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Updated almost 6 years ago, 12/23/2018
Are cash-flowing rental properties recession proof?
I need to stop doing this, but I had a discussion with a work colleague regarding investing. He has a few rental properties but does most of his investing in the US stock market. When I brought up the fact that I was in real estate and told him my strategy (BRRRR) he was up in arms. When I tried defending myself, he brought up the fact that I wasn't around for the 2008 recession where real estate investors (and investors in general) got hit pretty hard, and that if it were to happen again, I would be in trouble since I am only investing in real estate, for now (I am only 24...).
So I started thinking about how a cash-flowing real estate portfolio could be hurt by a recession. If my $100,000 property value is decreased to $70,000, as long as I still have tenants paying the rent, I am still making money. And since I bought at below the market value (let's say $85,000), I may have paid off enough of my mortgage to not even be upside down on my loan. Also, if a lot of people aren't on BP and bought above market value, aren't cashflowing, or are upside down on their mortgage, not only will I be able purchase their properties inexpensively, but they will still need to live somewhere, so the demand for rentals will go up resulting in rental rates going up resulting in increased cash-flow and more properties purchased! As long as I have a decent amount of cash saved up (since I won't be able to take out equity) and I have had some good success investing, I should have no issue buying properties outright or getting a loan.
In a nutshell, this was my response to my colleague and he was telling me that I didn't know what I was talking about and that I was wrong.
So I write this post to get input to see if my logic is correct or if I am missing something? I am still very new to this so if what I said was ignorant or incorrect, I need to know lol Thanks in advance for the help!
If you have no intention or need to sell the properties anytime soon and they are making a positive cash flow and enough to cover a reduced rent amount if the recession causes a soft rental market, and you have enough reserves to pay the mortgage if you hit a multi month vacancy then you are good. In that case if you have some extra cash they are a good thing and a buying opportunity (same with the stock market really. The key is to not be over leveraged when the down turn hits.
#4 All Forums Contributor
- Plymouth, MI
You're right....he's wrong.
The fewer units in a specific building that you have the more risk you would have when there would be a market meltdown (ie if you are renting a single family home out you have only one renter bringing money in, hence higher risk of you having 100% vacancy for a while)
Your line of thinking is accurate though, and as long as your renters don't all lose their jobs simultaneously and move out you would be fine. The ones who lose their shirts in these times are the ones who are not properly prepared or the ones that invested on speculation and over paid. Even if your property goes underwater it doesn't matter as long as you do not need to see immediately.
As a general rule I keep 6 months operating expenses on hand at all times per property to weather any storms.
- Andrew Dorazio
#5 General Real Estate Investing Contributor
- Mechanicsburg, PA
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#5 General Real Estate Investing Contributor
- Mechanicsburg, PA
During the 2008 recession, people needing to sell were hurt. People buying and HOLDing weathered the storm. It the property is positive cashflow then the fluctuations in value are not a big concern. Presumably you locked in fixed rate mortgages and so even if rates increase, you are not affected by those rates. As a point of fact, in my experience, none of my rents declined in 2008 recession.
I own rental property and I invest in index funds. The reality is that with rental property there is always the risk of rents decreasing due to low interest rates and a good economy. There is a chance for vacancies, a roof replacement, appliance, plumbing or electrical problem that can deplete your cash flow and even cause to I bring your own money to the table. As for the S&P 500, since it has averaged 11% since 1929 you don't have the same risks as a vacancy, etc that a rental has. You simply Max out your Roth IRAS each year for 30 years and you'll easily exceed a million dollars tax free.
There are real estate guys and there are stock market guys. Don't bother arguing with people who the trust the stock market more than they trust their own ability to select and manage a property. These are the same people that "don't want to get calls about clogged toilets" so they hand their life savings over to a financial advisor and hope for the best. Don't try to convert them.
well...... we really need more info to give you an accurate answer.
Is your interest rate fixed?
Are you competitively priced in your market?
Do you have reserves?
How much are you cash flowing?
If you are on the top end of your market you could have issues during a bad economy. If you have a renter kill your property during a recession and you need a full rehab and you are properly funded you could have an issue.
if you have an ARM that shoots up the % of your loan and can't find a way out, you could have a problem.
If people get laid off and stop paying and you can't evict them quick or easily enough.
nothing is guaranteed. You don't know if rents will stay the same in a future recession. I'd just prepare for rents to drop at some point when making new purchases and have reserves ready if needed.
The property I purchased was at a fixed 3.5% rate. The location is kind of a niche because they properties are not very expensive but the area is so "hopping" that all the young professionals want to live there! So I am actually cashing flowing 1k after expense (I took into account 5% vacancy, 5% repairs, 5% capital expenditures, taxes, insurance, mortgage, etc.) so the cash on cash return is 50%+.
Reserves is an issue for now (I have about 4 months worth of payments saved up) but I luckily have a good job (company car all expenses paid, phone, etc.) that pays well with flexible hours (technical sales, loophole in my opinion) so I currently don't have any expense besides my property, which is cash flowing, so building up reserves should be fairly easy.
I am definitely still a novice, but I have access to the cash to make continue to build my portfolio, hopefully at a rapid pace!
Thanks for your input!
Thanks Andrew.
As for the 6 month rainy day fund, do you calculate that based off of you having to pay for all expense for that property for 6 months? So as you add properties, the first thing you do is save up the cashflow until it hits that 6 month coverage point? So if you have 10 properties whose operating expenses are $1000/month each, you'd have $60,000 saved up that you do not touch?
I knew we weren't crazy!
@Theo Hicks - You are a wise young man. Keep doing what you are doing and your future self will be very thankful:)
Get the property or properties paid off, then you will no longer be a debt slave. Also build up reserves. Then, what might be a tragedy to others will simply be an inconvenience to you.
The fewer units in a specific building that you have the more risk you would have when there would be a market meltdown (ie if you are renting a single family home out you have only one renter bringing money in, hence higher risk of you having 100% vacancy for a while)
Your line of thinking is accurate though, and as long as your renters don't all lose their jobs simultaneously and move out you would be fine. The ones who lose their shirts in these times are the ones who are not properly prepared or the ones that invested on speculation and over paid. Even if your property goes underwater it doesn't matter as long as you do not need to see immediately.
As a general rule I keep 6 months operating expenses on hand at all times per property to weather any storms.
Theo Hicks for the 6 months operating expenses I typically take everything from mortgage, taxes, forecasted repairs, CAPEX etc. and tally that number up to get to my 6 month number. I like each of my properties self sustaining, which is why each has their own reserves. This becomes helpful when you have different LLCs and partnerships for each property so you are not comingling funds across the different properties. As for the ten property question, of course it depends on whether or not there is a better opportunity to use that 60k, and what market conditions are like, but cash is king, so depending on your risk appetite you have to make that call yourself. Also, you don't have to have the 6 month amount right up front, typically I work to get to that point then start drawing excess once the account hits the amount. I am in a situation now where there are several initial evictions and repairs on an 11 unit that I just bought that is eating all my cash flow, so it may take longer to get to that reserve amount going. Also to consider when your taxes are due, because if they are not escrowed you will have to factor that lump sum amount to come out once due.
Let me know if this helps. Good luck. I started at your age and love real estate more now then ever. Your making good decisions. Keep it up
- Andrew Dorazio
No necessarily. I have first hand experience with 2008 recession. Long story short, I could NOT keep my rentals rented not even to Sect 8 because when economy took a dive, people who wanted to stay employed moved OUT of the area and that made room to the "other" people that trashed the asset class from a B- to a blunt D in as little as 2 years.
Due to local city harassment like Fine over fine for trashcan on the driveway and other nuisances, plus insurance rates tripled cus heh insurance knows when an area goes class D and also thanks to street neighbors who looted the property 3x times while I tried to rent it, I simply cut my loss and moved on. I had a valuation wipe from 90k to 30k. Every other house on the block was in foreclosure for similar reasons. Then tax lien sales happened and so on.
And now the "other" guys own property with a replacement cost (as per insurance) of $150k for a tax sale of less than $10k. Speaking of wealth redistribution heh? :)
While the anecdotal evidence provided here by most posters is born out in fact we can actual look at basic RE market statistics and economics to see why Theo is correct and his friend is not.
RE rents are "sticky" compared to home prices, at least in the short and medium term. Just like stocks home prices largely reflect future expectations of home worth; rents are a factor of the current market conditions and short term demand. We know that home supply is generally inelastic, meaning inventory can not expand or contract severely in the short term therefore we all see that a small increase in demand has a much bigger impact on home prices (San Francisco) and conversely an excess housing stock vs. demand (Cleveland) means much lower home prices as a whole.
If you simply compare the variance of Zillows Price to Rent ratios to their average home price indices over the past 7 years you will see this relationship. Both these data sets are downloadable (as .xls files) from Zillow research.
Again this illustrates another advantage the cash-flow crowd has over the "real wealth" appreciation proponents. While we see the later group as the most vocal about their "achievements": being invested in a strongly appreciating market, even with negative equity. Its the slow and steady cash flow professional investors that have the most consistent, predictable, and boring returns.
In 2008 speculators lost, investors made a ton of money. Those were the good ole days... I wish I could buy like that again. Your buddy doesn't know the difference between an investor and a speculator. Chive on...
I saw that you had vacancy at 5% and capex at 5%. Generally I've seen people allocate 10% for vacancy and 10% for capex. Costs will obviously vary and some years you'll have close to zero in both, but it's also very possible to have a 20% capex year, mostly depending on how much you've fixed up the place before you've rented it out and how old it is. But it sounds like you're off to a great start, and at age 24, you've certainly got a lot of upside potential. Keep at it!
- Vincent Crane
Thank you very much for starting this post @Theo Hicks. I had the exact same discussion with some people. It's like nothing in the world is worth investing because of the fear of another downside. Well then why live if you're going to die in the first place is what I'm thinking. There is risk in every thing we do.
A couple of things to consider:
1. We're in the Rust-Belt, which tends to be very isolated from the sometimes brutal nature of the 'hot' areas to invest in real estate. We don't ever 'boom', but we tend not to 'bust' either. Then again, we don't get much in the way of natural appreciation either.
2. If you're using the BRRRR strategy, you're likely going to get to a point where your purchases and rehabs are financed by hard and/or private money, if they aren't already. If the market turns while you're seasoning a property, and it becomes impossible to cash-out refinance, this is where you can get into a lot of trouble very quickly. If that property isn't cashflowing at 10-15% APR, now you're losing money every single month until you can sell it. If you're in a market where you can't sell it, or where values dropped and now you're upside down, you'll need to bring cash to closing to sell it. If you're losing money every month on a property, and things are tight everyplace else, where are you going to get the cash to get out of it? Your private/hard money lender probably won't give you any more, because everyone else is going to be in the same boat. BRRRR is a great strategy, for as long as cash-out refis exist, or as long as you're cashflowing even on your higher interest rate properties. It's also how a lot of people have gotten into trouble in REI over the years. It only takes getting stuck in one property to completely stall your business.
3. Sufficient cash reserves are critical, and that goes double if you're following BRRRR.
4. To what I read as your greater point: It's very common for people to stick to what they 'know' and denigrate anything different. Example: Almost everyone thinks they have an awesome Doctor. Why? Because no one wants to think their Doctor is actually terrible. Personally, I have investments in the stock market, because I think it would be foolish to ignore the advantages of a Roth IRA and a matched contribution 401(k) - but one of the primary reasons I got into real estate is because I dislike the lack of control I have over those investments, and really dislike the very poor returns I've seen. I'm not pulling any money out of the market, but I'm not contributing over the IRA or Match limits right now either. (If you haven't listened to the BP Podcast with Clark Howard yet, you should.)
@Marcus Johnson I think that 11% is without adjusting for inflation. I believe the real return has been closer to 7%.
Last aspect to consider is the balloon... I know several people that had few months reserves for cash, had tenants in place , but ballooned at a time when banks would not refinance. They got in trouble with just couple of properties (balloon was due - no refinancing) and it created a domino effect... So to weather the storm you need cash reserves + long balloons that do not come due close together + keep your total leverage no higher than 60%... Then you will be fine
Or you look for BRR deals that can be done using short term fixed loans. I haven't had much luck with refinancing mostly because of the types of properties I am buying, but it is nice to have something that cash flows well and will be paid off in 5-7 years.
This might be some helpful data for you.. Take a look. Hint: Rents never really dropped even as home values did a few years ago.
Here's a question I would ask your friend:
How did his stock portfolio fare during that 2008 recession?
(Silence)
I also think that some of this comes down to where your properties are. I know in my area, rents went UP in the downturn, not down. As folks had to get out of their homes, they still needed a place to live so rental demand when through the roof. Some areas were different. They saw a drop in rental demand and therefore a drop in rents.
I am not the light my hair on fire and ride the bull style investor. So I like to put in extra effort to have a cushion in case rental markets decline.
Having said that, I think in most markets what a downturn tends to equal is a hit to equity but not a hit to income on a rental. So your paper value may decline, but your cash position remains good. Does that make sense?
R