New Rules For Real Estate Investing
How To Profit With Real Estate Investing Regardless Of The Economy
Key Ideas
- Discover the 4 simple rules you must follow to succeed with real estate investing.
- How homeowner's can benefit from following these rules – not just investors.
- Why timing and evaluating the market can make or break your success.
How do you safely build wealth in real estate when the economy is difficult?
Most people believe inflation will return with a vengeance (someday) making real estate a smart inflation hedge.
Dan Amerman is an advocate of this strategy (along with some big name financial gurus).
While I agree with the basic concept, I also believe there are many issues to be wary of.
The first and most important issue is timing.
In a nutshell, Dan and I agree buying real estate as an inflation hedge strategy will ultimately be successful, but we disagree on timing for implementation.
My concern dating back to 2007 is we would face a deflationary credit collapse that would wreak havoc on real estate prices.
In fact, I sold all my investment real estate in 2006 partially due to that belief… which proved to be true in subsequent years.
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Dan counters my deflationary concerns for real estate by citing his research which shows the primary profit source from this investment strategy comes from the synthetic short position in your currency through long-term real estate mortgages.
The way it works is when interest rates rise during inflation, the value of your mortgage debt declines.
It’s the same reason you don't want to own long-term bonds (be a creditor) as interest rates rise because the value of your bonds decline.
Similarly, you do want to owe long-term mortgages (be a debtor) when interest rates rise because the value of the debt declines.
They are mirror images of the same issue producing opposite financial results.
In other words, there are two components to profiting from real estate investing during an inflationary rise.
The first one everybody understands – the value of the real estate should rise over time.
The second is less commonly understood, but potentially more important:
The value of the mortgage should decline, but only if you lock in artificially low mortgage interest rates for the long-term.
Some advocates of this strategy, like Dan, believe it’s more important to focus on the mortgage than to worry about paying the right price for the property.
I remain unconvinced of that conclusion and believe it’s really an equation of balance.
The reason you can't pay any price for real estate and rely on inflation's magic to destroy the value of the debt is because there are too many unknowns between now and then.
You never know how long or deep deflationary collapses will run. You don't know how they'll affect rents and vacancies, thus lowering cash flows. A lot can happen between now and the time inflation returns.
On top of that, real estate investing involves financial leverage, which cuts both ways: it makes the good times great and the bad times unbearable.
Witness all the bankruptcies, foreclosures, and bank failures during the 2008-2009 deflationary decline to get a little taste of how quickly things can turn bad in the leveraged world of real estate finance when inflation turns to deflation.
When you put it all together, this means you must carefully time your purchase to balance the issues.
Purchasing property too early can result in devastating price declines and potential cash flow losses from rent reductions and vacancies that might bury your deal before inflation returns.
But if you purchase property too late, then long-term, low fixed rate financing may already be a thing of the past.
Putting both components of the investment strategy together while minimizing risk requires a delicate balance.
4 Rules For Real Estate Investing
Below are my personal rules for real estate investing that attempt to strike a reasonable balance between risk and reward:
- Finance only with with long-term, fully amortizing, fixed rate mortgages. No balloons, no adjustables, no short duration loans, nothing esoteric, nothing exotic. If your goal is to build real wealth after inflation, then there’s no flexibility on this issue because most of the value of the strategy is in the loan. If you have a variable or a balloon then you’re accepting interest rate risk that could destroy your investment down the road.
- Only swing at fat pitches. In other words, don't do thin deals. This investment strategy is designed to be a long-term hold. That means you don't need very many deals to fill your portfolio, so be very picky. There are hungry sellers out there right now that are likely to get even hungrier. Don’t rush and don't accept marginal deals.
- Positive cash flow increases safety. No deal qualifies as a “fat pitch” unless it provides significant positive cash flow from the day you close. Positive cash flow gives you an infinite holding period since you’re paid every month to own. Significant positive cash flow gives you room for error if things go from bad to worse. Fat pitches provide large cash flows. If inflation returns, then you’ll do extremely well. If another leg down in deflation occurs first, then the cash flow will help you weather the storm long enough to wait out the eventual return of inflation that validates this strategy.
- Reduce leverage. Financial leverage is the root cause of the credit problems crippling world economies today. Don't make the same mistake. The goal of this strategy is to build wealth in real terms after inflation. It doesn't take 9:1 leverage to achieve that objective, and higher leverage may force you to abandon a property before inflation finally returns to validate this strategy. In short, reducing leverage increases your margin of safety and cash flow. My own tastes lean toward 50%-70% financing, but the final number is dependent on the quality of the deal, local market conditions, and other factors beyond the scope of this post.
Remember, the goal is a long-term hold that puts cash in your pocket today and increases those cash flows as inflation rises while providing moderately leveraged equity growth to build wealth in real terms after inflation.
In order to achieve those objectives, very specific rules apply.
While these rules are designed for investment real estate, there’s a low risk way for every homeowner to capitalize on this investment strategy as well.
If your home is financed by any type of loan other than a conventional 30 year, fixed-rate mortgage, you may want to consider refinancing so the interest rate risk is owned by the banks and not by you.
If interest rates decline significantly, you can always refinance again – the cost is minimal for many programs.
If interest rates rise, you’ll be locked in and never regret it. Many lucky homeowners built wealth in real terms during the last round of serious inflation in the 1970s using this strategy, so learn from their good fortune.
In summary, the long-run outlook for inflation and interest rates when measured in a time frame of a decade or more is clearly higher, but a lot can happen between now and then including brief, dramatic declines. Nobody has a crystal ball, so you must always manage your risk.
You can no longer rely on increasingly permissive financing, declining interest rates, and stable inflation to provide a tail-wind that produces profits out of thin real estate deals.
The new investment environment is much riskier and requires a new set of rules providing an investment premium to justify accepting the risk.
While I consider these rules the bare-bones essential requirements, I'm also confident many of my readers have other rules for their own real estate investing during the economic crisis that I did not mention.
Please join the discussion by sharing them below in the comments so we can all learn and benefit…
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Hi Todd
as I read you from Spain, I would like to know what´s the current low interest rate, long-term, fixed rate in the US (I mean which %) because I don’t know if this strategy can be applied in Spain.
Greeetings and thanks for your teaching
Pedro
Hi Pedro,
Interest rates vary among states and regions but according to Yahoo Finance they are around 5% for a 30 year fixed. Hope that helps…
Investing in the real estate industry is a serious business and it is better to avoid it completely if you do not have sufficient experience and expertise in the field. It may seem easy from the surface to simply invest and wait for the inflation to arrive. However, many other points need to be factored in before all that can be achieved. Moving into the trade is easy but progressing forward requires a lot more. If not practised carefully, you could end up packing up your boxes and dumping the investment papers in the archives.
Hi, Todd. Thanks for all the excellent information. I thought one of our retirement income streams could come from selling one of our rental houses and holding the loan ourselves. “Owner financed.” It works for banks–would it work for us?
loving the comments everyone ?
When investing in real estate, there is always a best time to do it. Sometimes, the market can get unpredictable, but you will have to be able to recognize the signs on when is best to seek financing and to invest. There are no hard and fast rules. Sometimes, it is the ability to recognize the best time to do it.
I always say that the only good rental property is a 100% debt free one. When there is a payment one a rental, I would rather work at McDonalds because there is more money and less headache there. lol
I believe that the entry point or value is the most important part, 2nd is the type of fund used ie, self or funded. In either cases the ratio of fund infused, how much will it affect your lifestyle, savings etc.
Yes, purchase price or “entry point” is key. The money is made on the purchase when you buy right.
Great article! Wish we could lock in our term over 30years in Canada.
Todd, I’ve really enjoyed your podcasts (why did you stop? 🙂 ) and as I look into rental income real estate I am desperately looking for a book with a conservative thoughtful voice such as your own. I see a lot of the opposite out there. Do you have a book on rental income real estate or have some recommendations? Thanks!
I think the crew over at BiggerPockets.com has done a good job in that arena. That would be a good place to start your research.
In a real estate market everyday some properties will be bought and sold . However in the time of economic crisis the investors hesitate to invest in buying the new property. So here is the solution given in this article. Thanks to you.