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Choosing Capital Gains Over Rentals – Lessons Your Don’t Want To Learn First Hand
As the prospect of making capital gains from property appreciation is so tempting, it is easy to see why people are going crazy buying up highly priced properties.
Just look at the records.
Property prices in many developed markets have risen faster than the tide over the most recent years.
The profit you would gain from appreciation alone will cover negative cash flow, all related fees, and even an extra property agent’s commission if you feel charitable.
Optimistic property buyers actually expect appreciations of between 10 to 20 percent annually. And who can blame them.
We can hardly say that they have lost touch with reality as market data from recent years proved a point that even the most extreme of mythbusters cannot deny.
But if you barely cared about the price you have to pay for an apartment and the expected rentals you would collect, you are walking a very tight rope.
It is not a given that you will be able to sell your property in a few years at double the price you paid in the first place.
To avoid having a first hand experience with these bad scenarios that your mother warned you about, here are some things to think over and be aware of before investing in properties solely based on expected price gains.
1) You can never confidently expect prices to increase 10 to 20 percent each year
Real estate markets are cyclic and the only certainty is that the market will respond to each phase of the cycle.
When the only way you see yourself making money from your investment is through capital gains, you are carrying too much risks on your side.
It would be like placing all your money on a bet for a winner in a football match. There would only be one scenario in which you would win.
If you really see yourself as an investor, you would not put yourself in a situation like this.
Meaning there is very little upside remaining for market forces to fire up mass market condominium prices.
2) Rental income cash flow does not cover your expenses
So instead of living off your rental income, your apartment is actually living off you with negative cash flow.
The very least that you have to set as a target is getting enough rental to make up the costs of owning it.
The biggest cost is your mortgage liabilities.
If making negative cash flow is your strategy since you are looking at the bigger picture of capital gains, you are a speculator.
There is nothing wrong with that.
Just take note that you are playing a very dangerous game.
Taking into account the possibility of volatile interest rate fluctuations, it is best to keep a buffer cash pile of 6 to 18 months worth of mortgage payments in your bank account.
3) High leverage
You must think that if a billion dollar lender with credit professionals decides that you can afford a mega gorilla sized mortgage loan, you must be doing fine.
Well the thing is that they do not have any way to track your lifestyle expenses.
You might be able to manage mortgage payments in a constant world where nothing changes.
But we all know that that is not reality.
Prolonged vacancies, interest rate spikes and unforeseen high expenses can push you over the edge.
You might say that you can always sell off the property in that instance.
But when property bust occurs due to macro economic forces and setbacks, you face huge competition to sell your holdings at a good price.
Property prices tend to increase over the long term.
In this period of long term, it is subject to cyclic forces.
When you do not have enough cash to ride over down turns, you could be in deep financial trouble.
How to protect yourself
It’s not that you should take as low a loan as you can.
Just that when you do take up extreme or even creative financing for your property purchases, you have to anticipate down turns and have the resources to withstand them.
To manage the risks of over leverage and getting yourself into deep waters, you can do these to protect yourself.
1) Only buy properties being sold at bargain prices
When you can get a good discount from what the property is worth, you immediately build a buffer to withstand financial setbacks.
2) Buy properties that you can improve upon
You can often “force” appreciation with renovation, remodeling, creativity, etc.
When you look out for these properties that visually seem like it never got past the 1970s, bear in mind that location is a key criteria.
3) Buy properties with tenants paying below market rental rates
As rental is an indication of a property’s market value, a property with tenants paying below market rates will command a lower price.
You can take over these properties and revise the rentals upwards to reflect market rates when the current lease expires.
The higher rentals will help afford your high mortgage as well.
The irony of financing with lenders is that when times are good they lend out money like tissue paper. And when times are challenging, they hold onto money like gold.
So when you do forecast a down turn, refinance before lenders tighten their credit processes.
You can refinance for lower interest rates or stretch out the tenor to make monthly payments more manageable.
5) Bring in a partner
Properties are one of the most sort after assets.
It is actually very easy to get third party investors to take a piece of the pie.
It could be against your objectives to share your cash flow with a partner, but when you do require more working capital, consider raking in partners.
Your family members can be your first choice. If you are partnering with a company, consider setting up a company yourself for the partnership.