Investment Strategy to Protect Against a Downturn
I have received several questions along the line of “What if this is just a bubble?” and “How do you know prices won’t fall again?” While I think real estate is on a fairly solid footing, there are definitely conditions in the world that could change that. Last issue I wrote about how to protect yourself against a drop in the market for those people looking to purchase a primary residence. This issue, I want to look at the same concept for investment real estate.
For the past two years, we have been stressing cash flow to our real estate investors. Prior to the housing crash, many inexperienced investors were willing to take on a property with negative cash flow because the market was rising so quickly that the appreciation was larger than the monthly negative. That story had a bad ending. Purchasing a property with large positive cash flow insulates an owner against the ups and downs of the market.
We have been helping investors purchase 2-4 unit San Diego property that generates
a cash-on-cash return in excess of 8% the first year. What this means is that if an investor puts $100k into a property for down payment, closing costs and a repair reserve, the first 12 months of ownership should yield $8k of positive cash flow after all expenses (including mortgage) are paid. In some of the 4-plexes, the cash flow is still positive when one unit is vacant.
The importance of positive cash flow cannot be overstated. For example, if you were to invest $100k in the property above, you could apply the positive cash flow to early principle payments and have the loan paid off in 15-16 years (if you do not increase rents at all). In that case, your initial equity investment would increase as the property is paid off to about $350k (the initial purchase price) if there is no inflation. Even if property values fall 25% in 15 years, your $100k would grow to $262k – not bad in a down market and only possible because positive cash flow lets you hang onto a property through tough markets.
Next issue, I will look at marketing strategies to create an auction environment when selling your home.