New Rules For Real Estate Investing

I've received many questions from readers during the past few months about real estate investment strategy during this economic crisis. The common thinking is that somewhere down the road we should expect a nasty inflation to return making real estate a smart inflation hedge.

While I agree with the basic concept, I also believe there are many issues to be wary of…

The first and most important issue is timing. I wrote this post last summer highlighting one of the more outspoken advocates of this investment strategy, Dan Amerman. You may want to re-read it for specific insights. In a nutshell, Dan and I agree that buying real estate as an inflation hedge strategy will ultimately be successful, but we disagree on timing for implementation.

My concern dating back to 2007 is that we would face a deflationary credit collapse that would wreak havoc with real estate prices. In fact, I sold all my investment real estate in 2006 partially due to that belief which proved to be true (and continues to develop).

Dan counters my deflationary concerns for real estate by citing his research showing the primary profit source from this investment strategy comes from the synthetic short position in your currency through long-term real estate mortgages. The way it works is when interest rates rise during inflation the value of your mortgage debt declines. It is the same reason you don't want to own long-term bonds (be a creditor) as interest rates rise because the value of your bonds declines. Similarly, you do want to owe long-term mortgages (be a debtor) when interest rates rise because the value of the debt declines. They are mirror images of the same issue producing opposite financial results.

In other words, there are two components to profiting from real estate during an inflationary rise. The first one everybody understands – the value of the real estate should rise over time. The second is less commonly understood but potentially more important - the value of the mortgage should decline – but only if you lock in the current, artificially low, mortgage interest rates for the long-term.

Some advocates of this strategy, like Dan, believe it is more important to focus on the mortgage than to worry about paying the right price for the property. I remain unconvinced of that conclusion and believe it is really an equation of balance. The reason you can't pay any price for real estate and rely on inflation's magic to destroy the value of the debt is there are too many unknowns between now and then. You don't know how long or deep this deflationary collapse will run. You don't know how it will affect rents and vacancies thus lowering cash flows. A lot can happen between now and the time inflation returns.

On top of that, real estate investing involves financial leverage which cuts both ways: it makes the good times great and the bad times unbearable. Witness all the bankruptcies, foreclosures, and bank failures to get a little taste of how quick things can turn bad in the leveraged world of real estate finance when inflation turns to deflation.

What this means when you put it all together is you must carefully time your purchase to balance the issues. Purchasing the property too early can result in devastating price declines and potential cash flow losses from rent reductions and vacancies that might bury your deal before inflation returns. But if you purchase the property too late then the current low interest rate, long-term, fixed rate financing may already be a thing of the past. Putting both components of the investment strategy together while minimizing risk requires a delicate balance.

Below are my personal rules for real estate investing in this economic crisis that attempt to strike a reasonable balance between risk and reward:

1. Finance only with with long-term, fully amortizing, fixed rate mortgages. No balloons, no adjustables, no short duration loans, nothing esoteric, nothing exotic. If your goal is to build real wealth after inflation then there is no flexibility on this issue because much of the value of the strategy is in the loan. If you have a variable or a balloon then you are accepting interest rate risk that could destroy your investment down the road.
2. Only swing at fat pitches. In other words, don't do thin deals. This investment strategy is designed to be a long-term hold and you don't need very many deals to fill your portfolio so be very picky. There are hungry sellers out there right now and this post explains why they are likely to get even hungrier in the future. Don't be in a rush and don't accept marginal deals.
3. Positive cash flow increases safety. No deal qualifies as a "fat pitch" unless it provides significant positive cash flow from the day you close. Positive cash flow gives you an infinite holding period since you are paid every month to own. Significant positive cash flow gives you room for error if things go from bad to worse. Fat pitches provide large cash flows. If inflation returns then you will do extremely well, but if another leg down in deflation occurs first then the cash flow will help you weather the storm long enough to wait out the eventual return of inflation that will validate this strategy.
4. Reduce leverage. Financial leverage cuts both ways: it makes the good times great and the bad times unbearable. Financial leverage is the root cause of the credit problems cripling world economies today. Don't make the same mistake. The goal of this strategy is to build wealth in real terms after inflation. It doesn't take 9:1 leverage to achieve that objective, and higher leverage may force you to abandon a property before inflation finally returns to validate this strategy. In short, reducing leverage increases your margin of saftety and cash flow. My own tastes lean toward 50%-70% financing but the final number is dependent on the quality of the deal, local market conditions, and other factors beyond the scope of this post.

Remember, the goal is a long-term hold that puts cash in your pocket today and increases those cash flows as inflation rises while providing moderately leveraged equity growth to build wealth in real terms after inflation. In order to achieve those objectives very specific rules apply.

While these rules are designed for investment real estate, there is a low risk way for every homeowner to capitalize on this investment strategy as well. If your home is financed by any type of loan other than a conventional 30 year, fixed rate mortgage you may want to consider refinancing so the interest rate risk is owned by the banks – not you.  If interest rates decline significantly from here you can always refinance again – the cost is minimal for many programs. Whereas, if interest rates rise from here you will be locked in and never regret it. Many lucky homeowners built wealth in real terms during the last round of serious inflation in the 1970s using this strategy so learn from their good fortune.

In summary, the long-run outlook for inflation and interest rates when measured in a time frame of a decade or more is clearly higher, but a lot can happen between now and then including brief, dramatic declines. Nobody has a crystal ball; therefore, you must always manage your risk. 

The days are over where you could rely on increasingly permissive financing, declining interest rates, and stable inflation to provide a tail-wind that produced profits out of thin real estate deals. The new investment environment is much riskier and requires a new set of rules providing an investment premium to justify accepting the risk. 

While I consider these rules the bare-bones essential requirements, I'm also confident many of my readers have other rules for their own real estate investing during the economic crisis that I did not mention. Please join the discussion by sharing them below in the comments so that we can all learn and benefit…

Further Reading

• Overview of Dan Amerman And His Free Real Estate Education Ideas
• Learn Why The Mortgage, Banking And Real Estate Crises Are Likely Far From Over