

Homeowner A, who put down 20%:

  • 50% appreciation return on contributed capital ($10 of appreciation/$20 of down payment)
  • $30 of total equity

Homeowner B, who put down 3%:

  • 333% appreciation return on contributed capital ($10 of appreciation/$3 of down payment)
  • $13 of total equity

In this scenario, you would be insane not to put down 3% on about 6 or 7 homes and make 6 or 7 times the money! The problem is that things don’t always go up, and leverage can have the opposite effect.

Related: If An Economy Crashed In The Woods And No One Cared, Would It Make A Sound?

Here is the scenario if prices go down only 5% from the initial $100 value:

Homeowner A, who put down 20%:

  • Still has $15 of equity in their home

Homeowner B, who put down 3%:

  • Underwater on their mortgage by $2

Some people might scoff at being underwater by $2 and say that it was worth the risk of making $10. However, keep in mind that by making leverage (3% down mortgages) available, there are now way more owners in the market with that leverage. What can happen is that people get nervous and start to sell en masse, which creates a spiral effect that is only enhanced by the increased leverage. The results from the massive leverage are the increasing volatile swings in values of hard assets.

To put what is happening (again) to the single-family market in context, in 2008 I purchased a stock fund that was an ultra-short stock that was essentially leveraged 50%. I received a letter in the mail from the SEC telling me that investing in this stock was risky because of the large amount of leverage associated with it. I found that somewhat ironic since the stock was shorting real estate mortgages that were leveraged 97%.

Prices are going up right now, and they may continue for quite a while. The Fed is dumping cash from helicopters (read: leverage), and that is a hard train to stop. But it will stop. The argument I hear from many people is that when prices go up, many people increase the equity in their home. Yes, this certainly happens. But there are still a lot of people who are buying the inflated prices with 20% or even 3% down. These people will be in trouble when the market corrects itself.

Even, and maybe in particular, the US government is overleveraging itself. The US government has about a $480 billion federal budget deficit and a national debt over $18 trillion. Federal tax revenue is only about $3 trillion. I’m not making the point that this is right or wrong, good or bad. The point is to understand that our world is massively, and increasingly, leveraged. At some point the market will go down, and in a drastic way because of all the leverage.

Here are five ways to protect yourself as you invest in this maniacally turbulent investment world.

5 Ways to Protect Yourself in a Leveraged Environment

1. Buy properties that have average rents below the median for the area.

I have always been a fan of this strategy. Maybe it was because my real estate career was born in the flames of the Great Recession, where during my senior year of college, in Fall of 2008, I saw 80% of the people working in my real estate office let go. Just as I was about to enter the real world, I saw dozens of high powered commercial real estate brokers who made hundreds of thousands of dollars per year lose just about everything — and quickly.

The question I ask myself is simple: can a family pay rent for my units if they lose their job and need to work for an hourly wage? The goal of this is to limit downside during a negative swing. If you can keep your units in good condition and at a reasonable price point, then you should always be pretty close to full. The same thing goes for buying single-family rentals.

The other benefit of having your rent below the median for the area is that there are necessarily more potential tenants who can afford your units. If you buy the million dollar single-family home with the hopes of renting it to some rich person for $10,000 a month, you may be waiting for a while. It is also more likely that a person who can afford $10,000 of rent will be able to buy a home, even in a downturn.

2. Have ample cash reserves.

This can be a very difficult thing for first time investors. I know because I never was able to have a lot of cash reserves on the first properties I purchased. I don’t have a great rule of thumb, but I usually try to have about six months of expenses available in cash. When I didn’t have the money myself, I made sure to partner with investors who did. Partnering with an investor will likely dull your personal returns, but it will give you staying power and security during a downswing, which is the key here.

Related: Affording Rent is Becoming More and More Difficult – Could This be a Warning of Another Crash?

Part of saving up cash reserves is resisting the urge to pay yourself out every single dime, right this frickin’ second! I like to defer payments for the first year on any property so that I can get comfortable with the operations and get a sense of what amount of cash I may need going forward. If you are investing in a property with the idea that you need the rental income to stay afloat in your daily life, then you are probably over-leveraged, at least by my definition. Yes, you want to be able to rely on the income from properties — this is the beauty of real estate — but you shouldn’t need it off the bat.

3. Be good to your tenants.

Anyone who has invested in real estate knows that tenants can be fickle. They love you when they need you and are willing to discard you the second it’s in their best interest. It actually reminds me a lot of the girls I usually date! However, in a downturn, tenants become nervous like anyone else. The news and media are powerful influences in today’s society.

Once, when the stock market was getting crushed, I had a tenant tell me that they were really worried about “the Dow going down.” This particular tenant had been renting from me for about eighteen months, and I had given her some leeway when she paid late a few times. I was somewhat surprised to hear that she was following “the Dow,” so I asked her what stocks she owned.

“None,” she said.

“Well, why are you worried about the market?” I asked.

“The last owner I rented from lost his house after the market went down…” was her response.

I told her that I wasn’t going to lose the house and that she had nothing to worry about. She gave me a hug and told me she never wanted to leave. I’m not Robin Hood; my goal is to make money. However, I do believe strongly that being good to tenants is great for business. This lady was going nowhere as long as I owned the property — and particularly if the economy started to falter again. All she wanted was security, which was the same thing I was after.

4. Keep a close eye on cash flow.

I don’t think cash flow and appreciation are mutually exclusive; I look at it more like a spectrum. Which end of the spectrum you fall into depends where you are in your life and career. I do believe that appreciation will make you rich, but you have to have cash flow to stay afloat, particularly during downturns.

Debt service coverage ratio (DSCR) can be a useful metric (there is a great post and thread on BiggerPockets that go into more detail). The key is to understand what your expenses are going to be and purchase properties that have ample cash flow to cover them. Understanding expenses can be difficult and is often the overlooked aspect of cash flow. Talk to your contractor, property manager, and other investors in the area. Really try to nail down the expenses aspect of the DSCR formula, and your cash flow should be fine.

5. Be conservative.

You don’t often hear about conservative people going broke. It’s not the deals you should have done but missed that kill you; it’s the deals you do that you shouldn’t have done. In other words, the bad deals are the ones that break your back. I understand we are in a somewhat euphoric real estate environment right now. Single-family home prices are rising, debt is cheap and increasingly available, and real estate prices always go up!

Well, until they don’t.

Be conservative in your approach, and take the slow and steady route. Buy properties that have cash flow and lower rents than most in the area. Make sure to have lots of cash reserves, or partner with an investor who can keep you afloat when things go bad. And be good to your tenants — because in the end they are the ones that make you money.

Most of all, understand that the world is a leveraged place and that big swings in both directions are coming. Invest accordingly.

Do you agree that a crash is inevitable? What would you do to prepare for a downturn?

Don’t forget to leave a comment, and let’s discuss!

About Author

Conor Flaherty

Conor has experienced every aspect of the foreclosure and rental business for single-family homes. He was VP of Acquisitions at Silver Bay Realty Trust, and has flipped over 100 homes. Conor started a blog called Wall Street Slum Lord and is working on publishing his first novel.

37 Comments

  1. I think it was Rich Weese who said, own 200 houses, 100 Free and clear and 100 leveraged to the hilt! Or it could be 1 and 1, or 5 and 5, etc… Have a good mix, dont leverage everything!

  2. Conor, well said indeed. As a real estate investor for 40 years I have seen and experienced it all. I have made bad choices but luckily for me more right choices to more that shift the balance in my favor. While inflation/appreciation has made my family secure and we are now enjoying the passive income of debt free properies, I would be far wealthier if someone had told me your thoughts earlier in my career. I hope that every new investor reads this post and learns from it. Good job.

  3. Chi Cheung

    Great article. I would like to know more about the “Buy properties that have average rents below the median for the area” strategy. I guess the assumption is that lower rent houses have lower purchase costs, but this is not always true. Let’s say two houses have the same purchase price, one rents higher than the other, wouldn’t it make sense to buy the house that has higher rent?

    Thanks.

    • Conor Flaherty

      Good question, Chi!

      Given your assumptions, yes, I would take the house that rents for more. In reality rents usually track pricing pretty closely. In other words, if a house rents for more, then it is likely that it costs more also.

      With my assumption in mind, I prefer to buy properties that rent for below the average in an area because there are more people who can afford that rent. If there is a pocket like you are describing (where rents are high, and prices are relatively low) then I would be all over that area after I did my due diligence and figured out why there was such a disparity.

      The main idea behind my philosophy is that if you buy properties that rent at the high end of a spectrum then there are usually only a few tenants who will be willing/able to pay the rent you need to make it a good investment. If you buy properties that are cheaper (and rent for less) then there is a greater pool of possible tenants. In my experience you will have less vacancy and rents will probably grow more over time, than a property that is listed for the highest amount of rent in the area.

      Does that make sense?

        • Deanna Opgenort

          My property is toward the lower end of the market, but larger and nicer than homes with comparable rent (it’s what I’d look for — it’s a “great deal” for the renter).
          The trade-off is that I get to be very, very, very picky about who I will accept as a tenant, and I’ve gotten amazing, responsible tenants, and extremely low turnover times (2 days & 0 days vacant in last two turn-overs)

  4. You are extremely correct about the dangers of leverage, especially when not managed appropriately. I knew a Japanese billionaire who owed multiple commercial high rise office buildings in west Los Angeles (Wilshire and Sepulveda) in the late 1980’s. He was over-leveraged at about 100 to 1. This level of leverage is what allowed him to become a billionaire, but it was also his downfall. When the recession hit in 1989, the vacancy rates for his commercial properties shot up, his cash flow from these properties fell, he was unable to make his mortgage payments, and he went bankrupt.

    Here is the moral of his experience (as explained by him when I met him in 1999):
    Once you’ve made money and lost money, it’s easy to make money again, because you already know how. The question is when you make money this time, what are you going to do differently with it so as not to lose it again.

    I am all about using leverage appropriately (key word appropriately). It’s all about identifying the risk associated with the leverage, then managing and shifting that risk. All of our Appreciation Investment Models do that, whether it’s for real estate (flips), stock options (calls and puts) or business investments (growth companies). Leverage is typically not appropriate for Cash Flow Investment Models (buy and hold) unless you can manage the vacancy risk. For real estate buy and hold investments, we manage the leverage risk by entering into 30-year lease-purchase agreements with 7.5% non-fundable deposits, so that the deposit offsets/eliminates the vacancy risk. In commercial buy and hold real estate investments our preference is to own or manage the company that is the tenant as the means of managing vacancy risk.

    I greatly appreciate your post and insight on the topic.

    • Conor Flaherty

      Thanks for the comment, Michael!

      You made a number of really good points. I really like the saying about “what are you going to do differently with it (money) so as not to lose it again.” It would be a good lesson for everyone to learn before they lose….

      What happened to your friend?

  5. Jeff Jenkins

    Thanks Conor,

    Great topic! I actually find myself debating this topic with myself (and others) all the time. No I’m not crazy, I promise.

    In contrast, I love debt, or good debt to be specific. In fact, the most successful real estate investors I know are hundreds of millions of dollars in debt. The economy we live in is not so much a capitalist economy as much as it is an economy based on credit, or Creditism. Credit is the new game. Well it’s actually not new. It’s pretty old really.

    The old days where we were truly capitalist were when businesses and banks would make a profit and reinvest that capital back into the business. Hence the term capitalist. There wasn’t much debt. That’s still common now, but throughout the 20th century the banks started leveraging their holdings quite dramatically. The banks are legally allowed to lend 10 to 1. That means for every dollar they hold they can lend out 10. Talk about a Ponzi Scheme!

    That’s okay though. We have no control over it so we might as well play the game, and play it well (carefully). The wealthy understand this.

    The key with real estate is having the best product at the best price. Yes, I agree with the rents being below the median. Good call. There will always be a lower middle class. One of the absolute worst-case scenarios is a massive loss of jobs. I’m talking about losing more than 25% of the local population due to job loss. That hurts. But people will always need a place to live and that will never change. Best product, best price. Don’t be greedy! The overly greedy tend to lose in the long run. Simple business principles really.

    And please don’t ever use anything less than a 30 year mortgage. Amateur move. With maximum leverage your expenses are lower which allows you to get really competitive if need be. Not only that, but the goal is cash flow, not principal build up. Principal doesn’t pay the bills.

    Be sure to also pay attention to local economists. They can throw up warning flags several months in advance. Beat the mass of sellers to market if you want to.

    The absolute worst-case scenario is a global financial collapse. But is it really bad for a leveraged real estate investor? I think not. If the global economy collapses, the dollar becomes worthless, and what is our debt? Dollars most likely. Now you can repay those debts with cheap, and I mean cheap (or worthless) dollars.

    The more we learn about our current monetary system the more attractive debt becomes. Most people fear debt, or the things they do not understand, and most people have extremely limited knowledge about the reality of debt and our monetary system.

    Like I always say, “Learn to play the game, not get played by it.”

    The most important thing about using debt, or leverage, is your financial education. I can’t stress that enough. Education is the most important aspect. it’s the first and continual step along the road to wealth. It’s not just a one time thing.

    I love this topic and others related.

    I also offer free advice and financial education on my site. Click on my profile picture to learn more.

  6. One more quick comment. How many FREE and CLEAR properties were foreclosed on in the last “real estate bust?” The article is entitled …When an Eventual Real Estate Crash Happens! Let me ask everyone this, “If you received NO RENT for one year, what would happen to you?”

  7. In the market I am in which is Austin, Texas the frenzy of buying by big & out of state investors (one shack had 19 offers in just 2 days!) has cooled due to being the highest price/earning power of the middle class in the nation and they know people are being priced out in purchasing and renting. So, big investors are taking money out and putting on the next big thing (maybe oil, startups etc.). It is possible people who bought recently or currently buying will be holding the bag soon..

    • Conor Flaherty

      Thanks for the comment, Austin!

      I actually know a number of institutional firms who are still buying dozens of homes in Texas (I think the ship has sailed on Austin). I think you are right that some people who purchased recently may be caught holding the bag.

      What is the demographic of people currently buying in your area?

      • In my neighborhood, existing houses used to fly out in few days ~6months back but now even Berkshire Hathaway houses are sitting idle for few months (sellers expectation is too high – $175-$200/sq-ft)! My builder friend’s new homes are not being sold (2 in a month vs. 15) as much. Most of the people are buying outskirts of Austin (Buda, Kyle, Manor, Leander, Georgetown etc.). Texas has seen quite a boom due to Fracking. But with Oil prices getting so low, it will affect the economy negatively in near future.
        Massive debt is OK when it works for some folks for some of the time or some lucky ones..but I don’t take those examples. In 2006, I know my friends in Phoenix were buying properties every month and then took a big loss bec they didn’t know when to get out or how to manage the debt well. You have to manage your own risk that you are comfortable with and maximize the potential from the properties of what you have before taking on more and more…bec. there will always be deals/properties around…
        But make sure you are doing it not to impress or compete with someone and are not sacrificing your family life, due to having no time, to the point where it is too late (delaying family life, kids grow up w/o knowing/bonding with parents, not creating lasting memory with them etc.). My 2 cents…

  8. Jerry W.

    Pretty thought provoking article Conor. It seems bad enough to be trying to avoid the hidden pitfalls, termites, bedbugs, bad tenants, buyers who go into bankruptcy, now add another possible recession. It is a mixed blessing/curse. Without leverage I would only have one or 2 houses now. With leverage more houses but greater danger of failing. I have been concerned lately about the falling price of oil. I only have two tenants I am aware of who work in the oil field. We are about 150 miles or more from the closest boom field. Still we have enough folks who work in the oil patch and commute and work in service industries that our local economy could suffer quite a bit. On the other hand I have been expecting inflation to go wild due to the heavy government spending and I have not seen it yet. The micro and macro economics involved has me pretty baffled.

    • Conor Flaherty

      It is interesting that you bring up oil, Jerry. I certainly don’t have the answer on oil specifically, but big picture it just seems that the world’s leverage is creating more risk for individuals. I don’t know much about oil (despite numerous current investments in it) but I do believe that the shale type wells are the ones that may be in trouble if they aren’t currently liquid. Do you know what type of oil wells your tenants work for?

      Thanks for the comment!

  9. Don Clark

    Staying afloat during a recession is my main concern as I prepare to embark on building my rental portfolio. I have considered doing lease-purchases with non-refundable deposits as mentioned above, but if the buyer follows through I no longer own the property for income/cash flow later in life. Partners aren’t really necessary for me unless the I have alot of vacancies because of the recession. I am wondering if selling when the job indicators/economics start looking bad or pulling in a partner, if possible, at that time is better. I look forward to hearing opinions on this and other options.

    • Conor Flaherty

      Thanks for the comment, Don!

      I’m not a fan of lease options – unless the options are mine. My feeling is that if you have a solid tenant base and property that you should hold on for the long term. The problem comes if you have a weird mortgage or a funky property. If you can build your portfolio with responsible amounts of debt in solid markets I think that makes sense.

      Where are you buying? What kinds of cap rates are you seeing?

  10. Don Clark

    I will be buying in St. Louis,, but I’m interested in other cities when I determine which ones are best, and when I can get a lender and team established in them. I am going for the $30,000 houses (leveraged at that amount), with a minimum ROI of 12 percent. I don’t think the mortgages will classify as being weird, 5-6 percent with a three year balloon. The only bad part is the balloon and refinancing at possible higher interest rates. What do you think?

  11. Pete Sailhamer

    Good article Conor. However, instead of putting down 20% to make it a “safer” less-leveraged property, simply negotiate the purchase price down 20%. Possible? Absolutely. This is my primary purchase strategy, and it allows for an equity pad while still leveraging to the max. If the seller doesn’t reduce enough, move on to the next property.

  12. Brian Oney

    Good thoughts in this article.

    One key lesson from my MBA was – “Leverage is not inherently good or bad…it simply magnifies the outcome”…which is what you showed. In good times, it magnifies the upside…and in bad times, it magnifies the downside.

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