How do you protect against downside risk? (Other than not being crazy with leverage)

Question

Hi all, curious to learn what strategies y'all employ to protect yourselves for when prices drop.  I know it is inevitable and it really stings when you have a lot of leverage, but maybe there is a good strategy so you can still use good leverage?

Theresa Harris · Answer

Prices dropping is only a problem if you plan to sell or use that equity for something else.  I don't pull money out of my rentals, so if I was to sell one when the market was down; I'd simply hold on to it longer.

Chris Seveney · Answer

@Justin Hughes

Our portfolio now consists primarily of mortgage notes. We focus on acquiring loans originated pre-2018 which protects on some downside risk pertaining to market correction as our loan to value is under 50%.

Leverage is of course the best method to avoid downside risk as well as a diverse portfolio.

Another is owning assets in a good location with good tenants, if prices go down do you care if you have someone paying the bills?

Having some cash set aside is the other way to reduce risk in case you need to use that cash, most people get in trouble not due to price correction but running out of cash and over leverage

Sam Yin · Answer

@Justin Hughes

Price drops should not be a focus of concern, if you purchase properly.  I'm not talking about buying below market, although that is nice.

Buying properly means you closed the deal with cashflow. It also means you underwrote with maintenance,  reserves, and vacancies.  Thus, if the market take a big downturn, the property should be able to sustain itself.  You just ride it out if you cannot sell it or refi it.

If you have negative equity, but still cashflow based on your current debt load, I do not see any problems. If your note is about to adjust up, and you have negative equity stopping your refi, your cashflow should be able to carry you if you took on the standard debt with average adjusting rates tied to prime or treasuries.

There is always the worse case scenario that includes having to just walk away and start over. But dont be afraid of that. It's a business. That's what happens in business.

This is how I mentally and actually protect against downside risk. AND that is what I feel it take to overcome hesitation and overanalyzing deals and not pulling the trigger.

Nicholas L. · Answer

I don't think there will be a big impact when prices drop if you aren't too leveraged, have fixed rate debt, and buy in high quality areas.

Mason Liu · Answer

As others mentioned, the best protection against downside risk in real estate is having enough liquidity and cash flow to keep properties afloat. If history serves as good data, we know that if you hold any property for more than 10 years, very rarely will you lose money on the property value itself (not taking into account tax benefits and cash flow). If you are financially solvent and the property is cash flowing, you probably don't have to worry about the property value all too much.

Adam Martin · Answer

I focus in areas that have a mix of cash flow and appreciation.  If I were to loose $100k in equity as long as the rents still covered my mortgage with ideally some cash flow left over I really wouldn't sweat it.  In fact to the contrary I may see it as a market opportunity to buy more so what you are describing as something you are worried about is something others are looking forward to for buying opportunities.  Especially for the homes I have owned for a while my margins are pretty high so if rents dropped I'd still most likely be fine.  I also believe in high cash reserves.  Some of it is savings to buy the next deal but I like to have a healthy cash cushion for several large repairs at once or to cover rents not coming in.  I did fine with Covid but with the crazy regulations passed I see even more of a need to have higher reserves.  It doesn't hurt that I'm keeping them in a 3 month CD ladder making and the last few I bought were at 5.35%.  Not a great return as far as an investment but if I'm going to have the cash anyway I like to get decent interest.  Really your equity is nothing more than a number to make you feel good on paper but unless you are selling or refinancing it doesn't matter much.  Just make sure you have enough cash on hand and a long enough horizon that you are never forced to sell and you will be fine.

Joe Villeneuve · Answer

By not putting too much cash into it.

Eliott Elias · Answer

Buy cheap. At least with 30% equity.

V.G Jason · Answer

Have liquidity

buy in good areas

keep the house healthy

keep liability protection

How do you protect against downside risk? (Other than not being crazy with leverage)

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