Bursting bubble? Bring it on
When housing prices fall, some investors' hopes rise.
NEW YORK (CNNMoney.com) - A housing-price drop would not be bad for everyone. In fact, many canny real-estate investors have been hoping for just such a hit.
"You can make a fortune in a falling market," says Hugh Bromma, CEO of Entrust Administration and author of "How to Invest in Real Estate and Pay Little or No Taxes."
You do it by buying low. Investors can build up rental property portfolios more easily in down markets -- if their initial pay out is smaller, they can more likely turn a profit on rents.
"You always want an investment property to make money from the get-go -- always, always, always," says Bromma.
That means that rents must exceed expenses every month. It's even more important when prices are falling than when they're going up.
"If you don't buy a rental right," says Erwin Jackson, a Florida landlord, "by the time you pay the maintenance, insurance, taxes, and everything else, you won't have any money."
Jonas Lee, of Redbrick Partners, a real-estate investing firm specializing in single-family homes, says his company has had success since 1993 by "playing in the lowest-priced markets." The typical single-family home his company buys costs a mere $80,000 and has three bedrooms and two baths.
Redbrick has found these bargains in the downtown residential areas of rust-belt cities such as Baltimore and Philadelphia. The company shuns hot markets like Boston and New York.
He's hoping a housing-market downturn will enable him to expand his holdings.
Many investors who bought in at the top may not have the resources to ride out a bust and they'll be forced to sell out or even give their properties back to the banks.
"In falling markets, people need to sell their homes more quickly," says Lee. "They'll take a discount to the true market value at that time."
Foreclosures become more common because there's little benefit to the property owner to cash out before it reaches the foreclosure stage; they may owe more than the property is worth. And foreclosures can pile up in local markets causing a spiraling down of prices and providing opportunities for bold investors.
The question becomes: How do you know when the price is right?
Investors must familiarize themselves with statistics and crunch numbers before they buy. They have to know what a home can command in rent and how long it takes to rent a property.
A key stat is the "cap rate," which is a percentage based on the annual rents you can collect, minus expenses, versus the property value.
For a property that costs $100,000 dollars and generates $650 per month in rent minus $250 expenses, the cap rate would be nearly 5 percent ($4,800 divided by $100,000). A cap rate of 5 percent or more should provide enough cushion to offset expenses. The lower the home price compared with the rent, the higher the cap rate. (See Correction).
If the numbers add up to positive cash flow, then it's a profitable time to buy.
The lower the price the greater is the margin of safety. Karen Pio, a small real estate investor from Bristol Connecticut, says she and her husband waited patiently until a property's price was way low. If it never reached the price they thought they needed, they passed on the property. That way even when "we had to reduce our rents during down periods, we were able to because of how we bought," she says.
Falling markets can even sometimes have a positive effect on how much landlords can charge for rents by increasing the demand for rental units.
Bromma says that investors should watch markets carefully for the next six months. Mortgage rate increases could lead to a market slowdown or turnaround. His advice for anyone looking to invest in rental properties is to be "in cash." That way, they can act quickly to snap up some bargains.
Bernice Ross, of RealEstateCoach.com, who has been in the business more than 25 years, says the most successful real estate investors she's known over the years have been contrarians. "They sell when everyone else is buying and buy when others are selling."
If the trend is toward bubble burst, those smart investors may be gearing up for a shopping spree.
Correction: An earlier version of this story defined "cap rate" incorrectly as a percentage of the annual rents versus the property value. That statistic is the gross rent multiplier (GRM). The cap rate is the net operating income divided by the property value and multiplied by 100.
Overall, house prices are still rising, but at a slower pace. For more, click here.
To see which house renovations add most to the property value, click here.