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One of The Motley Fool’s main tenets of investing is to focus on the long term. Don’t speculate on short-term movements and don’t let drawdowns during bear markets scare you out of a stock that still has good long-term prospects. These same arguments, plus a few more, apply to real estate investing.
Let’s go over why a bear market shouldn’t scare real estate investors away from business as usual.
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It takes a lot of time in stock investing, as new prices are flashing at you constantly, to train yourself not to pull the trigger and sell when the price is falling. Real estate investing is different — there are no flashing prices and pulling the trigger can be a several-month process. Nonetheless, the argument is the same for both types of investing: If the economics of the business are still strong, the current price doesn’t matter.
As long as you have a good loan-to-value ratio, can keep the property occupied, and can continue paying down the mortgage, short-term drops in real estate prices don’t matter much. The bank won’t worry unless the price drops an incredible amount and, usually, falling real estate prices follow an increase in demand for rentals, so rents probably won’t fall as much.
The key is that you don’t have to sell the property. You can hold onto it through changes in market price (and really you wouldn’t even know what’s happening to the price exactly without getting an appraisal) and continue to collect cash flow while waiting for the prices to recover, which they will in almost every case.
That said, consider increasing your reserves so that you can withstand vacancies or reduced rent. Keeping your mortgage current and being able to make tax and insurance payments are paramount for long-term investors.
Another variant of the argument about prices not mattering is that you shouldn’t be investing in real estate for capital appreciation in the first place. There are four ways you make money in real estate investing: capital appreciation, rental income, debt paydown, and tax avoidance. It’s possible that of those four, capital appreciation will have the least impact on your returns.
Real estate prices simply don’t go up as much as stocks over the long term. When you buy a rental property, most of your gain comes from using leverage and having someone else pay the debt off and then, eventually, generating a good amount of cash flow from the property. Let’s say you buy a $500,000 house with 20% down and over time the tenants pay off the mortgage for you. That’s an initial investment of $100,000 and a gain of $400,000 from paying off the debt, plus any change in the value of the property.
Real estate in most places had a great few years prior to 2022. Where I live, in Utah, prices were up more than 150% from 2015 to 2021 in some areas. This makes it hard to find values.
For example, the popular BRRRR (Buy, Rehab, Rent, Refinance, Repeat) method only recommends buying properties that have an 8% or higher capitalization rate. Cap rate is calculated by dividing the cash flow the property generates by the price of the property. For comparison, if properties appraised at a 4% cap rate — which was typical in the past year — it means they would have to either sell for half as much or generate double the cash flow to work for that investing strategy.
The BRRRR method is, admittedly, a distressed real estate strategy, but a cap rate rule is a good one to follow. If you make sure to only buy properties with a 6% cap rate, for example, you’ll ensure that you always have sufficient cash flow to pay the mortgage and other fixed expenses. It’s hard to find properties that can meet this hurdle if cap rates are low for the whole market.
If prices start to fall now, value properties may finally hit the market.
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