To varying degrees, most of my friends and family think we’re fairly crazy for owning more than one house. While owning two houses is palatable, buying a third house causes eyes to roll and heads to shake. When I mention possibly buying a duplex on top of all that, I might as well be certifiable. And that’s even before you get into details about how much money we’re borrowing to pick up all of these properties.
Much of the above is more a result from a gap in risk tolerance, as far as what I’m willing to bite off at this realtively early stage in my life, and what the “safe” thing to do is. If you think that wise investing is owning one home, paying it off completely as quickly as possible, and putting every extra penny into savings, then you’re likely always going to think I’m crazy. I can’t do much about that, other than agree to disagree.
But the above discussion about buying houses is barely half the real discussion, as it doesn’t involve a pretty crucial component: why am I buying these properties and what are my plans?
If you tell someone that you’re buying a house and give no other information, the default assumption is that you think the property is going to appreciate in value over time. In this more than a little uncertain real estate market, that’s a pretty iffy proposition, fraught with peril. That gets multiplied as you acquire more properties, especially if you’re taking on debt to purchase them. So if you stop there, it’s more than reasonable for anyone listening to think you’re crazy.
But if you’re exercising a little brain power and patience, paying less than actual value for your properties, and have multiple exit plans, well, maybe you aren’t so crazy after all.
The plan for the 1002 S. Main St. house is pretty straightforward: buy it, fix it, sell it, and make a profit. Sounds great. But what are my plans (before I even buy the property) if that doesn’t work out? It’s different for every property, based on the individual details, but here are my exit plans, roughly in order:
1) Renting the property: One of the reasons I purchased the property is that it’d produce positive cash flow as a rental. The housing market is pretty tight in our area, especially for affordable 3-2s and 3-1s. The property was previously rented for $750/month and it would take a major economic downturn to push rental prices below that. After property taxes and maintenance expenses and other fun stuff we wouldn’t net much when it was all said and done, but it would produce positive cash flow.
2) Sacrificing sweat equity: Let’s say that I completely misjudged the economic climate, and that even our stable, somewhat rural corner of central Texas is hit with the mother of all property value corrections, and the house not only drops in value but rents drop as well.
Since I’m buying a property in need of repairs and plan on doing the vast majority of the work myself, I’ll have a certain amount of sweat equity to play with. I can sell for a loss and not take as big a hit (if any) as someone who bought a house and paid a contractor to do all of the repairs. Yes, I know, my time and labor is in theory no different than money, but it’s a whole lot more palatable in the real world to wave goodbye to sweat equity as opposed to cold, hard cash.
Again, this needs to be accounted for before you buy the house, as far as considerations you weigh.
3) Willingness to sell at a 10% loss: In the world of investing in equities, this is basically your stop loss. Savvy investors typically enter a position and immediately set up a stop loss order, so that if a stock they buy drops a certain percentage amount, their position is automatically sold. The amount is up to you, but many people use 10% as a good baseline stop loss.
Let’s say that I not only misjudge the economy and/or local property market conditions, but that it’s a nuclear winter scenario, and things fall off a cliff, with property values dropping quickly even in stable areas that normally take a year or more to move dramatically either upwards or downwards. If that happens, I’m willing to take a hit and sell at a 10% loss, as far as the total purchase price (plus fees, closing costs, repairs, etc.)
I wouldn’t be happy to do that, at all, but it wouldn’t be the end of the world, either. Part of investing in anything is taking your occasional lumps. As long as you preserve as much of your investing capital as possible, the occasional times you whiff won’t cripple you, which is the whole point of setting a 10% stop loss on investments. If taking a 10% loss on a property you plan to buy would cripple you, you’re probably operating far outside your comfort zone, overleveraging yourself, and should re-think your game plan.
4) Ability to pay the mortgage on an empty house: Conjuring up the nuclear winter scenario again (where you can’t rent the house nor sell it soon enough to even unload it at a loss), can you simply pay the mortgage on a house sitting empty?
My wife and I have pretty simple tastes, but we like to take trips, eat out, and buy fun things. If push came to shove, we could cut out enough extra expenses each month to pay the mortgage on the 1002 S. Main St. house. I’m talking long term here, not just a few extra months until it can be sold, and as an option of last resort, in the face of economic conditions that fall off a cliff.
Would that make me happy? Of course not. But it’s something to keep in mind. If you don’t have savings or room in your budget to pay the mortgage on an empty investment house, are you willing to get a second job to produce the necessary income? If the answer is no to both those, again, you may be playing in waters that are too deep for your comfort zone. It doesn’t necessarily mean that the answer always has to be yes to both those questions for an investment to be profitable to you, but it’s a pretty good indicator.
Pulling back a bit, keep in mind that all of the above are emergency exit plans. No one hopes to ever have to use them, and people successfully flip properties and make money without ever having a single viable exit plan. People also successfully jump out of airplanes without a working backup chute, too, but that doesn’t mean that backup chutes are unnecessary and silly.
Moral of the story: have as many emergency exit plans in place before you buy as possible, as predicting the future is always hard and every investment has the potential to decline in value.
