Many people worry about buying rental properties because the market value could decrease. Many parts of the country are seeing rising housing prices, and that can make it tough for investors. But if values decline, it will not be devastating if you bought the rental property below market value with cash flow. The only reason a decrease in values will hurt the rental property investor is if the investor has to sell the home during the downturn, or rental rates decrease significantly. In most cases, rental rates do not decrease as much as property values when there is a downturn, and in some cases rental rates don’t decrease at all when property values decline.
I am making at least 15 percent cash on cash return on all of my rental properties. With this kind of return, I don’t need my properties to appreciate for them to be a great investment. Please check out my complete guide to purchasing long-term rental properties to see detailed numbers, how I find properties and how I finance properties.
For more information on how to buy the best rentals which will make the most money, check out my book: Build a Rental Property Empire: The no-nonsense book on finding deals, financing the right way, and managing wisely. The book is 374 pages long, comes in paperback or as an eBook and is an Amazon best seller.
Invest for cash flow and declining values won’t matter with rental properties
I have purchased 16 rental properties in the last 4 plus years and they all cash flow at least $500 a month. That cash flow leaves me plenty of room if values or even rents decrease. I plan to hold these properties long-term so the only reason to worry about appreciation is if I need to refinance. I think of a cash out refinance on my rental properties as a bonus, not a part of my strategy. If values decline on the properties, there is a chance rents could decline as well, but they would have to decrease by almost 50 percent before I start losing money. I have no plan to sell my rental properties and if there is a market downturn, I can hold those properties and wait for the market to recover.
Make sure you have equity in your rental properties if values decline
I buy rental properties with at least a 20 percent down payment, and that builds instant equity when I buy the home. If values decline on my rental properties and I have to sell a property, I will be fine because I have equity. I also buy every rental property below market value, which increases my equity position even more. If values decline 10 or even 20 percent, I will still come out ahead if I have to sell.
Buy rental properties below market value to improve your equity position
I buy properties that are below market value and add value through repairs or improvements. I only buy properties that are at least 15 percent below market value. I also buy properties that I can add value to by adding a bedroom or bathroom. When the property is repaired and ready to rent, I have usually increased my equity position by at least 20 percent. Because I already put 20 percent down when I purchased the home, my mortgage is usually 60 percent or less of the value of the home. This leaves me plenty of room to sell if values decline.
If you don’t need to sell your rental properties a decrease in values doesn’t hurt you
I don’t plan to sell my rental properties for a very long time. I plan to collect rent every month and keep buying properties to increase the passive income I make. If values decline on my rental properties and I don’t sell them, it does not affect the money I make, just my net worth. My net worth is a nice number to look at, but it doesn’t pay bills.
Even if rents go down, I have enough room between my mortgage and rents to absorb a rent decrease and still cash flow. In the last housing crisis some properties saw the rental rates drop. Other properties saw no rent decrease and some even increased. The rental rates are not tied to the property values, and a decline in property values does not guarantee a drop in rents. In Colorado our rents dropped slightly during the downturn, but not nearly as much as housing prices dropped.
What if you want to invest for appreciation and not cash flow?
Historically values have always gone up given enough time. If I can wait out a drop in the market, eventually prices will go back up again. Some people buy rental properties at what they think is the low spot in the market, in hopes the market will appreciate. Some will buy rental properties in a hot market, assuming prices will keep on rising with no cash flow. I don’t call this investing, I call it speculating, and I think both strategies are dangerous if you do not have cash flow. You are hoping values increase, and you can make money when you sell the home. This strategy has many flaws.
- No one knows what the market will do; it could go up or it could go down. When it does go up, how do you know when the right time is to sell? If you wait too long, the market could decline again.
- It is expensive to sell a house. If you are not a Realtor, it will cost about 8 percent of the selling price in commissions and closing costs. The market has to appreciate at least 8 percent just to break even on a rental home.
- Most people buy homes hoping they will appreciate and do not worry about cash flow. If you are losing money each month, then that money has to be figured into your returns as well. It is not fun to have to spend money on an investment every month, investments are supposed to provide money every month.
Cash reserves are needed to protect against down markets
If money is tight and you want to invest in a rental property, make sure you have enough saved to cover expenses. Rental properties are expensive as I detail in this article. You will need a down payment, money for repairs, holding costs and reserves in case unexpected repairs are needed or the home is vacant for a period of time. One of the most common reasons investors are forced to sell when values decline on rental property is they run out of reserves. Here is how you can get into a rental property with less cash if you are just starting out.
If values decline on a rental property, it won’t hurt you badly if you planned your strategy well. If you are buying rental property and cash is really tight, maybe you should save up a little more. Remember, repairs always cost a little more than you think and the house might be vacant a little longer than you think. If you really want to jump in the game as soon as you can, make sure you invest for cash flow and buy below market.