If the tempo of your real estate investing strategy feels something like running down a hill with scissors and hoping you reach the bottom before you wipe out I am worried for you.
Over the last eight years I have met hundreds of real estate investors who had this exact approach.
I don’t know if it is due to the emerging culture in many real estate investing groups, real estate coaches or investors having massive goals but it seems to be getting worse.
Many investors feel they need to purchase 100+ doors to reach their goals and more often than not they are taking on significantly more risk than needed. All investments carry risk and for most real estate investors** the goal should be taking as little risk as possible to reach your financial goals (with a healthy margin of error). This approach puts a heavy emphasis on defining your “why” and actively adjusting your approach over time.
An Example of Safe Real Estate Investing
A simplified example – Five rental properties purchased at $500,000 each would require $500,000 in down payment (20% down would be $100,000 for each).
If each of these properties rented for $2500 per month you could reasonably assume the following.
Over 30 years with an average annual appreciation and rental increases of 2.34% the value of your portfolio would be close to $5,000,000, fully paid off and would generate $300,000 in gross rents.
Assuming operating costs of 33% you would have an income of $198,000 (before taxes).*
Contrary to popular belief it does not take a massive real estate portfolio to make a meaningful impact to your financial future but it does (usually) take a long time! Personally I feel one of the biggest mistakes many real estate investors make is too much real estate.
A Look at the Current Real Estate Investing Environment
Over the last thirty years we have seen interest rates gradually decline from 14% down to lows of 1.5%. We know there is a strong correlation between interest rates and property values.
Now we are on the upswing with rates nearing the average over the last 30 years (5.78% – https://tradingeconomics.com/canada/interest-rate )
Unarguably real estate has had a great run and likely will be a strong asset class long term.
I would argue that many who benefit from the sale of real estate use the performance of the real estate market over the last 30 years to push real estate investing. While I think real estate investing can be lucrative I do not believe it to be risk free, guaranteed or something you should invest all of your wealth into.
Rather real estate should be something you use to compliment your overall investment strategy.
I’ll save my rant for another day but please be cautious and do not get caught up in the hype!
For those that do invest in real estate (which I do as well) I would suggest an alternative to the “run down hill with scissors” approach.
Real Estate Investing Guidelines
Here are a few guidelines to follow and adapt based on your own goals.
Maintain A Reserve Fund
Try at all times to maintain a reserve fund to minimize the risk of cash calls, vacancies, rising rates etc. As your real estate portfolio and total debt grows you should increase your reserves. As a target I would suggest 3-6 months of expenses for your portfolio.***
Maintain A High Standard for Potential Investments
When your total financial resources are low, have an incredibly high standard for potential investment properties. As your total resources increase (more cash/HELOC room) gradually decrease the standard you are looking for (down to a certain minimum standard).
Be Cautious With Your Reserve Fund
It is ok to dip into your reserve fund for the right deal but be cautious about this. Don’t let cash burn a hole in your pocket, big picture there is no shortage of opportunities but always a shortage of cash! Real estate investing is a marathon, not a sprint.
The above graph demonstrates the following – 1) When you are below your minimum cash reserve the only property you buy should be a 10/10. 2) Once you have more cash than your minimum reserve you can gradually reduce the quality of property you are looking for. 3) Once you have enough capital to purchase the property and maintain your minimum cash reserve you look for your minimum property criteria (maybe an 8/10) This will vary from investor to investor.
Diversify Your Investments
Diversify! No buying detached houses, condos and townhouses in three different markets is not diversifying. Nor is self directing your RRSP’s into private lending or investing your pension into development projects. Real estate (through all avenues of real estate investing) has a great track record and strong potential but it faces some very serious risks. I strongly suggest you investigate other non real estate related investing options as well and consult a professional adviser.
Investing With Vision
Overall your investment strategy should be based on your long term vision and goals. I suggest having a financial target or the point where extra money has minimal value to the quality of your future. Once you are conservatively on-track to reaching these goals focus on minimizing your leverage (risk).
Where am I coming from with these suggestions?
Imagine if you own $5,000,000 in real estate and have $4,000,000 in debt. Your total cash reserves are $225,000.
You are now considering purchasing another $1,000,000 property using $200,000 of your reserves as down payment. This would reduce your reserves down to $25,000.
Let’s consider the possibilities.
Positive Market Scenario
Real Estate does really well and goes up 10%
No extra property – Your net worth improves by $500,000.
Extra property – Your net worth improves by $600,000 (a 20% improvement to your upside)
In the positive scenario without the extra property you do really well, having an additional property increases your upside but only by a marginal amount. In other words, a significant win becomes a slightly better win.
Negative Market Scenario
Real Estate does poorly, interest rates rise and you have multiple vacancies.
No extra property – You have $225,000 in reserves to cover additional costs and have the luxury of riding out a bad period in the market. Even with negative cash flow you may have the ability to carry your properties for years. If you need to sell you have the ability to plan a “soft” landing and choose the time you sell (IE spring market, renewal date to avoid penalties ect).
Extra property – You have $25,000 in reserves. If your mortgage payments increase by 25% you may have as little as 5 months of carrying costs. If you encounter a few vacancies you may have under sixty days before you are missing payments.
In the negative scenario without the extra property you have the luxury of choosing your next steps. You may be able to adapt your strategy, cut costs, or lower your mortgage payment by extending your mortgage (all of these options take time which means you need money to carry the loss!). Ultimately having the extra reserves allows you to think and choose how you deal with the situation.
With the extra property you are in trouble. Very quickly you could be forced to sell properties, take on expensive loans or face missing payments and destroying your credit. Due to your minimal reserves you are not in control of the situation and are forced to react quickly. This could result in additional mortgage penalties, selling at a loss, selling at a bad time in the market ect.
Take away – For an established investor an extra property may only improve your best case scenario marginally but magnify your worst case scenarios exponentially.
Investing is about managing risk and I strongly believe that it is best to think long term, plan ahead, diversify your investments and to have a “slow is steady, steady is fast” approach.
If there is anything I can do to help or support you please do not hesitate to reach out, I am happy to refer you to financial planners and accountants as well.
*This example does not factor in closing costs, carrying costs etc.. It is intended as a simple example to show that it does not take a massive real estate portfolio to generate a large asset base and strong cashflow over 25 – 30 years.
** Newer real estate investors should be extremely cautious and focus on keeping their risks minimised. As your skillset and experience grows you can determine what risks are worth taking.
*** This is a rough guideline, the age of your properties, location, total leverage you have and other liquid assets will influence what the right contingency fund is for you. If you have questions or are unsure reach out and I’ll do my best to help you.