The Merit of Discipline in a Hot Market

[Daniel Kurkowski]

Hello everyone,

This may seem obvious, but I wanted to put this out to all of the newer investors who may be working with some partners, agents, etc. who don’t really know what they are doing and are offering poor advice.

Those of you who have been investing in real estate for over a couple of years likely remember a time when you could purchase a flip that fit perfectly into the 70% rule. Your cap rates for rentals were consistently 3-4% higher than the amount you could borrow money for to have a secure delta between your cap rate and interest rate to cash-flow.

Nowadays, these deals are becoming more and more difficult to find with any sort of regularity, so many investors, in an attempt to stay "productive" and "relevant," are bending these metrics and creating thinner margins.

I see buyers in my area consistently purchasing properties at a price where they expect to make $20,000 on a $200,000 project, without any consideration for an exit strategy if their valuation was off or if the project comes in over budget.

This has a dramatic effect on further compressing the margins beyond what the influx of money from Wallstreet has already done, not just for that individual investor, but for the market as a whole. One of the expressions we always use at our office when we find out our offer came in second place is “it only takes one bigger idiot than you to lose out on a deal,” and these days we are finding multiple “bigger idiots” despite our many competitive advantages in construction costs and brokerage fees.

After you have missed a few of these deals, there is naturally a temptation to want to continue to make higher and higher offers and shoot for thinner margins to keep your money working for you. Anyone who was around during the last collapse can tell you that this is a dangerous game to play.

Case study: A friend of mine was buying homes in 2005-2007 that were slightly cash flow negative in areas appreciating extremely quickly. He rehabbed them and rented them for a year to sell them for a profit taxed at the capital gains rate. His business was going well and by his estimation he had about $1 million in equity to realize. Then the market went the other direction and he filed for bankruptcy.

This is clearly an unconventional strategy, but I think it does a great job of reflecting the optimism in an appreciating market and how people can justify deals that ordinarily wouldn’t make sense by developing specific strategies based on the assumption of market growth.

When real estate is this hot, I think that unfortunately, there is a need to stick to fundamentals while you wait for the market adjustment to demolish the bankroll of all of the overzealous investors and speculators out there.

Ignoring proper fundamentals may work for a few of the more sophisticated and experienced investors, but they will and should always have a specific reason why they are transacting unconventionally. If your reason for overpaying is simply, “I want to invest and can’t win any deals right now,” you are firmly in the camp of people who the more experienced investors are waiting for to go broke.