What could possibly go wrong?

[Daniel O.]

What Could Possibly Go Wrong? A Cautionary Tale for Newbies and Not-So-Newbies

This post is intended to share some observations gained from more than a decade as a real estate investor, and to offer some words of caution for those of you who are new to the game and those of you who have been around for a while. Most of us don't like to hear views that disagree with our own. We tend to discount them and instead seek out opinions that support the ones we already have. This is true in politics, but also in investing. Beware: this tendency carries the very real danger that we may come to believe we are living in a world that is very different than it actually is. The superior investor seeks out ideas that challenge his or her view of things. The superior investor has a plan that includes a strategy for dealing with unexpected setbacks. And remember: Hope is not a strategy. But enough about philosophy, and on with the tale.

In 2008, the stock market had crashed, the credit market had imploded, and the housing market was sliding into the into the toilet. Millions of people lost their life savings. Many who had invested in the stock market saw their wealth cut by 40% or more. And if they panicked and sold for a loss, they locked in those losses forever. People lost jobs as company after company closed its doors, and those job losses rippled throughout nearly every community in the country. People who had bought more house than they could afford, or whose circumstances changed when the economy went south, lost their homes because they could not afford to pay their mortgages. A great many of those people simply have not recovered financially and never will. The important point here is that this tale begins at a time with conditions that were exceptional within the long history of the nation. The stock market has tripled since that time and housing prices are on a tear in many areas too. In other words, the tale begins when things were unusually bleak but also (with the benefit of hindsight) unusually cheap. If you extrapolate from my experiences, don't make the mistake of thinking that things are cheap now. They absolutely are not.

In 2008, I was fortunate to have savings, a good job, and great credit, so I was able to buy a house. Let's call this House #1. This was not an investment property, it was where I wanted to live. In hindsight, while I loved the house, it was a terrible investment. I was quickly underwater on my mortgage. But I loved the house, so I kept paying and kept living there and everything was fine. I'll come back to House #1 in a minute.

In 2009, when I inherited some cash, I was at a loss as to what to do with the money. The stock market was still in the toilet and the losses I and everyone else had suffered were still very fresh in my mind. The housing market was also in the toilet. Few people could get mortgages, and home prices continued to fall. More and more houses were coming on the market, but few of them were selling. But I had this chunk of money and I had great credit and a good job. And I had kind of gotten hooked on the whole idea of house hunting.

So I started trying to figure out what might be a good real estate investment. And I found a place that was bank-owned and seemed decent. They wanted $240K for it, and I figured even with a 15 year mortgage, it would be more or less cash flow positive. But I was nervous. I didn't trust myself (which was smart). I hadn't thought about things like exit strategies or tenants rights or all that stuff (which was naive). So I was agonizing over the decision. And my caution turned out to be fortuitous because the bank was really trying to unload non-performing assets. While I dithered, they dropped the price to from $240K to $185K. And that was enough to get me to pull the trigger on what we will call House #2. The existing tenants stayed and they have been great. The place has been cash flow positive since the day I closed on it. I've slowly been able to raise the rent, and the property has appreciated nicely to where it is now worth more than twice what I paid. I'm about 5 years from owning the place free and clear, and I manage it myself. When it is paid off, the place should generate ~$25K in cash flow annually, which will be a big help when I retire. And that cushion should allow me to retire earlier than I otherwise could. Today, houses in that area almost always sell within a few days of going on the market and they frequently have multiple offers. So as of now, it looks like my first investment property is a real success. I know some of you are thinking I am wasting all that equity I have tied up there, and I will return to that topic below.

I used the remainder of the money I inherited plus some savings of my own to buy another place in 2010. We'll call that House #3. The owner had fallen behind on the mortgage and eventually the bank foreclosed. Note Well: When people fall behind on their mortgages to the point where they are foreclosed upon, they almost certainly have stopped doing preventative maintenance. Or any maintenance for that matter. And that was certainly the case here. I got a place that rents for $1850 a month for $105K. Not too shabby. Except it was pretty shabby and I had to put another $50K into it. So, $155K. This was more than I had originally estimated, but still provided decent cash flow with a 20 year fixed rate mortgage. I had a property manager who dealt with the tenants and was supposed to actually manage the place. They charged 10%, which is common in my area. And it is not at all clear what I got for the money I paid them. Twice in 8 years I've had tenants trash the place, so it clearly wasn't the quality of the PM's applicant screening. Each time its been trashed, I end up putting at least a year's worth of cash flow into fixing it. But here too I have been very fortunate. The house that cost me $155K is now worth ca. $260K. (Again, I know some of you are thinking BRRR, and I'll return to that below). This year, I decided not to renew the lease when it was up because the tenants had started wracking up unpaid utility bills and had been late with rent several times. And rather than put a year's worth of cash flow into fixing it, only to have this happen again, I have decided to sell it. So, I am paying the mortgage while I get it ready to sell, and it is costing me about $1100 a month in mortgage and utilities. Will see how quickly it sells, but suddenly this has become a drain on my cash flow, both to fix it and because it will be vacant until I sell it. I remain undecided about whether to do a 1031 exchange or whether to just suck it up and pay taxes so I can do something else with the equity. It will be ready to put on the market in a couple of weeks.

But back to what was my primary residence (House #1). In 2012 I moved and now live about 45 minutes from there (in House #4). But because House #1 was worth less than I had paid and I didn't want to sell at a loss, I became a landlord by default. This is a common experience for many people here on BP. For whatever reason, they find themselves with a house that makes more sense to rent out than to sell. Or at least they think it does. In some cases, sentimentality clouds our thinking. In other instances, there is a failure to fully appreciate costs and risks. And that is what happened to me. I thought I was lucky. I found a tenant who seemed responsible. He took good care of the place and he always paid his rent. And his rent covered my mortgage with just a little left over each month. And gradually the house value was creeping back up toward what I had paid. I didn't really have an exit strategy per se, just a vague idea that I would sell when I could make a little money on it… or at least not lose money. But remember, this was not a house I had bought as an investment. I hadn't crunched numbers and looked at it through the unsentimental lens of trying to make money. Let's pause here for a simple question: Does this sound like you or someone you know?

For several years, the tenant was great. He paid his rent, usually on time, and almost never more than a week late. He kept up with the utility bills. The place looked tidy when I'd stop by. Fast forward to the present. A few months ago, I started getting notices from the utility companies that bills were past due. I called the tenant and he said he would take care of it. He entered into payment plans with each of the utilities, and the notices stopped. Then in June, he moved out. I got his notice a week in advance when I was on vacation on the other side of the country. He was gone by the time I got home. And while he didn't leave a forwarding address, he left a huge mess, significant damage, and a $1300 unpaid water bill that I have to eat. The security deposit doesn't even come close to covering the damage. And here's the kicker: I am having to spend far more to fix the house up to sell than I made from renting it out for 6 years. And in fact, I would have lost less money had I sold for a loss in 2012 than I will having held onto it as a rental, even though it has appreciated. And I had all that equity tied up for all those years. Importantly, this also means that I am having to cover that mortgage and those utilities as well for at least a few months. And that is happening at the same time as the cash flow crunch on House #3. Mortgage and utilities on House #1 are ca. $2600. Problems with the contractor caused delays in getting it onto the market, and I missed the active buying season in my area. I share this example not because I want sympathy or criticism, but in hopes that readers here might learn from my mistake as they evaluate their own situation.

I have a handful of other rental properties that I've added since 2012, and I consider these to have been moderately successful. I'll share a bit of information about them too because I think there is real value for readers in seeing the totality of my situation with real estate investing.

House #5 is a 2 unit property bought in 2015 for $95K with a 15 year mortgage. It has been tough to keep good tenants for more than a couple of years, so I have had more vacancies than I anticipated. And there is drama. The property manager is decent but not great, and he has a lot of other places to manage. The place pays for itself on average over the course of a year, and even makes a little, but cash flow has been uneven. Some years it does very well, others not so much. Fortunately, it has appreciated nicely and is probably worth about twice what I paid for it. Ironically, I bought the place for the cash flow and wasn't expecting much appreciation. It is in an area that is very “block by block” and I got lucky. A group of investors offered me $170K for it pending inspection.

House #6 is a 2 unit property bought at auction in 2016 for $25K and another $5K in repairs. It is owned free and clear and generates $600 / month in cash flow. In two and a half years, it has paid off more than half of my investment, and it has more than doubled in value. Importantly, while it has doubled in value (and the taxes have followed along), it is in an area that the improved economy hasn't really reached. There is a lot of property on the market and not a lot of demand. Just because it has doubled in value, doesn't mean I can actually sell it for twice what I paid. I could take out a mortgage on it, but I prefer to use it as a cash flow engine.

House #7, purchased a year and a half ago, has been my greatest disappointment in real estate investing. Bad tenants and high turnover have meant negative cash flow. It has appreciated enough that I could probably sell it and cover my closing costs and more or less break even. The PM says he thinks we have turned the corner and the tenants are now sorted, but I'll believe it when I see it. In the meantime, it has cost me about $400 per month since I acquired it. IF the tenants are sorted and it stays occupied, it should produce $800+ per month in cash flow. I'm hanging on to it because the area shows some signs of improvement. Rents may rise and demand may go up. I'll give it a few years to see what happens.

House #8, is a SFR built in 2007 and purchased in 2017 with a 15 year mortgage. It needed nothing when I purchased it, and my PM quickly found a great tenant. It generates $200 / month in free cash flow. Unfortunately, the tenant just notified the PM that she is moving immediately, having been the victim of a violent crime that has left her feeling completely unsafe in her home. I don't blame her, that's not what she signed up for. But suddenly my $200 free cash flow has turned into -$850 while I cover the mortgage and utilities and try to find a new tenant.

So, to summarize free cash flow:

House #1 was +200, currently -2600

House #2 currently +900

House #3 was +700, currently -1100

House #4 (primary residence)

House #5 currently +300 but uneven

House #6 currently +600

House #7 currently -400

House #8 was +200, currently -850

In other words, when things were going as planned, my real estate investments were generating about +2500 per month beyond what was needed to cover the mortgages and pay expenses. I was building equity and I had cash to use for other things….like buying properties. But with some unexpected disruptions, I suddenly find myself with 3 properties off-line, and my free cash flow looking more like -3150 per month. Make no mistake: Those are not happy numbers!

And this brings me to the point of this lengthy post. I think you can see how easily and unexpectedly you can go from positive to negative cash flow.I have made some mistakes, most notably hanging onto House #1 instead of selling it in 2012. But I am also very fortunate. I was able to get several properties at a time when they were cheaper than they had been in a decade, and that has given me a real cushion. But perhaps most importantly, I am not highly leveraged. I have not pursued an aggressive strategy in building my holdings. I have not pulled equity out of one property to purchase another and another and another. If I had followed a BRRR strategy, the mortgage payments on my properties would all be much higher than they are now, and the drop in cash flow would really hurt a lot more than it does. Yes, I might own more properties than I do now, and yes they might provide a buffer IF everything was going well with them. But it should be clear from the examples above that things can sometimes take an unexpected turn for the worse.

My goal was to own properties free and clear so that the cash flow could fund an early retirement. And that is why I haven't been aggressive.I have endeavored to build my real estate portfolio using conventional financing with (mostly) 15 year mortgages at very competitive rates, and to only purchase properties that I thought would pay for themselves and generate free cash flow to boot, even with higher than anticipated vacancy rates and increased property taxes. Note well: It has gotten a lot harder to find such places as more and more people get into real estate investing, and people afraid of missing out pay more than is prudent for properties that will only generate positive cash flow if everything always goes right. My portfolio and the way I have structured it are resilient. I have a lot of equity in my properties. If necessary, I can do a home equity loan to cover the negative cash flow until I either sell or lease out the properties. Or I can sell some stock, because being resilient also means being diversified.

As I read these boards and talk to various friends and colleagues, I grow increasingly concerned that many people trying to make money investing in real estate are highly leveraged and have built portfolios that leave them very vulnerable to things going wrong. I know it is common to use 10% as a vacancy factor when trying to model performance of an asset or a collection of assets. I take a conservative approach and use 15% to be safe. But right now, I am looking at four of my seven properties having negative cash flow. That has never happened to me before. And my whole portfolio has turned negative. That too has never happened to me before. I provided the lengthy narrative so that readers could understand how I got to this place. The sorts of things I describe – problem tenants, unexpected vacancies, etc – are part of being a landlord. They tend to be more common when the economy is struggling. But the economy is good now, or say they tell us.

I started out this post talking about the value of listening to things we don't really agree with or that contradict our view of reality. I'll leave you with this thought. The circumstances that have led to the current situation differ for each of the properties involved. The opioid crisis has hit this country hard, and I suspect that is part of what is happening here as previously solid tenants flaked out, and another left due to violent crime. These were all solidly middle class tenants, with good jobs and good credit histories. And yet, here we are. Because I have not been aggressive in using leverage to build my portfolio, I will be just fine. But what about you? How aggressive have you been in building your empire? What would happen if your 10% vacancy rate suddenly shot to 40 or even 50%? Could you still cover your payments? For how long? If you don't think it can happen to you, you might not be paying attention. And what if you also had to put a bunch of money into your properties in order to have any chance of renting them and getting that vacancy rate back down to a more sustainable level? Where would that money come from? How are your properties financed? Will rising interest rates affect your payments? Is your strategy predicated on property values always increasing? How will your portfolio perform during an economic downturn when asset values are declining? And finally, what if you have a major uninsured loss? You know, like the hundreds of thousands of people in the Carolinas who had no flood insurance and who have had their homes damaged or destroyed by hurricane Florence? Does your insurance protect you from such a flood or from a wildfire? We know that such things are becoming more and more common and affecting more and more places. Could your portfolio survive a hit like that? How are you structuring your portfolio to be resilient when things go wrong? What changes can you and should you be making now, while things are still going well?