How Can Real Estate Investors Protect Themselves From A Market Crash?

Can a crash be predicted?

Prices are very high in many parts of the United States, but that does not mean we will see a crash. Yes, we could see a crash, but we also may not see one. We could see a gradual decline in some areas and no decline in others. Real estate is very market-specific. In the last crash, the media made it seem like the entire country saw huge declines in the value of their house. In reality, many areas saw no decline in prices—and not just low-priced areas.

Prices in Colorado have almost tripled in some areas over the last 10 years. That is a huge gain, and many people are waiting for a crash. You have to look at much more than just prices to determine when and if there will be a crash:

• How many new houses are being built?
• How much is the cost to build new houses?
• Is the population increasing or decreasing?
• What is the unemployment rate?
• How strict are lending guidelines?
• How much inventory is there?

Even if you know the answers to all of these questions, it is tough to know what prices will do. Some people have declared that lower population growth will cause a crash, but that has never caused a crash before. Other countries have been losing population for decades with no real estate decline. It is important to remember that just because someone states something will cause a crash, does not mean they know what they are talking about.

Affordability in the US has been going down but it is still much more affordable than almost every other country in the world! Decreasing affordability has never caused a crash before so why should it now?

Betting on higher prices can also get you in trouble

One of the most important rules of thumb I work by is to never base my purchases on what housing prices might do. If I am flipping houses or buying rentals, I never assume prices will go up. I base my investment strategies on today’s prices. I also have a plan in place if the market decreases. Yes, we have seen huge price increases in Colorado, but that does not mean prices will keep going up or that they could not go down. One of the easiest ways to get yourself in trouble is to invest in real estate because you think prices will increase. This is called speculation—not investing—and here are some things to think about:

• When you buy for appreciation only, the only way to make money is if the value increases. You are also usually spending money on the investment every month.
• When you sell a house, there are a lot of selling costs for agents, closing costs, title insurance, and taxes. These costs can range from 5% to 15% (not including income tax) depending on what state you live in.

If you are only buying for appreciation, you may have to sell a house for 10% to 20% more than you bought it for just to break even. Since there is no crystal ball to tell us exactly what prices will do, this is a risky play. If you have tons of money, many other investments, and are hoping to hit a home run, maybe speculation is a good idea. But you have to be very secure financially. If prices go down while you are holding these properties, you could easily be in a heap of trouble.

How to protect yourself from dropping prices as a house flipper

There are many things I do to protect myself in case the market changes. There are things to consider, like if I am going to flip or rent a house. The first rule I already talked about is I never assume prices will keep rising. Some wholesalers try to sell me deals to flip at 85% of the ARV. I have always bought my flips from 65 to 80%. You may often hear this called the 70% rule which means If a house will be worth $200,000 after I fix it up, and it needs $30,000 in work, I should pay $110,000 for it ($200,000 x .70 – $30,000). The wholesalers will tell me I have to pay more for flips because the market is doing so well. Actually, I do not. Maybe other people will pay more, but I will stick to what I have always done.

If I start paying more for house flips, I might make as much money as I do now if the market keeps going up. But if prices stay the same or they go down, I could lose money. A lot of work goes into flipping houses, and there is no way I want to break even or lose money. By sticking to my profit numbers, I protect myself against market decreases. If prices go up, awesome—I will make more money, but if they go down, I should still be okay.

When I flip houses, I usually use local banks or private lenders to finance the deal. I put 20% to 25% down with the local banks and zero down with the private lenders. However, I do not finance any of the repairs on projects I do. Even when I finance 100% of the purchase price, I have a lot of equity in each deal because I am repairing it with my own money and paying carrying costs with my own money. If the market were to drop, I would not have to pay off a huge loan to sell the property.

Something else to consider as a house flipper is the type of project I take on and the amount of work needed. The more work a house needs, the riskier the project is. Not only is the project riskier because the budget could explode with a big project, but it’s also riskier because completing a big project takes much longer. The longer it takes to flip a house, the more exposure you have to the real estate market. If prices go up, it will not hurt you as much to hold on to a property, but if prices go down, it could be a disaster. I have some monster projects I am taking on now that I realize may not have been the best idea. We will make money on them, but they take a ton of resources, a ton of money, and a ton of my time. It is usually more profitable to make less money on a house that needs less work. You can get the job done faster and move on to the next project.

When flipping houses, the best way to protect yourself against a crash is to avoid:

• Huge remodeling jobs.
• Fudging your profit numbers to make a deal work.
• Holding properties for a long time.
• The assumption that prices will go up.

Sometimes, the more expensive houses are harder to sell and are more affected by market changes. Many of the investors on my podcast who ran into problems during the last crash were flipping high-value houses. Most of my flips are starter houses. You can see the numbers on all my flips here: Fix and Flip Scoreboard.

How can you protect yourself as a rental property owner?

I am asked all the time if I am worried about going bankrupt if the market crashes. I have bought 38 rentals in the last 23 years (commercial and residential), and I have loans on almost all of them. Many people assume having a loan on a property makes it a risky investment. However, I do not think that is always the case. If you finance 100% of the value of the property, it can be very risky if there is no cash flow, but loans themselves are not very risky if structured right. Here is how I buy my rentals properties:

• I always buy properties below market value just like I do with my flips.
• I always buy with plenty of cash flow (at least $400 a month).
• I usually put 20% down and then make repairs, leaving me plenty of equity.
• If I refinance, I make sure the properties will still cash flow up to my standards.
• I buy properties that do not need a massive remodel.

I bought a lot of proprieties from 2011 to 2015, but I stopped buying rentals because the numbers were no longer working. I was not seeing the cash flow I wanted in the Colorado market. I could have kept buying houses because prices were going up, but I did not think that was a safe strategy. Eventually, I found commercial properties that cash flowed much better than the residential properties I was buying and bought rentals again.

The nice thing about rentals is that if prices go up, you can take advantage of the market by refinancing a property and taking cash out. If prices go down, it does not affect landlords that do not sell their properties if they cash flow. Rents could go down, but they also may not. I know many rental property owners who saw their net worth drop a lot during the housing crash, but they made the same amount of money every month because rents stayed the same. To be protected during a down market, you must have properties that cash flow well. Although rents may not go down, they could go down, and you want to be able to pay all the bills and make money, even in a down market.

When I buy my rentals, I usually have at least 50% of the value of the house in equity. After getting a great deal on the property, putting 20% down, and making repairs, the property is worth much more than my loan. Getting loans allows me to buy more properties, which means more:

• Tax advantages.
• Possible appreciation.
• Equity from buying below market.
• Cash flow.

Not only do I have the advantages listed above when buying more properties, but I have more diversification. One of the biggest fears for new investors is the property going vacant. If you own one rental and it goes vacant, that is a huge hit to your finances. If you own ten rentals and one goes vacant, it is not a big deal. Many also think that it is safer not to have a loan when a house goes vacant, but the mortgage payments are just a small part of the expenses on a rental. You will have maintenance, utilities, taxes, insurance, and other costs, whether you have a mortgage or not, which brings me to one of the most important parts of being a rental property owner.

You must have cash reserves if you own rentals. The biggest way to get yourself into trouble as a landlord is to spend all your money on investments or other things and not have cash available if something goes wrong. I think you should have at least $10,000 in the bank at all times for emergencies if you own a rental. The more rentals you have, the more money you should have in the bank. I think it is much better to have a loan on a house with cash in the bank for emergencies than to have no loan but no cash.

Here are the things to remember when buying rentals so that you are protected from a crash:

• Do not buy for appreciation unless you have cash flow coming in every month as well.
• Make sure you account for all the costs, like maintenance, vacancies, taxes, etc.
• Buy every house below market value, even if it cash flows.
• Do not be afraid to finance properties since it will leave you more cash.
• Make sure you have enough cash for problems that will come up.
• Do not be afraid to use a property manager.
• If the market drops, you don’t need to sell.

Conclusion

A real estate crash is not imminent, but it could happen. I do not think it is wise to at least plan for a drop in prices, even if you don’t think a crash is coming. I like to hope for the best and plan for the worst. There are many ways to protect yourself from a crash, and the keys are getting great deals, not taking on more than you can handle, and having plenty of cash available.

Source: Investfourmore.com