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If You're Thinking of Buying Rental Real Estate, Read This FirstBy
Thursday, May 30, 2013
One of the most common questions I get from my readers these days concerns real-estate prices:
"Prices have been going up fast. Is there still time to invest?"
As DailyWealth readers know, my friend and colleague Steve Sjuggerud believes there is a good deal more room for real-estate prices to go up. As a real-estate investor who owns many properties, I am comforted to know that Steve – who has a proven record of identifying market trends – believes prices will continue to rise.
But I won't be chasing those prices, because I do not consider market trends when I make investment-buying decisions – with real estate or with anything else.
Instead, I use a rule of thumb I learned from my brother Justin, who is a real-estate pro...
Justin recommends making an initial assessment based on the relationship between the price of the property and how much rent you can get from it on a yearly basis.
My rule is to never spend more than eight times yearly rent for the house, including any money I need to put into it to get it rented. (In real-estate parlance, this is called "buying on a multiple of gross rent." In this case, a gross rent multiplier, or GRM, of 8.)
In the first lesson of my Wealth Builders Club Rental Real Estate 101 series, I gave the following example:
Let's say the house you rent in your neighborhood costs $1,500 per month. That would be $18,000 in rent each year ($1,500 x 12 months).
Using a GRM of 8 "forced" me out of the real estate market in 2007. That was about a year before the market crashed. I did not exit because I could foresee the market topping in 2008. I stopped buying properties simply because I couldn't find any with GRMs of 8 or less.
Had I been able to predict the future, I would have bought and flipped properties for another year. And in fact, one of my partners did that. Against my advice, he bought a property in 2007 – with a GRM of maybe 12 – and managed to sell it six or eight months later for a profit.
But he was sweating that deal in the last few months because the market was falling apart quickly by then. He got out by finding "a bigger fool." I'm glad he did get out. But I wasn't tempted to join him. Not even for a minute.
I was and am willing to give up whatever upside speculation offers in return for the ability to sleep at night. I can't feel comfortable hoping that the market will bail me out. I want to know that my money is safe the moment I invest it.
In other words, I don't believe in timing. Or, more precisely, I don't believe that I have the information and intelligence to time the markets consistently. I do everything I can to be cognizant of the fundamental and technical factors at play. And when I read analysis such as Steve presented, it makes me feel better.
But that doesn't mean I'm going to pay more than eight times gross rent for a rental property – even if I am 90% certain that prices will continue to rise. I am so averse to risk that even a 90% confidence level is not enough to cause me to risk my money.
There are many ways to invest in real estate. Some people like to "buy and flip." This practice gained huge popularity between 2005 and 2008 as the market soared.
Real estate speculators – millions of them completely new to the game – were buying up anything without regard to cash flow. They were sure prices would continue to rise and felt confident they could make tens of thousands of dollars by buying and then selling properties over a short span of time.
This is also a popular strategy for investing in stocks. Some investors buy almost any stock – without reference to its value or price – simply because they believe the market as a whole or in certain sectors is in a bull run.
And some people are good at this. But most people, including me, are not. And that's why I use the GRM technique and recommend our Wealth Builders Club members use it, too.
Back in 2010, I was buying houses very cheap. One house had sold for $300,000 at the top of the market, and I bought it for $85,000. That gave me a gross rent multiplier of 6. Through my brother, I bought several houses with even better GRMs. And a client of mine heeded my advice and bought 30 small homes for GRMs of 3 and 4!
But I knew those deals wouldn't last. I warned readers last July that the window of opportunity was rapidly closing. I made the same point about the future:
I believe that real estate prices will continue to edge upward this year and next year... it is possible that in 12-24 months, the house that costs $105,000 today could cost $120,000 or even as much as $135,000. Now here we are, in a market where great deals are much harder to find. And this leaves you with a choice: You can buy properties above my recommended GRM of 8. And if everything goes well and the market continues to rise, you may be able to sell those properties for a nice profit in a year or two.
Or you can play the market according to my rules and work harder to find the deals with GRMs of 8 and lower that cash flow at 8%-plus.
My strategy won't give you the maximum profit, but it will protect you from the devastating losses many real-estate investors faced in 2008 and 2009.
Best,
Mark Ford
Further Reading:
"U.S. housing is the greatest value it's ever been in our lifetimes – and probably the greatest value it will ever be," Steve Sjuggerud writes. And "housing is about to soar." So don't wait a moment longer. Learn why you should jump in today here. And find out exactly how high home prices should go here.
If you aren't in the market to buy real estate, one company has already "done the dirty work for you," Steve writes. "This company is the very best way to get invested in residential real estate THROUGH the stock market." Get all the details on the one-click way to play real estate here.
Market NotesUNIQUE INSIGHT ON THE GREAT CHINA DEBATE If you want a good opinion on one of the world's biggest investment debates... just ask Brazil.
Regular readers know China is at the center of a great financial debate. Some world-class analysts, including Jim Chanos, say the country is a powder keg of government malinvestment... which will cause a huge economic slowdown. On the other hand, you have "China bulls" who say bearish arguments are overblown and overhyped.
China is a key cog in the global economic engine... so what happens there affects nearly every investment you own. One way to track the situation is with Brazilian stocks. Brazil's economy is heavily dependent on natural-resource production... much of which is sent to China. If China catches cold, so does Brazil. The two economies are joined at the hip.
Below is a three-year chart that displays the price action of the big Brazil investment fund (EWZ). As you can see, Brazilian stocks are down big from their 2011 highs. And despite the broad market rally off the November 2011 lows, EWZ is still sputtering near its low. Bottom line: China isn't humming.
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