I’ve heard a lot of talk lately about an impending market crash that is coming in the next couple of years. Consequently, I’ve heard a lot of people asking, “What impact will a crash have on me as an investor and/or what can I do in preparation for a crash?”
I can only speak and educate in regard to rental properties because those are all I have working knowledge of. Answers to those same questions may vary for flipping and other types of real estate investments.
In no particular order, I’m going to bring up several different aspects involved with a market crash and address how each may be impacted—and possible ways you can help mitigate risk with each, as applicable.
Here goes! Again, these responses are specific to rental properties. They may also apply to other investment strategies, but you will have to assess that for yourself.
6 Property Factors Associated with a Real Estate Market Crash
1. Property Value
I cannot say this enough—property values only matter if you are buying or selling a property! This would include refinancing as well. But let me say that again—property values only matter if you are buying or selling a property (or refinancing)! The most common thing I heard during our last crash was how many people were freaking out and selling their properties just because. This was more often primary home buyers than investors, but it’s still worth putting out there. People were panicking when their houses went “underwater” and felt more comfortable selling the house in order to—I’m actually not sure what. There were some cases, of course, where people lost their jobs to such a severe degree that financially, they were forced to short sell their house or sell it while it was underwater. This is not the case I’m referring to. I’m referring to the case where people were selling simply out of pre-emptive panic.
I feel like I should say this, again, one more time—property values only matter if you are buying or selling a property! Since buying a property isn’t so much of a threat, I can focus primarily on the owning and selling aspect. If you own a property and the market crashes, the crashed value of your property does not matter unless you try to sell or refinance the property. So, an easy solution would to not sell or refinance your property during a crash. There are a couple factors that I will get to in a minute that can affect whether or not you might be forced to sell your property, but outside of those, just know that there really is way less reason to worry about the value of your property than most people seem to think. First step—don’t panic.
2. Debt and Loans
Just as I say “don’t panic,” people immediately think of leveraging and panic. Leverage is quite often the major player in the panic game during a crash. Being leveraged means you have a loan, likely a mortgage, on the property. Unfortunately, loan payment requirements don’t stop or change with the market, so it makes sense that this is a primary source of panic because regardless of anything on your property, you owe the bank (or whoever) money every month. If you don’t pay it, you can lose the property. Whereas if you own a property outright, meaning you don’t owe a bank or anyone a loan payment every month, you may have a lot more room to maneuver without major financial implications.
Related: 3 Important Points to Remember When Considering a Potential Real Estate Crash
One common thought during an impending crash surrounds how much someone should be leveraged—maybe 65% loan-to-value (LTV) or 75% LTV or something. Personally, I don’t think any particular number is better than the other because no one can say for sure what the implications of the crash will be (see upcoming note about speculation). I think the only rule that should absolutely hold true is to hold to whatever LTV you are personally comfortable with. Some people aren’t comfortable with any debt (0% LTV), and people like me are comfortable with maximum debt. I will address later some ways to help you survive having debt, should you need it, but there really is no right or wrong answer—you just have to be where you are comfortable.
With that said, there is one major precaution about debt and loans that everyone should be extremely clear on when it comes to fixed-rate loans versus adjustable-rate loans. I don’t know that I have ever heard of any major problems during a crash with a fixed-rate loan. I have, however, heard of a tremendous number of financially devastating problems with adjustable-rate loans, also known as “ARMs.”
Here’s a scenario—you buy a property with an ARM with a 6% interest rate. The property cash flows decently. The market crashes. Then your ARM jumps to a 10% interest rate. Now you are suddenly stuck with negative cash flow each month. Because of the crash, the value of your property has tanked, so you can’t refinance to help make up for the monthly cash flow loss, and you can’t sell unless you are willing to take a significant loss. You are now paying out-of-pocket on the property every month, and depending on your job and/or savings situation, that may only be feasible for so long. You eventually can’t make the payments, and you end up short selling or foreclosing because you have no other choice. Now, how would all of that have been different with a fixed-rate loan? Assuming the rents didn’t decrease dramatically with the crash, your interest rate never changes on the loan, and the rents continue to cover your expenses. The difference between 6% and 10% doesn’t sound like a lot, but trust me, it can mean the difference between profit and loss when it comes to cash flow. There are some factors we could still discuss related to this, but for now, understand the significant risk you are taking on if you go the ARM route. Remember, ARM rates don’t care if there’s a crash or not, and they can be ruthless on interest rate changes with no second thought given.
Now, assuming you’ve handled the other crash factors appropriately, this is the only one that can really cause you problems. While the value of your property decreasing doesn’t really matter, if rents decrease during a crash, that can matter. If you own a property outright, you can probably get away with a significant decrease on rents. If you have a mortgage on the property, a decrease in rents may very quickly put you into the same scenario as I…