Acquiring Rentals in an Appreciating Market

[Dan M.]

In a market that has quickly appreciated over the past three years, I am looking to obtain cash flow properties. If I run the numbers on an income-property and the cash flow is acceptable as well as the long term ROI, some would look at the calculations and say that's a good deal. My concern is acquiring one of these properties at the price they're asking, and then the market calming down again and I now have a home that is worth less than I'm paying (negative cash flow).

I feel like the houses I'm seeing are not worth what everyone in town is asking. How do you determine the actual value of an income-property so you pay the best price for when the market goes back down?

[JD Martin]

Originally posted by @Dan M.:

Thank you gentlemen, I think I'm tracking now. Please let me know if I'm wrong... @JD Martin, your last sentence made it click. As an example: If I paid 200k for a duplex in today's market, each tenant is renting at $800 and I'm receiving $200 cash flow, houses could be valued at 150k after the market goes down. I was concerned other landlords could offer lower rents in the same area and still cash flow nicely since their mortgage loan would be lower and my vacancies would increase. You're saying houses become more affordable so there is less inventory thus leading to higher rents (supply & demand)? 

Your first sentence left me puzzled. Am I confusing cash flow and asset value, or that I didn't have a clear picture on supply & demand? I understand that equity and a hefty price-per-door provides a nice cushion, but I was basing my question on the fact I'm very new to evaluating a deal and all the actual costs for my market so all my cash flow numbers look low. This left me short-sighted and only thinking of the loans we acquire at each part of the market cycle and how that would affect those who landlord and bought at the highest peak and those who can offer lower rents to fill vacancy because they bought in the valley. (Analog signals).

@Russell Brazil, haha no way. San Antonio is definitely not Detroit! Toyota is only a sliver of what San Antonio has to offer.

 Yes, confusing cash flow and asset value. There does not have to be any statistical correlation between the two, although there usually is to some extent (i.e. if something produces cash flow, it is going to likely have more value as a hard asset than something that does not, all things being equal).

Let's use an extreme example of some war-zone in Detroit. Let's say you buy a house for $10,000. You do $10,000 worth of improvements to get the property to a habitable state and now you've got $20,000 in it. You put it up for rent for $250 per month, which is what the area that you own will hold because it's a war zone. You get reliable renters (ha! at this price? in this neighborhood? But I digress :D  ). A year later there's a major depression in Detroit and you try to cash out on your house, only to find it's only worth $10,000 - you've lost $10,000 in asset value. What does that mean for your cash flow? Nothing. You still have people paying the rent at $250/month. 

The further up the food chain you go, the greater the risk of the scenario you outlined - that your mortgage, relative to all other mortgages in the pool of rental investment, is higher, leaving you less able to cut prices in the case of oversupply. But for you to make that leap, you have to have access to a whole lot of information at once, and also be able to predict how your particular market will respond to both micro and macro economics. All investing involves some risk, and while it's possible that your market could experience falling asset values, falling rent prices and reduced supply of renters all at the same time, it's not terribly likely, and even those scenarios can be hedged against if you purchase properly - meaning your spread between expenses and revenue is great enough to cover those contingencies. 

If it's any consolation, "perfect storm" conditions usually revolve around boom towns or single-industry areas - oil towns, car towns, etc (Dallas/Houston in the 80's; Detroit in the 90's/00's) - and are often coupled with governmental incompetence of foolhardy spending. If your community has a diverse economy, and a reasonably well-run government (what do Moody's/Fitch say about their ratings, for example?), most economic fluctuations are barely even noticeable.