Hold, Fold or Swap? Playing Your Hand in a Down Market
March 3, 2008 by bridgestohope
How do you manage your real estate investments when the market is falling? Most savvy investors relish a temporary down market; this is when they finally get the opportunity to distinguish themselves from the herd. When the red-hot bull market of real estate was beginning to overheat, you or your client did not have time to make considered decisions. Sellers were receiving multiple, over-asking-price offers. In a bull market, investors had to be quick, have money, and be a little foolish. Now that the market is cooling down, sellers are a little bit more humble. Today’s investors have more time to perform due diligence.
The evidence is clear that the market is well below its peak: foreclosures are at a ten-year high, and there is a glut of new properties entering the market, just as the market is softening. The people in the market who are suffering the most are the so-called “flippers”, the speculators, the overextended buyers, and those investors who took advantage of the no-money-down offers and 125% financing deals that were plentiful when the market was peaking. Finding these overextended speculators and negotiating deep-discounted transactions is one of the best strategies available during a market swoon.
Many investors find themselves at a crossroads and are faced with three potential choices: (1) sell quickly and cut losses before they become unmanageable; (2) employ holding strategies that minimize potential portfolio damage until the market turns back up; or (3) exchange or “swap” high-risk properties in a 1031 Exchange for properties that carry a reduced risk. The third option of exchanging is little-understood by most investors, but may also be the best strategy for those whose are feeling nervous about their portfolio.
Exchange Strategies. Take a look at your properties. Do you have multiple properties that have declined a little in value from their peak, or that you are struggling to finance? Do you own “high-risk” property such as condominium units, property that has been recently constructed or improved, resort area and vacation area property, or property that has gained a lot of value within the last 3-5 years? Most experts consider these investments as “high-risk, high-reward” properties. These types of properties are the most volatile – when the market swoons, they are the properties that are most likely to decline in value, and they generally give back their gains and then some very quickly.
Exchanging these high-risk properties for low-risk properties is the optimal strategy in a declining market. How do you find low-risk properties in a declining market? Look for the following types of investment property:
1. Commercial properties already under lease with stable tenants. For example, you could join other investors in purchasing a tenancy-in-common interest in a strip mall that has credit-worthy tenants already under a long tem lease. A major portion of this type of property’s value resides in the steady stream of income flowing from the current operating leases. Using Code Section 1031, you could sell your high-risk appreciated property that is currently costing you cash-flow dollars in a tax-deferred transaction, and through a “Qualified Intermediary”, purchase replacement property such as the strip-mall that provides you with a steady income stream. This income stream protects you from downturns in the market by guaranteeing a predictable return on your investment.
2. Foreclosure Property. Sell your high-risk property and go bargain hunting. Under Code Section 1031, you have 45 days from the date that you sell your property to identify your replacement property. You will want to do your research prior to the date that you sell your relinquished property, and you may identify up to three replacement properties of any value. Foreclosure property can be a great deal when thoroughly researched. You will also want to have your own inspector and appraisers examine the property before you identify it as one of your replacement properties.
3. Deeply Discounted Property. Contact 2 or 3 agents or brokers to search for properties that have been on the market for an extended period of time, and that have been discounted multiple times in order to sell the property. The sellers of these properties are often an emotional wreck by the time you speak to them, and they usually will make significant concessions in order to move their properties. Be sure to send your own inspector to the property— deep discounts sometimes exist for a reason. Exchanging your highly appreciated property for deeply discounted property adds a big margin of safety in a market downturn.
4. Properties in Other States. If your property is located in South Florida, Arizona, Las Vegas, Washington, DC or other high-flying markets, then you should consider exchanging into properties located in areas where growth has been steady and modest. These areas will not have seen such dramatic gains, and thus are less likely to suffer dramatic losses in a market downturn. You want to own properties in stable and predictable markets when real estate values are slipping. Using a 1031 exchange can also allow you to “tax shop”, and buy properties in markets that have low state income or real estate taxes. This can also keep your costs manageable in a down market.
Holding Strategies. Who should be holding their properties during a downturn? Holding strategies are for those investors who can afford the cash-flow costs of their properties. Remember that non-fixed mortgages are interest rate sensitive. In the early stages of a mortgage, rising interest rates can make monthly payments unmanageable. For example, in the early 1980’s, many new homeowners saw their monthly mortgage payments double when interest rates rose by 3-4 points. In many States, property owners were abandoning their property to the banks that held their loans. In a declining market, properties can fall in value below the mortgage payments, if you have not locked in a fixed mortgage.
If you have a fixed mortgage, can afford monthly payments and carrying costs, or better yet own the property without any debt attached, then you may want to hold your properties through the term of the decline. If so, you should consider the following strategies:
1. Lock in Credit-Worthy Tenants. In a declining market, it is very important to have stable tenants to protect your monthly cash-flow. If you have such a credit-worthy tenant, you may want to offer him incentives to sign a longer-term lease. One good way to do so is to tie an extended lease with property improvements, thus keeping the tenant satisfied with the improved appearance of the property, while also increasing the value of the property itself for potential future gains.
2. Look Hard at New Tenants. If you are getting new tenants, make sure that they are credit-worthy. Background check firms are now widespread. They investigate credit histories, asset holdings, and reputations as well as performing reference checks on potential new tenants.
3. Structure Leases Carefully. Unless your investment in the property is very small, you should have an attorney draft or review your lease with your tenants. You will want the lease to cover security deposits, damages to fixtures, liens on personal property kept on the premises, indemnification provisions, late charges, notification provisions if there is to be a non-renewal of the lease, and personal guarantees. Some leases even require that the tenant obtain a letter of credit from a financial institution to guarantee rent payments, defaults and damages to property.
4. Make Those Long Put-Off Improvements. Making improvements to your property that will bring increased value when the market re-heats up is a good idea during a down market. You will have an easier time finding affordable labor when new construction is idled, and adding such things as extra bathrooms or expansive kitchens will keep an older property up to date.
Selling Strategies. Who should be selling their properties during the downturn? Any investor who feels stretched to make his or her monthly mortgage payments on their investment properties should seriously consider selling at least some of their real estate investments. “Flippers” or speculators should get out as fast as possible in a falling market—their strategies are guaranteed to lose money quickly when property values move for a sustained period in the wrong direction. Other investors who should strongly consider selling are those who have experienced impressive recent gains that they want to protect, and those who could not afford their monthly payments if they were to suffer a financial setback such as being out of work for a few months.
When selling, it is important to keep several things in mind:
1. Keep your emotional balance. Do not to expect an extension of the supersonic price appreciation that some markets saw in the past couple of years. You are setting yourself up for frustration if you think, “last year, everyone’s house was worth 20 percent more than the year before, so why isn’t my house worth 20 percent more this year?” Most essential is that you cannot let yourself be paralyzed by the hope that prices will recover, desperately hanging on while prices continue to slide month after month.
2. Set Your Price Aggressively. Speak to several sales agents about the market. Are sellers generally getting their asking price? Or are they having to cut their asking price by an average of 5%, 10% or 15%? If you want your property to move quickly (and you should), you might want to price your property at a bargain level. In many cases, cutting your price from the start to appear as a bargain will get you multiple offers—and you may get the price you want by having buyers compete to buy your “bargain” property.
3. Spruce Up the Property. In a declining or nervous market, buyers will walk away because of dripping faucets, carpet stains, scuffed floors, damaged windows or other superficial imperfections. You cannot afford to see your property fall in price for several months just because you will not spend the money to fix all of its defects and detractions.
4. Research, Research, Research. In a bull market, the focus was for buyers to get their offer in as soon as possible, lest the property sell and prices rise too fast. In falling or nervous markets, buyers will be meticulous and they will comparison shop. Have your Realtor do a comparable assessment on your property; your buyer will do the same and you need to be better armed than he is. Look hard at recent sales, especially those that seem to be too low. Was that unit that sold at such a bargain purchased by a relative of the seller? If you don’t know, then the buyer is at an advantage when he asks why your price is not in line with the recent properties sold. You will also want to do your own inspection—the buyer will be doing one, and you want to make sure that his inspection will yield a clean bill of health. Having your property inspected by a thorough inspector may also prevent you from overlooking potential fix-up areas that will make your property more alluring with a minimum of investment.
5. Bend Over Backwards for Your Buyer. To get your price, you may have to make compromises. You can offer to pay the buyer’s points on his new mortgage in lieu of dropping your sales price a few percentage points. This allows the buyer to lock in lower monthly mortgage payments, and give the buyer a much needed tax deduction in his first year of owning the property (yes the buyer gets the tax deduction even if you pay the bill). If your personal financial circumstances warrant it, you may offer the buyer seller financing, or partial seller financing. This means that you will be receiving monthly mortgage payments rather than a lump-sum, but it also means you can negotiate favorable terms in the mortgage. Or you may agree to finance a portion but not all of the mortgage (be careful in such case, because your loan will generally be “second” to the bank loan).
Finally, if your personal investment situation doesn’t fall into the “Hold”, “Sell”, or “Exchange” categories, you may consider bucking the tide and buying when prices are falling. A declining market gives a potential buyer plenty of time to shop for the “perfect” investment, a luxury not available in a bull market. Taking your time and doing your homework has the added benefit of mitigating the emotional impact of your real estate investments.
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