Investing In a Hot Real Estate Market

It’s no secret that we are huge fans of real estate investing. Kinsey & I have bought long term rentals, we have done flips, we now have a vacation rental, and we’ve even done a wholesale deal.  We are getting more interest than ever from new investors. When real estate is hot, it seems more people seem to want to get into real estate investing. I don’t want to discourage anyone on investing, but I think investors should be somewhat cautious in the current market. Personally, I don’t think we are in a position where the housing market will come crashing down like 2008. With limited inventory, strong demand and low interest rates, all signs point to values continuing to increase. So why should investors be cautious?

We know that markets are cyclical, and we have been in a long up cycle. In the Madison area market, aside from 2007-2011, we typically have not seen significant price drops when the market cycle shifts to a Buyer’s market. This would mean a flattening of prices, increased inventory, and reduced buyer demand. If you are a buy and hold investor, this probably isn’t a big deal because you aren’t selling. If you are a flipper, this shift could be a big problem. Perhaps you bought when the market was on fire and you were competing against 10 other buyers to buy that fixer upper house. Now 8 months later, you’ve completed your renovation, which cost you more than you planned because construction costs were rising. However, if there’s less demand for that house, more inventory, and higher interest rates – you might be stuck holding the house awhile longer. Or you might not get out of it the price that you originally projected. I’m not saying don’t rehab houses in this market, I’m just saying plan and project with caution. Don’t expect the market to be this hot when you are ready to sell.

Rental property buyers should also be more cautious. I don’t have much concern if you are planning to buy a rental and hold it for 10+ years. However, if there’s any chance of you selling that rental in the next 5 years be careful. Investors generally buy rentals based on the income the produce. So, they’ll look at things such as cashflow, return on investment (down payment), rent to value ratios, and cap rates. I don’t want to get into all these calculations right now, but essentially cashflow and ROI (return on investment) factor in returns based on a leveraged (mortgaged) property. Rent to value ratios and cap rates help measure value without factoring in leverage. Right now, interest rates are extremely low, this is making properties cashflow that wouldn’t have in the past at similar prices. I’ve seen a few rental properties that have more than doubled in price in the last 5 years. If interest rates go up significantly, this could turn a property with positive cashflow into one with negative cashflow (if it were sold and financed at the higher rate). This would result in a reduced value of that property in an investor’s eyes. So, anyone who might be purchasing a rental property for a shorter-term hold should be extremely cautious. Overtime, average appreciation and rental increases will makeup for this, so I still have a lot of confidence in long term holds. Additionally, you’ll want to steer clear from any Adjustable Rate Mortgages, because it will certainly hurt when your rate jumps up.

Again, I don’t want to scare people away from real estate investing. However, I think investor Buyers need to hold back some of the excitement and hype and exercise a little caution. I think investors should start being a little more conservative in their estimates of cashflow, appreciation, or rehab profits. It’s far better to outperform your estimates then underestimate and get stuck in a losing deal.

I should also note, I don’t think the typical homeowner has much to worry about. You need a place to live and owning is almost always better than renting from a long term wealth building stand point.

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