Issue #2438 The Art & Science of Bear-Market Real Estate Investing

“Something is worth precisely what someone else is willing to pay for it.” So said a stock-market analyst to me one fine bull-market day many moons ago.

A statement like that can seem profound, but it’s useless. Yet it is the mantra of many investors in all fields. In bull markets, the sellers say it. In bear markets, the buyers say it. But it is about as helpful as saying, “Wherever the sun shines, there it is daytime.” So what?

It tells you nothing about why the sun is shining or, more important, when the sun may stop shining… and how long it will likely be before it shines again.

Intelligent investing is all about the why and how. It takes some thinking… not cheap aphorisms.

And so we turn our thinking to real estate investing and we ask the questions everyone has been asking…

“How low can the real estate market go? When will it bottom?”

Here’s the short answer: I don’t know. Here’s the longer answer: I don’t know but

I’m still finding some excellent opportunities. And, regardless of where the market heads the next few years, I can buy at prices today that assure me of respectable returns over the long run… and could well provide exceptional returns in the near to medium term.

It all boils down to understanding what is art and what is science in your investing… and paying due respect to each.

The Art of Judgment: How Not-So-Dumb Luck Can Help You Succeed in Real Estate

I’ve made the bulk of my real estate profits because of a force I cannot control: market appreciation. You buy under market in the sweet spot of the appreciation curve and – thanks to leverage – you can grow your investment five or 10 times or more in the space of a few years.

I have six key criteria for identifying good value and growth markets. I’ve written about them in ETR several times. Using those criteria, I’ve chosen markets I thought were undervalued and that were experiencing growing demand.

It turns out I was right. So I enjoyed much more than the standard 3 percent to 4 percent appreciation a year on my properties. I bought where the markets ended up appreciating 10 percent to 15 percent a year. And, because of leverage, I made many times that. And I even did this while some markets were imploding!

Understand that not all value and growth markets that you identify and buy into are going to go straight up. They can stay flat or fall for quite a while before they recover. And yet, even when that happened, I was able to make a decent return on my investment

That’s because choosing a market or a neighborhood to invest in is an art. You base your buying decisions on your best reading of the facts. But, ultimately, it’s a judgment call. You can get very good at it, but you can’t force it. Your reasoning may be perfect, but the market could suddenly refuse to accommodate you.

That’s why you have to pay even greater attention to the science of real estate investing.

The Science: Crunching the Numbers and Doing Rigorous Due Diligence

By “the science of real estate investing,” I mean all the measurable numbers and criteria that can help assure your success. In other words, before you buy an investment property, you have to know the answers to all of the following questions…

* How strong is the rental market? Okay, you just saw a couple of two-bedroom apartments in the area rent for $750. But you’re looking to buy a 20-unit building with all two-bedroom apartments. Is there enough demand? Can you rent them all out at $750?

* Will the property cash flow at market rent? Will it cash flow at a 15 percent to 20 percent discount to market rent (in case the market softens or you have to lower your rents to remain competitive)?

* Are you fixing your interest rates? By doing so, you don’t become hostage to another economic factor over which you have no control.

* Are you buying at a discount to the average $/square foot for that type of property in that area? When you buy at a discount to start, you have that much greater a margin of safety going forward.

* Have you thoroughly investigated what your operating costs will be? Don’t take the seller’s numbers at face value. They often understate costs – especially real estate taxes. (Your taxes may rise significantly if you’re paying a lot more than what he paid years ago.) The key point is: You must know your costs well in order to have a reliable idea of what your net operating income and cash flow will be.

* Have you considered deferred maintenance and any major expenditures that will be yours in the next few years? From a new roof to repaving a parking lot, significant expenditures of this sort can eat up cash flow and even cause a property that is not sufficiently capitalized to go into the red.

* Do you have honest and competent management set up for the property? Properties that look good on paper can quickly turn bad when you have poor management.

* Are you buying near or below replacement cost? This is especially important in a bear market.

These are all factors over which you have significant control. And when you get good at doing this kind of due diligence, you can scoop up bargains in a bear market – without caring that you may not be buying at the absolute bottom.

How to Make Money Even When You Make a Mistake

After all, if you have a fixed-rate amortizing loan on a cash-flow property, you’ll eventually own the property free and clear, regardless of price fluctuations in between. Buy a $1 million property with $200,000 down and you’ll eventually pick up $800,000 just from using the rents to pay off the debt.

In the meantime, you’ll also pocket net rents (the money left over after paying operating costs, the mortgage, and leaving a little something for reserves). So in a very bad case scenario – where the market goes nowhere for the next 20 years – you could end up making over a million dollars from a $200,000 investment. And, of course, if the market soon bottoms and improves, you could end up making a million or even millions much sooner.

So in a bear market, focus on buying cash-flow properties at below market value in areas that you believe are promising and where you are confident you can put in good management. At the same time, for added bear market protection, buy near or below replacement cost whenever possible. Here’s what that means…

Replacement Cost: A Great Reality Check for Real Estate

Let’s say that 20-unit building is 15,000 square feet, and to build that structure brand-new would cost $100/square foot – or $1.5 million. But, of course, the building isn’t new. If you were to bring it up to the standards of new construction (for its class), let’s say it would cost you $500,000. So that means, to stay below replacement cost, you’d want to buy it for less than $1 million.

In other words, if you spent $1 million on the property and $500,000 to upgrade it to brand-new status, you’d be spending no more than anyone else who was willing to construct a brand-new competitive building in the area. In fact, your cost would still be under theirs, as you would have gotten the land along with your purchase of the building.

Staying near or below replacement cost isn’t always possible – especially in increasingly popular, higher-end neighborhoods. But in today’s bear market, it is becoming easier in every kind of neighborhood.

And buying below replacement cost is not a guarantee of success. After all, if you buy into a neighborhood that’s in serious decline, you may find no one willing to build there in future years at almost any cost. However, that is an extreme case. And you’d certainly be worse off if the neighborhood went into serious decline after you had paid far more than replacement cost.

So at the very least, buying near or below replacement cost will greatly reduce your risk on every type of real estate purchase. That – and your insistence on buying at prices that cash flow with a good yield – will help you be a shrewd buyer in a bear market.

Your success will not hinge on your ability to guess the bottom. Go ahead and make that judgment call along with others – including the best markets and neighborhoods to invest in. But get the numbers right first and buy cash flow, undervalued on a $/square foot basis and on a replacement cost basis, and your rare mistakes can still make you money in the long run… while your more frequent successes can make you (and your investors) a fortune much more quickly.

Justin Ford is an active investor in real estate and global stock markets. He is also a veteran financial writer. He has published, edited and written for over a dozen international investment newsletters, including launching the US version of the Fleet Street Letter, the oldest continuously published newsletter in the English Language. He is the author of Seeds of Wealth, a program for getting children to adopt good money habits from an early age. He is the editor of the Seeds of Wealth Quarterly Investment Update Bulletin. He is a contributing editor and author to a number of books on personal finance, including Michael Masterson's Automatic Wealth and Dr. Van Tharp's Safe Strategies for Financial Freedom.