Given the current volatile and unpredictable real estate market, should you buy sell or hold your real estate investments?
In a previous post, Should You Prepare for a Housing Crash, I discussed the reasons why we might experience a crash in the housing market in the coming months. Since that post, the discussion in the real estate investing community on how to proceed in this market has become quite robust.
One thing is certain. Anyone familiar with the real estate market is aware that all real estate is local. Even if a crash occurs, not all markets will be affected equally. The decision to buy, sell, or hold is not only dependent upon the market but on your own individual circumstances.
Let’s take a look at the 4 major factors that you should consider before making the decision to buy, sell, or hold.
As previously discussed, a migration is currently underway from high priced, highly taxed, and highly regulated communities to communities where prices and taxes are lower. The recent WFH phenomenon has only accelerated this trend.
If you hold property in a market where the net migration is negative, it is logical to assume that the inventory of properties for sale and rental vacancy rates are likely to increase. This translates to lower prices and lower rents.
A great example of this trend is New York City, specifically Manhattan. As of July, the number of contracts has dropped 54% and the median sales price has dropped 17%.
Conversely, if you own property in an area where the net migration is positive, property values are likely to increase as well as market rates of rent. A good example of this is Nashville, TN. Property values have increased by 4.5% in the past year and are expected to increase a further 5.8% in the coming year.
Regardless of your location, you should be looking at your current return on investment as well as your cash on cash return.
In addition, you should also be looking at your return on equity. If your investment property has increased in value since you made your purchase, your return on the increase in equity has likely declined.
The question then becomes, can you refinance and put that cash to work elsewhere, or sell the property and invest the equity where you can earn a higher rate of return?
It is important to look at the industries providing employment in the area you are currently invested in or wish to invest in. Are they legacy industries that are in decline or are they up and coming industries that will grow in the future? This analysis should be included in your risk assessment.
As with any investment, you want to manage your level of risk. In an ideal world, you would want little or no risk. However, in the real world, there is always a risk. The objective should be to reduce the risk so that it is manageable.
There are 2 components to managing risk;
Debt to Equity Ratio
Commonly referred to as leverage, the debt to equity ratio should be such that the income from the investment can adequately service the debt. Optimally, the net income after expenses and debt service should be sufficient to allow you to add to your reserves on a monthly basis.
I cannot emphasize this enough. The rule of thumb here is, the greater the level of risk, the greater your reserves should be. In the event that something unforeseen happens, you should have sufficient cash reserves to deal with any shortfalls.
Let’s look at a few scenarios to understand how these factors are best utilized to determine the best course of action.
The property was purchased 10 years ago for $250,000 with a 20% down payment. The mortgage is $200,000 at an interest rate of 4%. Gross income is $2,000 per month. The monthly debt service is $1,238. Taxes and insurance are an additional $300 per month. In the interim, property values have increased and the property is now valued at $400,000, an average increase of 6% per year.
From the above example, the cash on cash return has dropped from 27.7% to 3.7%. In this scenario, it would be advisable to either refinance or to sell the property and invest the $150,000 in equity elsewhere.
Using the same example as above, let’s add a few more assumptions.
- The property is located in an area where the main employer is the auto industry.
- The owner of the property has spent the net income over the years on making improvements to the property and as such has no reserves.
- The net migration is negative and vacancy rates are beginning to rise.
In this scenario, it would be advisable to either sell the property and invest elsewhere, or at the very least, refinance the mortgage, pull out cash and add it to reserves. In the event that the market crashes, the owner has at least pulled his equity out of the property and substantially reduced the risk of loss.
Again, let’s use the example in scenario 1 but with a different set of assumptions.
- The property is located about 50 miles outside of a major urban center.
- A major tech company is planning to build a secondary headquarters in that urban center that will add 15,000 jobs to the local economy.
- The owner has built up substantial reserves that will cover at least 12 months of operating expenses including debt service.
Given these assumptions, it makes sense for the owner to hold the property. With the influx of new jobs, demand for housing is likely to increase, pushing prices and rents higher.
Since the owner has more than sufficient reserves he is well-positioned for most eventualities. It could be argued that under these particular circumstances, he should refinance and use the equity to buy additional property in the area.
The Bottom Line
All real estate is local and the decision to buy, sell, or hold is subject not only to the market but to the individual investor’s circumstances as well. There is no one size fits all rule when it comes to real estate investment.
We live in uncertain times. At the time of this writing, the presidential elections in the USA are just two weeks away. The outcome of the election is not clear and may not be clear from some time to come.
Additionally, the end of the coronavirus pandemic is not yet in sight, and the extent of the damage to the economy is still unknown. Proceed with caution.